FX vol enters the dead zone; fears mount over calm before the storm

By:
Peter Garnham
Published on:

Implied volatility in the FX markets has fallen to levels last seen before the eruption of the financial crisis, a fact that might concern investors who witnessed the violent price action in 2008.

Implied FX vols for the dollar against other G10 currencies slipped across the board in the wake of the Federal Reserve’s decision not to start tapering its asset purchases after its policy meeting last week.

The moves were not small, with one-year implied vols for both EURUSD and USDJPY falling by half a vol in the aftermath of the decision.

That might come as a shock to some, given the Fed delivered a 20-basis-point surprise for 10-year Treasury yields.

However, there was a rationale behind the move lower in implied dollar volatility.

First, the dovish Fed signalled there would be less divergence between its policies and those pursued by a dovish European Central Bank (ECB) and Bank of Japan.

Second, investors were expected to be much more active, seeking protection and taking directional bets, if the Fed took a more hawkish line.

Third, the market still fears a downside break in EURUSD, with spot and implied vols persistently negatively correlated throughout 2013.

As a result, EURUSD implied vol has now entered what Alan Ruskin, macro strategist at Deutsche Bank, describes as the “dead zone”, which marked the period between late 2006 and August 2007. That period, he says, will go down in FX history as the quintessential “calm before the storm” as investors continued to pile into carry trades before the financial crisis sparked a wave of deleveraging.

Indeed, one similarity between now and 2006/7 is persistently subdued equity vol, which eventually led FX vol higher in 2007. In contrast, a profound difference is that in 2006/7 bond vol was very subdued, whereas now it appears the most obvious candidate to lead FX vol higher.

Ruskin says that in macroeconomic terms, while 2006/7 represented a period in which the US growth cycle was slowly losing momentum, the current backdrop is one of transition, from a period of deleveraging and sectoral rebalancing to rate normalization, of which Fed tapering is just the beginning.

Deleveraging provided its own growth uncertainties and related volatility, he says, while rate normalization, including higher rates across the curve, usually precedes a period of higher FX volatility by as much as two years.

Ruskin warns, however, that relationship is likely to have broken down.

“Tapering and the unique aspect in which reduced QE impacts the back end of the yield curve should cut the long lags between FX vol and Fed policy to close to zero,” he says.

“The current slippage in FX vol then feels like a Fed-induced lull within this transition to rate normalization – a lull that will at minimum decisively give way as soon as rate hikes come on the horizon, say in the second half on 2014.”

As such, the ranges implied for the main dollar pairs by the current pricing of one-year straddles in the options market, as shown below, do not seem that far out of step.

 One-year straddle breakeven versus FX annual ranges
 
 Source: Deutsche Bank, Bloomberg
However, that does not mean there is no directional bias.

Take the current one-year straddle breakeven for EURUSD, which implies a range of 18 big figures – from $1.2620 to $1.4440. It is 190% of this year’s range, which is heading towards being the second narrowest since the collapse of the Bretton Woods system (see the chart below).

Indeed, the one-year straddle breakeven range is 127% of the full 2012 range, but well under 100% of the ranges that occurred during the height of the eurozone sovereign debt crisis in 2010 and 2011.

EURUSD annual ranges versus range so far 
 

Ruskin believes the $1.4440 topside breakeven range implied by the options market looks out of step with what is sustainable for a weak eurozone real economy, or the spot rate that should be expected from future Fed and ECB policy. In contrast, he believes the downside at $1.2620 is well within reach, particularly if there is any flare up in eurozone debt crisis.

Similarly, the upside in USDJPY at ¥107.43 looks well within range, in contrast to weaker dollar levels at ¥89.90 or $1.6960 in GBPUSD.

“It is less about the overall ranges being wide than the strong case for using period of relative dollar weakness, like currently, to accumulate dollar upside exposure,” says Ruskin.

For those looking to build exposure to a stronger dollar, the drop in FX volatility might represent a buying opportunity.