What?s Driving the Unusual Calm in Currency Markets Some traders worry volatility is too low, which could make future market moves more disruptive By Olga Cotaga, March 17, 2019, Wall St. Journal
Things have gotten quiet in currency markets, and too quiet for some traders.
The sense of calm is shown by remarkable stability in exchange rates and the cost of hedging against big swings in them. The worry is that volatility has gotten abnormally low, which could make any future market moves more disruptive.
The suppressed volatility is especially evident in the top-traded currency pair?the U.S. dollar against the euro, which has traded sideways since the beginning of October. A broader measure of volatility maintained by Deutsche Bank , which follows nine major currency pairs, has dropped by a quarter since the beginning of the year.
Meanwhile, the cost of purchasing options to protect against big currency moves, known as implied volatility, has dropped to its lowest since mid-2014. That was a quiet period before China?s 2015 devaluation set off months of wild trading.
?We are now at absolute extremes,? said Richard Benson, head of portfolio investments at hedge fund Millennium Global Investments.
Calm and Collected
The cost to insure against foreign-exchange market moves, as measured byimplied volatility for nine major currency pairs [chart]
The drivers are varied. The recent shift in tone from the Federal Reserve and the European Central Bank away from tightening policy removes the risk that sudden rate increases will upend markets. Meanwhile, U.S.-China trade talks have put pressure on China to keep the yuan stable.
Another factor: Some analysts say the cheaper cost of insuring against big currency moves is itself artificially depressing volatility.
When investors use options to protect against future currency swings, it is like purchasing insurance against bad weather. Buyers pay a premium; in exchange they get a big payout if a storm materializes. However, financial markets are so interconnected that too much selling of insurance against bad weather can in itself make the sun shine?at least for a while.
This is because there are more investors making bets that volatility will stay low or get even lower than there are wagers that it will go back up, says Julian Weiss, head of forex flow options at Nomura. ?Market participants that buy volatility are not there.?
Tight Band
The euro exchange rate against the dollar has been range-bound steadily since October. [chart]
In the absence of other investors willing to bet that it will go up, banks step in and will take that bet. Except banks?who don?t want to keep an open position on which way currencies go?then hedge those bets, a process which can dampen volatility. They do this by trading the underlying currency in the market. They sell it if the currency goes up, and buy it if it goes down. These bank trades thus help serve to smooth out trading in the currency, keeping volatility low.
With central banks standing pat and little else to drive markets, the betting on low volatility itself is helping to drive trading, says Russell LaScala, Deutsche Bank?s global co-head of foreign exchange trading. He calls the situation ?self-perpetuating,? adding that ?these loop orders control the market absent any events.?
But this can easily be undone. If an economic or political event leads to a market swing, banks can suddenly forgo their hedging activities, looking to profit from any rise in volatility. That would remove a stabilizing force from the market. At the same time, investors who had bet on low volatility would get burned and rush for protection. That in itself would feed further volatility.
Gaining Currency
Currency traders can profit when implied volatility, as measured by the price ofthree-month options, exceeds actual currency volatility, as measured in spotmarkets. [chart]
The risk is that the current situation proves similar to one that preceded the big selloff in stocks in January 2018 after a long stretch of ultralow volatility. In the case of stocks, investors were selling equity options to collect premiums, in essence betting that volatility would remain low. This pushed the cost of this insurance?measured by the Cboe Volatility Index or VIX?to record lows. When concerns about the economy overheating and rising interest rates unnerved investors, a sharp unwind of those low-volatility bets ripped through the markets.
Even a return to historical levels of volatility in currency markets holds disruptive potential.
And there are signs that the window is closing to make money betting it will remain low. That can be seen in the narrowing gap between actual current volatility in the cash market for currencies, known as realized volatility, and future implied volatility, which is gauged by the cost of hedging in the derivatives market.
?The risk reward of being excessively short volatility is nil,? said Mr. Benson of Millennium Global, which has $18.5 billion of assets under management invested primarily in currency markets. Mr. Benson said he avoids being short volatility.
What could trigger an end to calm times? Much depends on central banks and governments. A sudden policy reversal by the Fed, ECB or Bank of Japan , or a breakdown in the U.S.-China trade talks could be a trigger for markets to convulse.
Brexit is another wild card. A disorderly exit?or a surprise compromise over the terms of the U.K.?s departure from the European Union?could unleash the pound from its tight trading range.
Bill Wald, 3 days ago My guess is that the currency markets are quiet because the US dollar is the world reserve currency and President Trump is trying to maintain our international status.
Winthrop Smith, 4 days ago I wish there were a political VIX for the EU and for each individual country therein.
E Hines, 4 days ago It's quiet...too quiet.... Eric Hines
Gene Ramirez, 4 days ago During the VIX chaos of January 2018, there was a group of investment funds, the so called Volatility Control Funds that sell stocks when VIX rises, that contributed to the selloff. They executed as advertised, selling their stocks as VIX rose, increasing market volatility themselves, which made them sell more, in a self reinforcing loop. I imagine that the same dynamic is possible with currency volatility. The late Hyman Minsky of the Minsky Moment, recognized that during periods of market calm, participants become bored with small price moves and so begin to magnify little price bumps with leverage.
ROBERT GOODELL > Gene Ramirez, 4 days ago I kind of agree. Minsky was concerned about speculation in any asset class that allowed leverage. His concern was that long periods of stability create a false sense of security (this time will be different) and people are emboldened to take on debt to buy speculative assets. When the inevitable downturn comes, the rapid deleveraging of overextended investors forces them to sell good assets to cover bad assets. This leads to more deleveraging since other holders of once good assets face devaluation of their holdings as panicked and over extended investors sell their good assets at fire sale prices. For many, this is a good description of 2007- 2009. But the original point of this article was that forex has been very calm. I think it is because most trading (90%) takes place in 6 currency pairs. Not much is invested in emerging currency. However, I will add that the possibility of a minsky moment in forex is intriguing; this is a financial market where 10x leveraging is common.
Gary Palmero, 4 days ago We may have entered a period of relatively low volatility in many markets including the broad economic cycle itself . Low interest rates, plentiful energy, increased manufacturing efficiency and almost instant transmission of information and general communications all contribute to the current relative calm.
In polities of relative freedom there is much complaining but limited suffering. In dictatorships, there is limited complaining and much suffering. Over the long haul, we will get more Americas (US variety) and less Venezuelas. Nothing guaranteed, however.
scott starling, 5 days ago This "breathing room" for nation states reflects political stability. Is it a chance to pursue neglected domestic concerns?
Dennis O'Neil, 5 days ago "Lord Keynes and his disciples make the lack of the propensity to consume responsible for what they deem unsatisfactory in economic conditions. What is needed, in their eyes, to make men more prosperous is not an increase in production, but an increase in spending. In order to make this possible for people to spend more, an 'expansionist' policy is recommended. This doctrine is as old as it is bad." Ludwig von Mises, "Human Action", Chapter XVII - Indirect Exchange - Subchapter 10 - The Import of the Money Relation
ROBERT GOODELL > Dennis O'Neil, 5 days ago Yes, yes, we get that you have the books. But the issue in the article is not monetary management or the horrors of fiscal demand management via the multiplier effect. The issue is exchange rates. Von Mises has nothing to say on that topic beyond a Luddite allegiance to gold. Even Friedman, writing in a more sophisticated time, is not strong on exchange rate regimes. The guys you read assumed fixed exchange rates. That is a convenient simplification for their essentially static models. But since your intellectual heroes have been buried, the world economy has been forced into a period of empirical investigation as to what works in For Ex markets. My point is that a free exchange rate is compatible with multiple domestic arrangements, although issues like the Trilemma are very valid for small and midsized countries with substantial trading sectors.
Dennis O'Neil, 5 days ago If you lived in Germany early 20s, China circa 1950, Brazil and Argentina circa 1990, Yugoslavia circa 1994, Zimbabwe circa 2007, Venezuela today then you knew the horrors of a currency crack up boom .
Who remembers WIN =Whip Inflation Now - US 1974-81?
Price inflation is a mere symptom.
Money is a commodity and like any other, the supply and availability of said commodity diminishes its marginal utility.
When you have too much of a commodity on hand, its mere prevalence diminishes its purchasing power in relation to competing commodities.
When we measure central bank currencies against other fiat currencies we may as well be comparing veterinary exams of horses at a glue factory.
Inflation = expansion of money supply (period).
Price inflation is the mere symptom and the logical consequence of a rise in the money supply in excess of true economic growth.
Price inflation is therefore the logical outcome of the theft of today's central banking policy.
All we need is velocity.
ROBERT GOODELL > Dennis O'Neil, 5 days ago Yeah, I remember that identity, but Friedman, et.al were working in a theoretical closed economy. Closed economies can debase their currency through monetary mischief. In open economies some monetary leakage occurs and it takes some adjustment time for the currency exchange rates to adjust. But adjust they eventually will. Only America has the capability of exporting inflation out of our country to the rest of the world because we have a reserve currency. For most economies the linkage between currency debasement via monetary inflation and exchange rate devaluation via free exchange rate markets is a function of the size of the trading sector. The same is true of the reverse direction: the circumstances when exchange rate changes affect domestic inflation via cost increases (an example of where inflation is not a monetary effect) in the imported goods, such as food imported into the U.K. if the U.K. imports 30% of its consumer goods, and the GBP falls 10%, expect 3% CPI.
Dennis O'Neil > Robert Goodell, 5 days ago The world reserve currency status of the USD is certainly not a permanent fixture.
The only reason we have been enabled (enabled in both the practical and psychological use of the word) to have an almost one-half century run post Nixon's repudiation of the Bretton Woods' regime, is the amount of monetary mayhem that has taken place and the lack of a currency of sufficient size to supplant the USD monstrosity. "The final outcome of credit expansion is general impoverishment. Some may say they increased their wealth; they did not let their reasoning be obfuscated by mass hysteria and took advantage in time of opportunities offered by the mobility of the individual investor. Other individuals and groups may have been favored without initiative of their own, but by mere time lag between the rise in prices of the goods they sell and those they buy. But the immense majority must foot the bill for the malinvestments and overconsumption of the boom episode." von Mises 'Human Action' Chp XX
Dennis O'Neil > Robert Goodell, 5 days ago "(Murray) Rothbard saw the danger that the government-controlled fiat money could be held up and running indefinitely, that it would not necessarily drive itself into a fatal and final collapse. As long as people do not expect that a money supply increase will spin out of control, the central bank is in a position to debase the currency without completely destroying it."
But still we are only a psychological twist, a failed bond auction, or a spurt of exchange velocity away from witnessing von Mises' crack up boom.
ROBERT GOODELL, 5 days ago I think the Forex markets, and market based exchange rates in general, have proved to be a source of elasticity in the larger market structures. That is not what most commentators and academics expected after Nixon took the dollar off gold convertibility. They thought volatility would wreak havoc on trading relationships. It was a rough few decades as countries tried various exchange regimes; bands, pegs, managed floats, targets, etc. We now have a whole range of policies, but all- except for those of the stubbornly benighted countries like Venezuela and Zimbabwe- seem now to acknowledge the power of the markets. It has been humbling to some, like Turkey, to understand the limits of sovereignty. On the other hand the Swiss, with customary skill, have nicely balanced the oftentimes conflicting virtues of trade competitiveness vs. currency valuation. The greatest experiment, the Euro, is as yet still providing data but not a conclusive answer re: optimal currency areas.