This year so far has been characterised by weak correlation between rates and FX as a consequence of ECB and BoJ QE. A re-rating of Fed hike expectations will temporarily disrupt the broader trend of global rebalancing away from the dollar. AUD/USD is a good example of this breakdown in rates-FX correlation; AUD has risen for two years despite the erosion of its 2y-yield advantage over the US, which has now turned into a discount of -50bp. On a previous occasion when the advantage turned negative, in 1998, the force of gravity eventually pulled AUD lower. The risk of a repeat has increased, and AUD/USD downside remains cheap.
The implied volatility curve is relatively flat, and AUD/USD puts are relatively cheap. As the effects of the US government's fiscal stimulus become clear later in the year, and as the Powell Fed continues along its policy path, FX volatility should also rise. With Australia's yield advantage eroded, any change in dollar dynamics may have an outsized impact on AUD/USD compared to other G10 currencies.
We buy an AUD/USD 20th Dec 0.75% put, and fund it by selling a 6-month put of the same strike for net cost of 58bp.
AUD fell 5% vs USD more rapidly than we had anticipated. We closed the trade on 20 June 2018 for a profit of 27bps.