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Less than a week before the all important Fed decision, and there seems to be a mix of tension and confusion in markets.

What’s going on? The team at BNP Paribas try to explain:

Here is their view, courtesy of eFXnews:

Currency market participants have returned from their summer breaks to a challenging market environment as the  fragile risk environment has complicated the outlook for G10 FX market, notes BNP Paribas.

“While these cross-currents in financial market are proving difficult to navigate for market participants, in foreign exchange markets we have the advantage of being able to trade monetary policy divergence, rather than simply expressing a view on individual central banks,” BNPP argues.

Against this backdrop, BNPP favours trades which will benefit (or at least not suffer) in the following circumstances.

1- Perform well if the risk environment improves, perhaps helped by stimulus measures in China, allowing the Fed and/or BoE to deliver rate hikes sooner than the market is pricing in.

2- Perform well if the Fed and/or BoE hike rates despite the fragility of financial markets, adding to market stress.

3- Perform well if the risk environment detiorates again, preventing the market from pricing in Fed and BoE rate hikes.

What is the trade? According to BNPP, the framework above suggests:

“1- Maintain exposure to the USD and GBP to benefit from a strengthening in the currencies on a renewed rise in Fed and BoE rate-hike expectations if the risk environment improves further or central bankers sound hawkish.

2- Avoid running short cash positions in funding currencies of current account surplus countries (such as the CHF, JPY and EUR), which could experience squeezes if risk sentiment deteriorates again.

3- Run short positions in non-funder currencies of central banks with scope to ease policy further in response to continued deflationary pressures: the NZD, CAD, AUD and NOK,” BNPP advises.

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