JPMorgan warns on FX market complacency

The bank says several developments suggest investors have been too quick to ignore the possibility of further turmoil on the world’s financial markets and have become over-confident on the outlook for the global economy. It notes positions in the haven of the USD have dropped from record long to flat, FX volatility has fallen too much for the current cyclical environment, vol premiums have evaporated in FXand equities, while the dollar has become cheap versus the majority of currencies.

JPMorgan says those developments suggest either the global economy is more resilient – and policymakers more competent – than presumed or risk is mispriced.

Paul Meggyesi, managing director FX strategy at JPMorgan, believes the latter, and that there is complacency in the FX market towards the economic and policy risks that are likely to feature more prominently as summer draws to an end.

Those risks include the US heading towards the “fiscal cliff”, uncertainty in Europe over aid decisions for Greece and Spain, as well the European Central Bank’s role as a backstop for sovereigns, and worries over the lack of policy-induced growth in China.

Meggyesi admits that none of the risk factors are particularly new and there are not immediate trigger events associated with any of those issues to spark a crucial near-term re-pricing of risk.

“Still, neither familiarity nor the absence of near-term triggers justifies the almost complete absence of risk premia in the FX market, as evident in stretched spot market valuations – overvaluation of cyclical currencies, undervaluation of the dollar – and the compressed level of FX volatility and option skews,” he says.

JPMorgan recommends holding a basket of moderately defensive, largely option-based trades to profit from the over-confidence in the market, holding long USD and JPY positions versus commodity-linked currencies and EUR.

Specifically, the bank’s macro FX portfolio holds a $1.01-$1.03 AUDUSD put spread, a C$1.01-C$1.03 USDCAD call spread and a $1.22-$1.19 put spread in EURUSD.

This article was originally published by EuromoneyFXNews.