USD implied vols nearing all-time lows: The second half of the last decade saw an almost unremitting downtrend in broad currency volatility. Figure 1 shows this was broadly true for the USD with vols for both the EUR and JPY hitting record lows on the eve of the financial crisis. Along with other markets, volatility for currencies surged during the crisis but the downtrend since reemerged. EUR vols are nearing the 2007 lows; JPY vols have been slower to decline reflecting the seachange in BoJ monetary policy. While we are not of the view that reaching the 2007 lows bodes that another crisis is looming we do believe vols are not apt to go much lower and the seeds of a fundamental turn are germinating.
The decline in USD volatility (figure 2) – the average of EUR and JPY vol – has not been in isolation but closely tracked vol trends in fixed-income and equities. We would posit that it is the decline in vols in these major asset classes that has been a major source of lower volatility in the USD market. We would also posit that the broad decline in asset market volatility is tied to low rate targets and quantitative ease by the major central banks. Indeed, QE is inherently bearish for bond volatility; while early redemptions associated with declining rates can firm vols, ultimately, volatility will be compressed as rates become trapped in a narrowing range defined by central bank imposed cap and the zero boundary.
Quantitative ease is also weighing on implied volatility in the equity markets. A primary avenue for QE to stimulate the economy is via asset appreciation so, by intent, it is supportive for equity prices. As shown in figure 3, there is a strong directional link between equities and the VIX – specifically, a rally equity market is negative for implied volatility.
The Fed’s decision to taper is perceived as the beginning of the end for quantitative ease. Indeed, 10 year Treasury rates are roughly 25 basis points higher than last October and a full percentage point above last year’s low. As long as the tapering continues and ultimately leads to higher rates we believe volatility will firm across asset markets.
Diverging central banks are another plus for FX vols. As shown in figure 4, the aggressive ease by central banks pushed rates towards zero largely eliminating interest rate spreads. The alignment of macroeconomic policy across borders has been another reason that currency volatility has been depressed. But the Fed move toward tapering is not being mirrored abroad. Indeed, the Bank of Japan is still aggressively easing while the ECB is sending mixed signals on its policy intent. We believe divergent trends in central bank policy should gradually be reflected in widening yield spreads and a pickup in exchange rate volatility.
The Fed is still early in the process of reversing course and may yet switch back to an easing bias if US economic growth falters. If this were to occur then the low volatility environment is apt to persist. But if, as we expect, the economy continues to improve and the Fed gradually tightens then a more volatile world is likely ahead.