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Beware the summer lull; no time to be complacent in FX

For those hoping that the holiday period will usher in some calm on the world’s currency markets, there is likely to be disappointment.

Every summer, traders take the view that there will be a lull in activity, with volatility expected to decline and liquidity to thin out. This summer is no exception, with London-based traders facing the additional distraction of the Olympic Games on their doorstep. But those hoping for a couple of weeks to enjoy the action in London might well slip up.

Mitul Kotecha, head of FX strategy at Crédit Agricole, says that over recent years spikes in the bank’s risk-aversion barometer and FX volatility in July and August highlight the risks in being complacent.

Indeed, an analysis of risk-off and risk-on periods shows that most of the risk-off periods have taken place over the summer since 1999. Furthermore, the trend has become more pronounced over the plast few summers, with greater periods of risk aversion.

 Risk aversion more prone to spike over the summer

 Source: CA CIB, Bloomberg

In the summer of 2010, fears of a double-dip recession in the US rattled the market after a run of weak US economic data. In 2011 worries over Greek debt intensified at the same time that investors began to fret over the health of the US economy and a failure to reach agreement on the US debt ceiling and associated deficit-reduction plans.

“The summer of 2012 is fast replicating the last few years,” says Kotecha. “Once again economic data are deteriorating globally, while the eurozone crisis rumbles on and Greece remains the centre of attention.”

Of course, hopes of policy action from the European Central Bank or the Federal Reserve have so far helped to limit any deterioration in market sentiment, but as Kotecha points out, markets cannot continue to rally on policy stimulus alone.

“Ultimately underlying conditions need to improve for any risk rally to be sustained, and it is far from clear that the necessary reforms and structural changes are being implemented in some countries or are taking place too slowly in others,” he says.

There is clearly a real risk that the market’s high expectations over further policy action from the ECB or the Fed will be disappointed.

That does not bode well for risky assets or the high beta currencies – such as AUD, MXN, SEK, BRL, INR and ZAR – that have benefited most in recent weeks.

This article was originally published by EuromoneyFXNews.

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