Yield plays from Asian central banks crush volatility in EURUSD
Asian FX reserve managers are making it hard for EURUSD to break out of its tight trading range as they seek to improve the low returns on their FX portfolios by selling options.
During the past three months, EURUSD has traded firmly in $1.30-1.35 and since the beginning of April has sat snugly in the middle of that range. This is at a time when market stresses in other eurozone assets have intensified due to growing concerns over Spain’s solvency, weaker-than-expected economic activity indicators, and political uncertainty surrounding elections in France and Greece. So, why are renewed eurozone tensions not being felt in the currency market?
One driver behind the euro’s inertia is Asian FX reserve managers, who are taking large FX options positions, effectively capping the euro’s movements, say currency analysts at ING.
Reserve managers are no exception to the swathes of currency managers struggling to generate returns in a market with few trends and in which volatility stands at multi-year lows. To enhance the performance of their currency portfolios, they are adopting alternative strategies in the options market, in turn reinforcing the placidity of the spot market.
Using data from the International Monetary Fund’s currency composition of official foreign exchange reserves to gauge the average composition of FX reserves and using two-year government bond yields for each currency, ING estimates the blended yield of an average FX reserve portfolio has fallen from 3.5% in 2008 to just 0.29% in 2012.
Blended yield from average FX reserve portfolio
|Source: IMF, ING|
“Some reserve managers are expected to make returns on their reserve portfolios that are subsequently used for national or regional budgets,” says Chris Turner, head of foreign exchange strategy at ING.
“With budgetary pressures generally rising, it is no surprise that reserve managers should be looking at ways to make their reserves work harder.”
This is where yield enhancing strategies (YES) come in. In current market conditions, these often take the form of short volatility positions, effectively allowing managers to collect options premia as a low-risk way to boost returns. In the event of the options being exercised, their existing FX holdings can easily be used to pay out.
Reserve managers are also frequently linked to FX option strategies, such as double-no-touch structures, where failure of the spot exchange rate to hit upper and lower barriers over a certain time period can generate a large payout.
With these structures, central bank FX reserves can also be put to use to defend options barriers, further contributing the EURUSD’s narrow trading range.
Lower volatility might prompt return to EM carry strategies
ING expects the low returns on government bond yields to maintain demand for YES structures over coming quarters.
The reinforcing cycle of reserve managers supplying volatility and the subsequent hedging from the market-makers will continue to depress traded volatility, says Turner, making it even harder for macro fundamentals to drive EURUSD out of its recent $1.30-$1.35 range.
EURUSD three-month volatility has broken below 10% and is now trading at its lowest level since the start of the financial crisis in 2008.
“If EURUSD is not going to define major trends in the near future, investors will be turning to the carry trade again,” says Turner.
EUR traded volatility tumbling
The euro’s low volatility might enhance its appeal as a funding currency but for investors seeking yield, opportunities in the G10 space are increasingly limited. Global interest rates have converged lower and even the traditional high-yielding AUD is now vulnerable to further Reserve Bank of Australia rate cuts. Carry-trade strategies might therefore only produce suitably attractive returns if investors turn to the higher-yielding currencies in the emerging-market world.