Goldman Sachs on Fed (FX Options Trading) - FJElite

We expect USD to catch back up to real rate differentials in G10. Short GBPUSD (short-term) + Long USDCHF (medium-term) in options is favoured trade.

Heading into Warsh’s inaugural FOMC meeting, the US Dollar was arguably held back by 'credibility premium.' This was reflected in gap to rate differentials. The market thinking was that the asymmetric risk was a potential dovish tilt, under the assumption that Warsh would look through short-term inflationary pressures to let the economy 'run hot’ We got almost the opposite - the dots were more hawkish than expected, whilst Warsh made INFLATION the over-riding topic of this press conference. Little mention of employment side.

There was a ‘wedge’ between EURUSD and 2y real rate differentials (Chart 1). With the FED pivoting to a potentially more orthodox reaction function, we could see this ‘credibility premium’ in the USD begin to erode (EURUSD converge to real rate moves). Real rates have also moved back to wides. The USD is also now threatening to break out of YTD ranges, having taken out 50d/100d/200d MAs last month. These coiled, tight ranges in the USD have created apathy in the FX Options market and G10 vols still sit on the lows despite the potential for a larger breakout in the USD.

For shorter-dated expressions we favour GBPUSD downside - we’d keep expressions simple and buy 1m 25d puts at 6.95v