Before the financial crisis that began in 2007/08, the world’s central banks’ principal, and often sole, responsibility was price stability.
However, since then their remits have broadened out to include a range of socio-economic targets, such as employment levels, interest rates and inflation, challenging traditional FX strategies, says Marc Chandler, global head of currency strategy for Brown Brothers Harriman (BBH), in New York.
As a corollary of these, he adds, many of them, particularly those of G10, have been engaged in “smoothing operations” of FX volatility since the crisis, sometimes working in tandem. This explains why – even during the recent “mini blow-up” in EMs – the global Volatility Index (VIX) still only stood at around the 21 level (briefly), relative to its 20-year average of about 20.50, and indeed has spent most of this year trading below 13.
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Jane Foley, senior FX strategist for Rabobank in London, says: “Across the G10 currencies as a whole, the past year has seen volatilities drop markedly, with one or two exceptions, so the opportunity to generate revenues for traders dropped significantly as a result.”
Having said this, there are still opportunities to ride momentum strategies on some volatility plays, both in the EM arena and in some developed markets too.
Eric Viloria, currency strategist for Wells Fargo in New York, says: “Part of the reason for the ongoing lower level of volatility in many of the developed markets (DM), especially those in G10, is the increased level of policy transparency in the adjunct countries through forward guidance, which has meant that the corollary currencies are less prone to policy shocks.
“However, in many of the emerging markets, there is less forward guidance, therefore less transparency, and therefore a greater propensity for increased volatility.”
This tendency towards greater volatility has been further compounded, he concludes, by the lower level of liquidity flows that has occurred in the past few months. This is partly as a consequence of tapering quantitative easing by the US Fed, reducing the pool of money looking for higher-yielding currencies, together with apparently improving economic prospects in a number of DM countries, causing a shift in sentiment to the detriment of the EM world.
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In this context, although EM FX and wider risk-appetite has stabilized in the past week after the recent large position liquidations, it is probably wise at this point to exercise caution over the near-term volatility in EM FX as an asset class, according to various analysts.
“Arguably, the re-correlation of EM FX volatility with equity volatility is a return to the pre-crisis period when EM was priced in line with riskier assets, rather than developed market currencies,” says Chris Walker, FX strategist at Barclays in London.
In fact, he adds, the pre-crisis implied volatility of high-carry EM FX was priced and consequently traded largely in line with implied equity volatility (see Period 1 of the chart below).
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However, after the crisis, and partly as a function of steady portfolio inflows (see Period 2 in the chart above), both the absolute level and the volatility of implied EM FX volatility declined closer to the levels seen in developed market FX. Effectively, the risk premium in EM FX was being priced closer to that of G10 FX rather than equities.
“The recent rise in EM FX volatility [see Period 3 in the chart above] may thus represent a normalization to the pre-crisis period when EM FX was generally priced as a riskier asset,” says Walker.
Indeed, the chart below shows this difference between levels of the VIX and high-yield EM FX (HYEMFX) volatility versus the difference between HYEMFX volatility and G10 FX volatility.
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Walker concludes: “The level of the latter – that is, the level of implied volatility in HYEMFX above G10 FX – volatility rose last summer and has drifted higher since, consistent with normalization, rather than spiking higher as it has done in crisis periods.
“So, amid a gradual withdrawal of global liquidity, EM FX volatility may remain at elevated, pre-crisis levels.”
It is not just region-specific political and economic developments that drive EM FX volatilities, with much of the trajectory coming from the DM world, which, in turn, will also drive volatilities in DM FX.
This week, for example, volatilities spiked notably ahead of Tuesday’s first semi-annual testimony of new US Federal Reserve chair Janet Yellen to the House Financial Services Committee, says Geoffrey Yu, FX strategist for UBS, in London.
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“Unsurprisingly as well, cable volatilities for Wednesday expiry were even higher when the Bank of England was due to announce an overhaul of its forward-guidance framework, the first edition having been rendered obsolete by the faster-than-expected decline in the unemployment rate,” says Yu.
In general terms, says George Saravelos, FX strategist for Deutsche Bank (DB) in London, only a limited number of variables do a good job of explaining realized volatility across most exchange rates. These are: the US unemployment rate; US industrial production – which accords with this week’s Yellen volatility spike, for example; and changes in commodity prices and equity valuations.
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“Better growth or higher commodity prices lower volatility, but higher stock-market valuations are associated with higher volatility, and we also find that better current accounts in the US – and Europe – lower realized volatility, but the sign is unstable across other currencies,” he says.
More specifically, he adds, in the leading G10-currencies area:
· for EUR/USD, higher European or US current accounts depress volatility, as does higher US industrial production and employment;
· for USD/JPY, higher Bank of Japan target rates, more expensive US stocks, and a larger Japanese current account all lead to higher yen volatility, whilst conversely higher US inflation and commodity prices lower volatility;
· and for GBP/USD, higher US unemployment, higher volatility of UK data, better FTSE performance and more expensive equity valuations all lead to higher volatility in sterling, whilst, in contrast (such as for the yen), higher commodity prices depress volatility.
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For other currencies, in the meantime, such as the Aussie dollar, which has been seen as a heavily commodity-price-driven currency, higher commodity prices and US industrial production depress AUD/USD volatility, whilst US data volatility, Australian GDP growth and the S&P 500 cyclically adjusted P/E ratio are all positively related to AUD/USD volatility.
In practical terms, though, and even before the run-up in EM FX risk recently, Saravelos adds that, in broad terms, volatility is fairly valued in terms of DB’s macro models, and cannot identify any exchange rate where realized volatility exceeds the model prediction by more than one standard deviation.
“Within the detail, EUR/USD volatility appears too low, so this is where we would be most comfortable buying volatility, and USD/JPY volatility is too high, but Abenomics and the ongoing regime shift in the Japanese economy likely deserves a risk premium that is not captured by our models,” he says.
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Saravelos adds: “In sum, buying FX volatility is one of the best hedges against a growth recession, but if one is bullish on the outlook, one shouldn’t expect too much of a rise in volatility, even if FX trends pick up, and options should therefore remain a cheap way of expressing directional views in currencies.”
For less option-centric strategies, concludes BBH’s Chandler, one enduring winning trading strategy of the previous couple of years, which might well have further to run, is mean reversion, and particularly that based on volatility, not FX pair levels per se.
“Non-directional term-structure volatility strategies geared towards reversion to the mean have provided sound returns in this new central-bank-managed FX environment,” he says.