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Own FX vs rates vol: cheapen USD call with rates strangle We like owning USD calls against selling US rates vol. In particular, we recommend buying a EURUSD 3m 1.05 put for US$100 pips (off 1.0730 spot), partially financed with the sale of US$100mn 150bp-wide 3m30y strangle (sold at USS$600k). While potential fiscal stimulus has already been priced into rates term premia and rates volatility to some extent, it is not sufficiently priced into the FX market, in our view: « Rates skew in gamma on long-tails has moved decisively for payers, while EURUSD skew is just beginning to price in higher US rates (Chart 59}. This suggests to us that the market may already be partially protected against higher rates in the long- end, such that a further selloff may not see as strong a rally in gamma on long-tails. « On the other hand, a further rally in the USD may catch investors under positioned and result in greater volatility in the currency markets. ¢ Aprincipal component analysis of rates (US, EUR and JPY) and FX vols highlight that US rates vols and USDJPY vol are expensive, while 3m10y vol in EUR and JPY are cheap, along with EURUSD vol (Chart 60). While the cheapness of 3m10y vol in EUR and JPY can be explained by expectations of QE expansion in the two regions, we think that there is value in owning EURUSD vol. From a terminal rates perspective, we are comfortable selling a 150bp-wide strangle for the following reasons: « We believe the result of the elections are a game-changer for the outlook on the US economy. As such we have probably entered a new regime for US rates whereby we are unlikely to retest the historical lows in 30y rates recorded in Aug-16 (1.67%). This suggests little downside in selling an ATM-75bp receiver (1.66% strike). « Inascenario where US rates sell-off, USD is also likely to strengthen. The positive correlation between US yields and the USD has returned due to expectations for fiscal stimulus boosting economic growth. Furthermore, we would also argue that a substantial selloff in US rates, accompanied with USD strength may be self- defeating as it would put pressure on emerging markets and risky assets, thereby resulting in a flight to quality bid for USTs. The risk is that of large foreign reserve selling by EM central banks, putting upward pressure on US rates and downward pressure on the USD. Chart 54: FX vol just beginning to price impact of higher rates Chart 55: Residual of FX and rates volatilities based on a ly PCA (*) FX Option BofA-Implied Volatility and USD Swaption-Normal Implied 8 4 6 244 4 2.04 2 144 Et E 0 12 a 2 4 044 6 s fF SS SF SF SF GF S| aay I 1 1 1 1 I 1 eas Ry g os os es es ri gs 17NOV14 16FEB1S 1SMAYIS 17AUGLS = 16NOVLS 15FEB16 L6MAY16 1SAUG16 = 14NOV1L6 59} Ss S ~~ PayerReceiver (bp) (2nd axis) — = EURUSD (a) Ss S$ S S } } Source: BofA Merrill Lynch Global Research (*) payerReceiver = 3m30y S0bp OTM payer vol: 50bp Source: BofA Merrill Lynch Global Research(*) Residuals derived from the first 2 principal OTM receiver vol. EURUSD = 6m 25% OTM EURUSD put vol 25% OTM call vol. components of FX and rates volatilities - based on a ly Principal Component Analysis. Bankof America 30 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014760