Currency volatility is expected to reverse impending policy changes
After more than a year of sleep, investors are preparing to revive currency volatility.
From Nomura International Plc to Rabobank, banks recommend cheap protection against fluctuations in exchange prices, which have so far been stifled by a liquidity barrage and historically low interest rates.
The premise is that as growth picks up and central banks begin to telegraph the end of any stimulus triggered during the pandemic, traders caught off guard may need to recalibrate their positions, paving the way for some jolts. sudden.
Investors are “ready and willing to pull the trigger,” said Neil Jones, head of currency sales at financial institutions at Mizuho Bank Ltd., who recommends traders buy currency hedges for up to one year.
Last week, JPMorgan Chase & Co’s gauge of exchange rate fluctuations fell to the lowest level since March 2020. false above a rebound, the latest calls indicate a significant change in the disposition of the market.
Unlike the long end of bond curves which suffered large losses as inflation started to accelerate and economies opened up, currencies are sensitive to changes in short-term rates which remain firmly anchored by central banks.
And that’s why traders are now looking clues that policymakers could tip the scales. On Tuesday, the New Zealand dollar jumped to a three-month high after the central bank predicted interest rates would start rising next year and were more belligerent overall than expected.
“The market is not ready for any serious surprises from central banks at this time,” Jones said, referring to any unexpected cuts in their bond purchases. “The next 12 months suggest a plethora of minefields.”
Among the potential triggers are the European Central Bank meetings in June and July and the Federal Reserve symposium in Jackson Hole in August. Julian Weiss, head of currency options at Nomura, tackles the one to three month volatility of the euro-dollar pair, contracts that capture all three events.
“Volatility is too cheap,” he said. “We are seeing more and more countries easing lockdowns and we believe that the rebound in global growth is not yet fully assessed by currency markets and the dollar in particular.
The three-month implied volatility of the euro-dollar cross is currently trading around 5.89%, below its year-to-date average. The relative premium on the tenors, as shown by the spread between implied and realized volatility, is close to parity, suggesting that options are not overvalued.
Hedge funds have also recently added long positions in euro volatility, expiring around ECB policy meetings in June and July, according to two Europe-based traders familiar with the transactions who asked not to not be identified because they are not. allowed to speak publicly.
Meanwhile, Jane Foley, head of foreign exchange strategy at Rabobank, believes that now may be a good time to buy the three-month volatility of dollar-yen or dollar-Swiss franc crosses, safe haven currencies that have fallen behind. on all their -10 peers in the last six months thanks to the risky mood of the market.
“Abundant liquidity is like a medicine for the markets and can make price action much less sensitive,” she said.
Some, like Ned Rumpeltin of the Toronto-Dominion Bank, remain cautious, saying the summer will likely be calm.
“I don’t know if buying six-month volatility on a ‘fire and forget’ basis is a foolproof idea,” said Rumpeltin, the company’s European head of currency strategy. “It’s probably best to buy three-month volatility in three months.”
Bond volatility fades as central bankers push back inflation
It wouldn’t be the first time traders have missed the mark. As discussions about cutting the Fed swept through markets earlier in the year, there was a short-lived rebound in volatility that subsided once policymakers downplayed the outlook.
Yet few people doubt that the market is moving. “It won’t take too much for investors to worry a bit and be afraid of how the situation will change,” Weiss of Nomura said.
– With the help of James Hirai and Robert Fullem