FX volatility: calm before the storm?

Short-dated implied volatility is at, or close to, year-to-date lows for many currency pairs, including US dollar pairs with sterling, euros and yen.

While this might be unsurprising, given the usual summer lull in trading and market relief after the resolution of sorts of the recent Greek drama, it is notable in the context of increasing anticipation ahead of a possible US rate hike in September, its first since June 2006.

This week, Dennis Lockhart, the president of the Atlanta Federal Reserve, indicated he would vote for a rate rise in the absence of any negative surprises in US data ahead of the vote, bringing the prospect of the tightening cycle a step closer.

Jens Nordvig, head of currency strategy at Nomura, believes the upcoming economic data releases in the next three weeks, particularly non-farm payrolls, retail sales and CPI, will determine whether the Fed does act next month.

The market seems to be preparing for action. One measure of the probability of the Fed move is the spread between the rolling first and fourth Fed funds futures contracts, which implies a current 45% probability of a September hike, says Nordvig.

However, given such a significant possibility of rate rises, suppressed volatility suggests an insufficient volatility premium, says Nordvig.

Whatever the reason, it is unlikely to last. If the Fed does hike rates in September, it could trigger volatility across the currency markets, but it is likely to increase ahead of the decision, particularly if the outcome remains in the balance.

Stéphane Monier, chief investment officer of Lombard Odier in Europe, expects “volatility to pick up around September time, when the market is once more focused on a possible Fed rate hike”.

Markets have been waiting a long time for the cycle to start, with forecasts continually being put back over the past year. The Fed could still hold off a September move amid worries of low inflation, the impact of weak global growth on the US economy or persistent commodity price weakness, says Monier.

Commodity price weakness, in particular, remains an issue for many currencies, responsible for much of the volatility that has been registered in recent months.

“Given the commodity move, there is little wonder that AUD, CAD and NOK were the three worst-performing G10 currencies in July,” says Gregory Anderson, global head of FX strategy at Bank of Montreal.

Some emerging market (EM) currencies have fared even worse. USD/MXN moved from 15.75 at the beginning of July to a high of 16.48 at the end of the month. USD/BRL rose 10% in the same period, while the rouble sank even further, with USD/RUB rising 11%. Monier believes these EM currencies continue to look vulnerable.

“This weakness is likely a structural shift, as the boom in Chinese investment, which created huge commodity demand, has run its course for now,” he says. “The currencies of commodity exporters Brazil and Russia could see further volatility ahead, especially as economic output in both countries is expected to undergo a significant contraction this year.”

He adds the Turkish lira to the list of currencies likely to see an uptick in volatility in coming months, given its large current-account deficit.

If US rates rise, however, the volatility will extend beyond such economies, but it remains difficult to predict exactly how the markets will react. The mere suggestion of rate rises was enough to trigger the taper tantrum in 2013, though few expect anything so dramatic this time around.

“[Still,] there is no precedent for a US interest-rate rise after such a long period of ‘easy money’, including near-zero interest rates and quantitative easing,” says Monier.

He expects increasing volatility in the dollar/euro pair in September and October, with the dollar making gains against the euro in the latter half of the year. However, he does not expect the move to be as aggressive as that seen in 2014, when the dollar gained almost 12% against the euro.

Nordvig says the current price of volatility argues favourably for gamma trades, which, in very simple terms, refer to the change in the likelihood that a given option will expire in the money.

He recommends long gamma trades, given the prospect of rising volatility and the corresponding allure of out-of-the-money options.

Nordvig also recommends being long short-dated volatility, specifically 1m USDJPY strangles – options that have both a call and a put element, meaning the holder profits regardless of whether the underlying price goes up or down. Strangles should therefore be profitable regardless of whether the Fed decides to raise rates, as long as the news moves the exchange rate. 

The breakevens, says Nordvig, the price at which the option does not make a loss if exercised, from spot for 1m strangles on USDJPY and GBPUSD are at their relative lows, as expected based on their level of implied volatility. The breakeven for the EURUSD strangle is low relative to its own historical levels – though still meaningfully higher than USDJPY and GBPUSD.