Can the mess become even messier? It seems that each new problem that a company faces quickly becomes a new risk to the market. The transmission between market risk and risk to the government or economy has never been any faster than it is today. Each rescue package, which would traditionally protect against market risk, raises more questions about ancillary markets and practices and winds up spreading greater risk. A little over a year ago when this whole mess emerged, the dollar was trading against the euro at $1.36. The systemic fear brought on a huge decline in its value to $1.61, while the remedial action has spawned a budding recovery with the dollar rallying to $1.3875. Today the CBOE fear gauge known as the VIX is once again indicating panic on Wall Street, yet the dollar’s value remains resolute.
That same equity market panic displayed by the VIX, which stands at 35.44, is turning up in currency options volatility as investors forced to ditch global portfolios are unwinding carry trades and buying dollars. However, compared to last week, call implied volatility is slightly down across all currencies except the Canadian and Australian dollars, which have felt the cruel winds of change hammer their value due to the hasty decline in the price of crude oil.
The notable story has been the performance of the carry trade currencies of Japan and Switzerland. The rally in the value of the yen, which gathered momentum last week, was already a red flag to the stock market and it could even have been a predictor of Lehman’s bankruptcy. The Swiss franc, although slow to find its feet did begin to benefit from the inflow of funds because of either paring of carry positions or simply to benefit from the safety of Switzerland’s traditional safe haven status.
All currencies rose against the dollar since one week ago, which is hardly a surprise given the close to parabolic ascent of the dollar. Risk reversal prices had indicated that demand for puts was indicating an imminent sea change if only in the short term. The exception here is the Aussie, which continued to slide and its December basis price of 78.49 compares to 79.54 this time last week. The Canadian dollar is slightly higher. Call implied volatility at 18.3% on the Aussie compares to 16.5% one week ago. Other currency volatilities have calmed. Earlier, uncertainty over a currency’s worth had driven put demand to extremes and sent volatility readings higher. Of interest in Wednesday’s options trading is the close out of some stale bullish call positions on the PHLX where the November 82.0 calls have been sold. This looks like an investor exiting a position established a week ago. Today’s price of 75¢ compares to an entry price of around $1.90 last week.
The Federal Reserve’s decision Tuesday to leave monetary policy unchanged received audible booing from traders in the CBOT treasury futures pit, where they clearly felt that easier policy was needed to prevent further systemic risk from spreading, perhaps creating more sizeable bankruptcy protection filings. At the time of the decision, no one knew the status of government discussions with ailing insurance giant, AIG. Investors felt that easier money was needed to help break up a money market seizure. Of course, it doesn’t since lower interest rates won’t curtail counterparty risk, which lies behind the hoarding of cash at financial institutions.
The Fed’s message and its acknowledgement that the strains on the system had increased was taken by investors as a dollar-positive that day. Ever easier monetary policy is not forthcoming, while the Fed still has to acknowledge the potential for inflation pressures from high commodities. The statement was taken by investors as a reality check severing any doubts that the rally in the dollar is fading. The overnight news on AIG did allow for some profit taking, but by lunchtime dollar bulls were hard at work once again with stocks at their intraday lows.
We’ve made the point consistently over recent weeks that the appetite for the dollar has resumed since the Fed is the only central bank to correctly understand the enormity of the problem and the systemic risk. Adding liquidity and easing monetary policy has left them ahead of other central banks that are not as hot on the topic. The British pound rebounded around 7¢ off its recent low by Monday as investors mulled over the impact of the Merrill/Bank of America (BoA) news. This is the kind of reaction in terms of dollar pullback that we are getting used to.
News in Britain this week read pretty much along the lines of what has occurred in the United States, but only several months later. In its open letter to the Chancellor of the Exchequer, Bank of England Governor Mervyn King said that inflation would soon peak and fall sharply in 2009. The market now understands that the next move in British rates will be lower. The threat from the systemic risks emanating from the U.S. and growing stronger each day only serves to accelerate the lowering of yields there.
Given that it’s the expiration in the September futures contract this week, open interest is down sharply on all currencies as investors close out expiring positions. In the currency options space, call volumes reinforced the prospect of a pullback for currency futures with call open interest building faster than put interest except in the Swiss and Aussie. Yen and Swiss implied volatilities sat 1.3 times the value of historic volatility on their respective currencies and indicated the prospect of a continuation of unsettled times ahead. For those with a stomach for risk, the 18% reading of implied options volatility on the Aussie unit infers a range between now and options expiration on Oct. 3 of 3.5¢. In other words, a short straddle seller would want to see the December currency future remain hemmed into a 75.50 – 82.50 range in order to retain the premium.
Andrew Wilkinson
Senior Market Analyst
ibanalyst@interactivebrokers.com
