JPMorgan’s notes on dollar versus basket of euro, sterling, yen play out dollar rally momentum

By Emma Trincal

New York, May 18 – Just as the U.S. dollar is hitting new highs against major currencies, JPMorgan announced a note whose returns are linked to the appreciation of the greenback against the currencies of the euro zone, the U.K. and Japan. For some, the trade makes sense from a fundamental point of view. For others, the bullish momentum on the dollar is overdone. All agree however that the terms of the structure are compelling.

JPMorgan Chase Financial Co. LLC was set to price 0% notes due May 18, 2020 linked to the performance of the U.S. dollar relative to an equally weighted basket of three currencies, according to a 424B2 filing with the Securities and Exchange Commission.

The basket return increases as the U.S. dollar appreciates relative to the basket of the three currencies.

The basket consists of the euro, the British pound sterling and the Japanese yen. The spot rate will be expressed as a number of dollars per euro or pound and as a number of yen per dollar.

The payout at maturity will be par plus the additional amount, which is equal to 242% of the basket return, subject to a minimum payout of par.

Bullish

The notes are a bullish bet on the U.S. dollar. The dollar has appreciated this year against all three currencies.

For the year to date, the greenback is at its highest against the euro with a move of EUR-USD from 1.25 in February to 1.17 today.

The same is true for GBP-USD, which went from 1.44 a month ago to 1.35 on Friday.

From a low in March, the Japanese yen has strengthened against the U.S. dollar as well.

Terms

“That does sound like an excellent deal, even though it is being released at a time when the U.S. dollar is likely to drop significantly during the upcoming year before probably rallying strongly the year after,” said Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments.

Investors need to evaluate the structure of a note and the underlying outlook. While Kaplan is not bullish on the dollar short-term, he said the structure did a lot to offset some of the mistiming.

“You’re getting back your money at maturity. You don’t have a cap and you have this multiple on the upside,” he said.

“The only risk is the opportunity cost. But given the structure and the protection, it’s a risk worth taking.”

Fund flows

As for his market view on the dollar, Kaplan was more neutral, saying that timing was key ahead of an impending recession.

Looking at fundamentals and avoiding, as a contrarian, overcrowded trades, he said he was expecting a correction in the dollar within the next 12 months.

“The dollar is at its highest point of the year against those currencies,” he said.

“Part of the reason is that emerging markets have done poorly. Money, which was previously invested overseas, is flowing back into the U.S. People are exiting Brazil, India and Mexico, causing the dollar to move higher.”

Big Mac

As a fundamental investor Kaplan uses the “Big Mac index” to gauge the “correct” level of a currency.

Invented by the magazine The Economist in 1986, the index compares the price of the same burger in different countries. Based on the theory of purchasing-power parity (the same ingredients are used everywhere), the index compares the average price of a Big Mac in different places in the world. A country with the lowest price for a burger will be seen as having an undervalued currency compared to countries where it costs more.

“The price of a Big Mac in London, after Brexit, is cheaper than it is in New York,” he said.

“In Zurich, the price of the burger is the lowest. That’s why I have been buying a lot of Swiss Francs lately, in fact every day this week.

Before and after

Kaplan’s view on the dollar versus the three currencies composing the basket moves in two steps.

At first he sees the greenback in correction territory for about a year. The second year however a recession should contribute to a bounce back.

Many assume that a currency is strong when the economy is robust.

Kaplan disagrees.

“The dollar tends to be strong in recessions. I know that’s not what we’ve been taught in school. But look at recent examples,” he said.

“In July 2008, the dollar was close to an all-time low and the economy was strong. In March 2009, it was at multi-year high and we were still in the depth of the recession.

He explained the reasons behind this inverse relationship between the economy and the currency.

“When rates go down, it usually means the economy is slowing down. That’s when the dollar becomes a safe haven. It’s the flight to quality that pushes up the dollar,” he noted.

Since Kaplan’s outlook depends on the timing of a recession, which he sees as unavoidable and looming, he had reservations about the sustainability of the current dollar rally.

“I don’t think it has legs,” he said.

“The dollar has been going down a lot in 2017. This year it’s up significantly. People are following a crowded trade. I’m skeptical about trends when they become too popular.

“I prefer to look at fundamentals like the Big Mac. People are not buying the Big Mac as a trade.”

Missing one year

Kaplan expects a “worldwide recession” within the next year.

“It’s impossible to know when but my guess is that we’re looking at somewhere next year around the spring or summer,” he said.

“That’s when the dollar will recover.

But between now and then, he expects the dollar to drop.

“That’s why I like the notes but not the timing of it.

“It would have been great a year ago. With this note, you’re kind of wasting the first year,” he said.

Hedging is optional

Kaplan still likes the trade. He usually hedges his bet, but the protection incorporated in the note may not warrant the cost.

“It’s still a good trade and given the terms there is no need to hedge it. However, if you need to hedge you can buy the currency funds for the three currencies in the basket,” he said.

The hedge components could vary. Kaplan said he would probably use the Swiss Franc exchange-traded fund rather than Japan.

“I would buy the weak currencies for that first year when the dollar depreciates. As soon as we see signs of a recession, it’s time to switch and abandon your hedge. The dollar at that point will recover.”

Europe in crisis

Juan Perez, senior foreign exchange trader and strategist at Tempus Inc., agreed with the underlying theme of the notes but more as a euro bear than a dollar bull.

His timing however was different from Kaplan’s.

“I’m bullish on the U.S. dollar. Two years is a big commitment but for next year I certainly see the dollar continuing to appreciate.

“I don’t look so much at the U.S. I look at Europe. To me, it’s not so much about the strength of the U.S. economy. It’s more about structural and political problems in Europe,” he said.

Last year, he said, the situation was in reverse: the major currencies were recovering against the dollar.

“The perception was that Trump was actively campaigning for a weaker dollar in order to encourage stronger exports.”

But this perspective faded this year after Europe appeared weaker than previously thought, he noted.

“In 2018 the reality of Europe and the U.K. started to become more obvious.”

He pointed to the “Brexit uncertainty,” “Italy becoming a big problem” and “political risks” in general.

“Next year we need to watch out how the euro zone deals with the possible implications of the anti-establishment sentiment,” he said.

“With Brexit, the U.K. has created a major headache by voting itself out of one the world’s largest economies. It’s a much bigger issue than a Donald Trump renegotiating trade agreements.

“I wouldn’t bet on a stronger euro.”

Pricing

A currency structurer said the terms were appealing in part because the notes take the opposite view of the futures market. High interest rates were also a factor at least for the capital protection.

“These are very good terms,” he said, pointing to the full principal-protection over two years.

Higher interest rates facilitate the pricing of zero coupons, which are the foundation of the full principal-protection.

“It makes sense. Dollar rates are higher. You have some funding to pay the optionality,” he said.

A key pricing factor was the forward.

“The dollar is a high-yield currency against the three others in the basket,” he said.

“In the forward space, high-yielding currencies depreciate. If they didn’t there wouldn’t be arbitrage.

“The note takes the opposite view. That’s how it gets priced.”

Common knowledge

While not particularly bullish on the dollar, he said the fundamentals of the trade were sound.

“It’s a view about the U.S. economy. Rates are higher because of a pickup in inflation. And why inflation? Because the economy is strong,” he said.

“These are the premises of the trade: a good economy, higher interest rates and a strong stock market.”

Yet this logical approach did not reflect his personal outlook.

“I think the dollar will weaken against the euro,” he said without elaborating.

“In terms of structure, it’s very attractive: short, good leverage, no cap, full protection.

“If you’re bullish on the dollar, it’s a very good trade.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will settle on Monday.

The Cusip number is 46647MRR6.

© 2015 Prospect News.
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