Currency Volatility Set for a Comeback
Banks are recommending corporate treasurers protect themselves against FX swings, which have been muffled recently by record-low interest rates and Fed liquidity support.
After more than a year of slumber, currency volatility is preparing to come roaring back to life.
From Nomura International Plc to Rabobank, banks are recommending cheap protection against foreign exchange (FX) price swings, which have been muffled so far by a barrage of liquidity and record-low interest rates.
The premise is that as growth picks up and central banks start telegraphing an end to all the stimulus unleashed during the pandemic, traders caught off guard may have to recalibrate their positions, setting the stage for sudden jolts.
Investors are “ready and willing to pull the trigger,” says Neil Jones, head of FX sales to financial institutions at Mizuho Bank Ltd., who is recommending traders buy currency hedges as long as one year out. Last week, JPMorgan Chase & Co’s gauge of FX fluctuations fell to the lowest level since March 2020.
While there have been many false dawns over a rebound, the latest calls point to a significant shift in the market’s disposition. Unlike the long-end of bond curves, which suffered steep losses as inflation started accelerating and economies opened up, currencies are sensitive to changes in short-term rates that still remain firmly anchored by central banks.
It’s why traders are now scouring for any clues that policymakers might tip the balance. On Tuesday, New Zealand’s dollar jumped to a three-month high after the central bank predicted interest rates will start to rise next year and was overall more hawkish than expected.
“The market is not prepared for severe taper surprises from central banks right now,” Jones says, a reference to any unexpected reduction in their bond purchases. “The next 12 months suggest a plethora of minefields.”
Among potential triggers are the European Central Bank’s (ECB’s) meetings in June and July and the Federal Reserve’s Jackson Hole symposium in August. Julian Weiss, head of currency options at Nomura, is snapping up one- to three-month volatility in the euro-dollar pair, contracts that capture all three events.
“Volatility is too cheap,” he says. “We’re seeing more countries easing lockdowns, and we believe the bounce in global growth is yet to be fully priced by the currency markets and the dollar in particular.”
Three-month implied volatility in the euro-dollar cross currently trades around 5.85 percent, below its year-to-date average. The relative premium on the tenors, as shown by the spread between implied and realized volatility, stands near parity, which suggests the options aren’t overpriced.
Hedge funds have also been adding long volatility positions in the euro lately, expiring around the ECB policy meetings to be held in June and July, according to two Europe-based traders familiar with the transactions who asked not to be identified because they aren’t authorized to speak publicly.
Meanwhile, Jane Foley, the head of FX strategy at Rabobank, says now may be a good time to buy three-month volatility in the dollar-yen or dollar-Swiss franc crosses, haven currencies that have lagged all their G-10 peers over the past six months, thanks to the market’s risk-on mood. “Plentiful liquidity is like a drug for markets and can make price action far less sensitive,” she says.
Some, such as Toronto-Dominion Bank’s Ned Rumpeltin, remain cautious, saying the summer is likely to be quiet.
“I’m not sure if buying six-month volatility on a ‘fire-and-forget’ basis is a foolproof idea,” says Rumpeltin, the firm’s European head of foreign-exchange strategy. “You’re probably better off buying three-month volatility in three months time.”
It wouldn’t be the first time that traders missed the mark. When talk of Fed tapering swept through markets in the beginning of the year, there was a short-lived rebound in volatility that faded once policymakers played down the prospect.
Still, few doubt that the market is in for a shake-up. “It won’t take too much to get investors a little bit worried and scared about how the picture will change,” says Nomura’s Weiss.
—With assistance from James Hirai, Robert Fullem, Susanne Barton & Namitha Jagadeesh.
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