Economists debated whether the sheer magnitude of last week’s share price declines marked capitulation and a potential closure to the current bear market. However, the equity spending spree that had greeted the announcement of capital infusion into the nation’s leading financial institutions gave way to the dawning realization that last week’s global meltdown will leave a vapor trail of slowing economic activity and rising joblessness. This is fast becoming an even bigger dollar bull story than we had first anticipated, and rather than watching the S&P 500 index futures for a guide to sentiment, more sane investors should be keeping an eye on the value of the Japanese yen.
In the same way that investors monitor the degree of investor fear by watching the VIX index, currency traders hold great stock in the value of the low-yielding yen as a barometer of global risk. It’s no coincidence that the yen peaked against the dollar this year at the time of the Bear Stearns crash in March when it reached ¥95.75. It’s no coincidence that last week’s stock market low marked a subsequent strengthening of the yen to back below ¥100 – this time to ¥97.92. One could almost say that in a sense this marked a failure swing or that the sense of panic was lower than in March. However, the ongoing fire-sale witnessed within stock market is happening in the aftermath of the well-heeled bank recapitalization program.
As we had expected, it was another week of creeping implied volatility as currency investors showed willingness to stump up for higher premiums to protect core positions.
Two new factors came into play this week. In a sense one could argue that a fixation with the impending G7 address to each nation about how to stop the flooding created investor myopia. Once the plan was out in the open and as welcome as the news was, enthusiasm quickly waned as focus returned to the ever more dim prospects for corporate earnings. The clear warning signs that the economy is heading for the rocks is in real contrast to the current prediction for record revenues and profits for S&P 500 index companies for the end of this year.
Flowing from the logical recessionary news is the increasingly dim view towards commodity prices, which continue to tumble. However, the new facet to take center stage this week is the difficulty that exporters face in securing export credit or financing due to the credit crunch. Testimony to this is the drop off in shipping rates around the world. Sticking with our core theme that the U.S. has reacted fastest and furthest, the fact that the downturn is proving without a shadow of doubt to be global in nature, leaves the dollar as the unit of choice at such a time. Notice that the price of gold (another fear gauge) is moving in line with the dollar as it strengthens.
Weaker data out of Europe in terms of confidence is undermining the appeal of the local currency while we hear more analysts predicting a return to the $1.20s for the unit and in some cases referring to it as “overbought.”
It seems to us that despite the best efforts of global monetary authorities and governments that confidence is proving difficult to restore.
There was a large decline in futures open interest on the Japanese yen during the past week – that follows last week’s surge if you recall, which saw interest in yen exceed that of the euro. It could be that investors were positioning for some yen rally or stock market weakness and had a predetermined exit point, which accounts for the change. Most other units saw a small loss of open interest except for Canada where it would appear that fresh shorts were built, which helped in part drive down the value of the loonie from 90.19 to 85.34. The continued weakness in the price of oil, which has fallen through $75 per barrel for the first time in two months, is weighing heavily on Canada’s dollar.
There also appears to have been liquidation from the Aussie dollar where some 6,851 outstanding positions were closed. That is a pretty hefty slide and represents 13% of outstanding open interest. One of two things happened: Traders correctly bought into what they felt might be a healthy correction from deeply oversold conditions last week or there were more forced liquidations as the unit hit its low on Friday at 63.09. We get the impression that traders have refused to give up the ghost on the robust Aussie despite its loss of a third in its purchasing power against the greenback since July. We noted a spike in call option volume during the week. Options can be a less harmful way to go long of a currency especially in volatile times. However, the implied volatility can hurt a long option position through time decay. More than three times the number of calls were traded over the last week compared to puts driving the number of open call positions to 1.4 times the outstanding put positions.
Thanks to weaker commodity prices and the growing disenchantment with the prospects for economic growth, implied volatility rose on both Canadian and Australian dollars last week. Option implied volatility shrank against every other currency. On the Canadian dollar volatility rose by more than one third to stand at 21.9%, while Aussie volatility added one quarter to last week’s reading to stand at 35.9%. This does make it more difficult for option buyers to hold protection and makes them vulnerable to snapback rallies in the underlying currency price. Note that the Aussie surged to reach 71.84 following the news that banks had been primed with fresh capital at home by the central bank and likewise abroad. That false sense of security lulls traders into offering down volatility until, that is, risk reversion rears its ugly head once more.
Finally, the British pound has fared remarkably well in the face of “mini-me” style problems shared with America. We are at a loss to explain the unit’s resurgence above $1.75 in the face of the fact that the housing market there has ground to a halt other than to suggest that sterling has benefited from the leadership shown by Prime Minister Gordon Brown. As with most politically-inspired victories, we expect the market’s confidence to be short lived helping send the pound back into the $1.60s.
Andrew Wilkinson
Senior Market Analyst ibanalyst@interactivebrokers.com
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