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FX volatility hits lowest level since start of financial crisis; don’t get carried away

Relatively stable FX markets during the current summer lull have pushed volatility down to its lowest level of the year.

Relatively stable FX markets during the current summer lull have pushed volatility down to its lowest level of the year.

By some measures, volatility is at its lowest level since the eruption of the financial crisis. Bank of Tokyo-Mitsubishi UFJ’s equally weighted index of G10/JPY one-month implied volatility, for instance, is at its lowest level since August 2008.

 G10/JPY one-month implied vol

 Source: Bloomberg, BTMU
Of course, the favourable combination of improving risk sentiment and declining FX volatility is encouraging a pick-up in carry demand for relatively high-yielding currencies and selling of low-yielding funding currencies.

Accordingly, during the past month, the low-yielding USD, JPY, EUR, CHF and GBP have underperformed the higher-yielding AUD, NZD, CAD, NOK and SEK.

One part of that has been confidence in the pledge from Mario Draghi, European Central Bank (ECB) president, to do “whatever it takes” to ensure the survival of the eurozone. The potential break-up of the euro is, after all, the biggest threat to the global economy.

Investors will be hoping Draghi makes good on his promise.

However, history suggests that periods of calm tend to end violently.

Standard Bank, for example, has created a volatility-adjusted return indicator for NZDJPY, one of the most popular carry trades, by deflating interest-rate differentials by implied volatility.

NZDJPY: Are volatility-adjusted returns stretched? 

 Source: Ecowin

Since early June, New Zealand’s volatility-adjusted return has risen sharply compared with Japan’s, pushing NZDJPY about 8% higher.

Standard Bank notes, however, that volatility-adjusted returns do not tend to stay up at their current elevated levels for long. In addition, rather than easing gently from those heights, volatility-adjusted returns in the NZD tend to collapse – taking NZDJPY with them.

Steve Barrow, head of FX strategy at Standard Bank, says those movements usually occur because of big increases in implied volatility rather than sharp falls in NZ rates, or increases in Japanese rates.

“We seem to be getting to the point where long positions in NZDJPY look more dangerous,” he says. “And, if they look more dangerous here, perhaps they look more dangerous for other carry-trade favourites as well.”

If implied volatility continues to slide, falling below the levels seen before the height of the credit crunch, then carry trades would be set fair.

However, with the looming event risk of the ECB putting its plans into action – or explaining exactly what those plans are – not to mention the small matter of a Federal Reserve meeting next month, there would appear to be plenty that could disrupt the calm.

Carry trades at these low levels of volatility come with a health warning.

This article was originally published by EuromoneyFXNews.

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