1. We have observed a significant positive correlation between foreign exchange (FX) and emerging market (EM) local bond yields. This correlation arises from hedging costs, which can be inferred from the FX forward basis. However, with the recent decline in the basis and the growing interest rate differential between developed and EM markets, this correlation is deteriorating.
a. We can develop models to predict the timing and probability of rate hikes or cuts. These models can help forecast differential projections, which can be utilized for trading FX pairs, given the strong relationship between interest rate differentials and FX flows.
2. With encouraging inflation data, the leveraged loan market is experiencing an upswing. Market projections after the July meeting indicate no further hikes, thereby enhancing the prospects of the leveraged loan market.
3. The upcoming week will witness earnings reports exceeding $25 trillion, along with policy decisions from nearly all central banks. These events make the markets, especially volatility trades, a compelling proposition. Given robust employment figures in the U.S., the Federal Reserve is poised to raise interest rates to a 22-year high.
4. The Euro, after weeks of rally, is now trading at its all-time high. This situation adversely affects its competitiveness against Chinese exports due to the longest tightening cycle in the EU. Investors perceive it as overbought and, without corresponding growth, anticipate a steep decline.
5. What indicators suggest a soft landing?
a. Consumer price increases have slowed to 3%, potentially the lowest in over two years.
b. The job market remains strong.
c. However, achieving the target 2% from the current 3% may be challenging, as the significant drop can be attributed to the Russian conflict and oil rally, both of which are now resolved.
6. Emerging Market Bonds:
a. Returns can be segregated into duration, FX, and carry. Interestingly, all three aspects have contributed positively to EM local debt this year.
b. The market-implied interest rate and FX forward rates predict a return of -1.38%, suggesting the carry must surpass this to generate net positive returns.
c. EM distressed debt emerged as the standout performer this year, with year-to-date returns of about 28%.
7. Carry Trade with EM currencies:
a. The Bloomberg FX Carry Trade Index yielded a 4.8% return this year, marking its best performance since 2017.
b. Major banks are considering the addition of more exotic features to FX options for trading the interest rate differential.
c. An intriguing strategy involves borrowing cheaply from the accommodative regime in China and investing in the tightening regime in the U.S., thus profiting from both interest rate differentials and FX movements.
d. What is the rationale behind choosing options, and how do they assist?
i. The key objective of a carry trade is to capitalize on the non-convergence of the spot to the forward FX rate today. This can be exploited by implementing a Put spread - buying the forward strike Put and selling the spot strike Put. If the spot converges to the forward rate, it reduces our profit, but if it remains below or at the current level, we earn the complete forward-spot differential at day 0.
ii. However, trading vanilla options on EM currencies can be costly, so we can utilize USD as an intermediary. For instance, if we wish to carry CNH/MXN, we could place an upside barrier on USD/CNH and a downside on USD/MXN. This method proves to be more economical than trading the cross directly.
8. In an intriguing announcement, the Bank of Japan signaled a loosening of its control on the yield curve, coupled with lower inflation projections. This news led to a 1% intraday decline in the USDJPY market.
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