Not Your Pater’s Ceteris Paribus
Ceteris Paribus is the Latin term meaning that we should assume that nothing else changes when we make assumptions about other economic variables. An increase in the money supply might boost inflation - assuming all other things remain equal. But economic agents are fast learning that the expression is about as redundant as the Roman language from which it came. Assuming all other things were equal, a reduction in interest rates would mend the sorry state that housing demand finds itself in. Alas, we know that what’s gone before us in terms of the malpractices employed in all areas of the housing market, that there is little point in ever assuming a return to normality. Moving ahead, this nationwide, at minimum, collapse in housing demand is now the root cause of a surge in demand for the U.S. dollar that has left a second round effect trail of global destruction that will take years to heal.
During the last several weeks, we have noted the ever-increasing levels of implied volatility associated with currency options. The drop in the underlying currencies was the cause, as investors were caught short wondering whether the American implosion would send the dollar bid or offered.
Assuming ceteris paribus and assuming the measures intended to shore up the U.S. economy did their job correctly; wouldn’t we witness a resumption of dollar weakness? After all, that trend appears on paper to have a pretty strong inverse correlation with the performance of the housing market. It’s not so much a question of what we should read into the dive into the dollar these days as what we should read into the significant moves that are happening as incremental news is unveiled regarding the weakness of competing economies.
Today, it seems that the dollar is everyone’s friend. Its role as the world’s reserve currency is once again a factor. In addition, the need to fund domestic balance sheets around the world is creating arguably stronger dollar demand at a time of illiquid Interbank markets. It’s easier to acquire dollar funding, which can be swapped into the currency of choice rather than source a willing lender of that currency in the first place. Knowing this helps understand why the dollar has been in demand despite the fantastic liquidity push from all central banks under the sun.
Hence the decline of just about every other currency and the associated rise in volatility. But now that, for example, the governor of the Bank of England admits to a recession in the British economy, investors at the margin are now deserting the sinking ship and exacerbating the move as if they had never known that the economy was on the rocks. Volatility thus increases as we enter an apparent new wave of uncertainty for the outlook for the economy.
Today, the euro has fallen to its lowest level in almost two years as it slipped to $1.2738 against the greenback. Currency traders were guilty earlier this year of assuming ceteris paribus and that the Euro zone would not be infected by a banking crisis or the transmission of economic destruction to its zone. So too was the European Central Bank guilty – whose core assumption was that nothing would change the threat of inflation stemming from commodity pressures. Its economy is now tanking and confidence is shot. Once again, it’s becoming a doozy when deciding what to hold in the euro-versus-dollar debate given the proactive stance of the U.S. authorities and the flexibility in setting monetary policy at the Fed, compared to what the ECB might struggle to conclude.
We’re also seeing nasty second round effects translating into violent currency conditions in emerging markets. If thoughts of the slaughter of the Aussie dollar over the last several weeks made you at all queasy, you won’t want to see charts of the Hungarian forint nor the Mexican peso. Argentina and Brazil too have seen currency values decimated. It’s hard to expect easier monetary policy in American to cushion the blows to the major currencies let alone those of emerging markets after so much has changed as these winds of change blow around the world.
Newswires have been busy gathering stories depicting carnage and devastation to typically strong emerging market companies whose desire to hedge against a formerly weaker greenback has hit the rocks. Those companies have entered opaque over-the-counter contracts with their bankers to buy their own currencies if the dollar rises. They are being stuffed with currency at locked in strike prices that are suddenly very different from the decimated spot value. The result is losses that are enough to cause bankruptcy filings in some cases. In others, the companies are now hemorrhaging red ink from activities not associated in many cases with their core activities.
Some weeks ago, we pondered over the likelihood of currency market intervention. We observed that it was unlikely given the fact that until recently the expectation was perhaps for coordinated central bank action to shore up the dollar. With dollar strength having further unintended consequences one has to raise the notion once again. But just to underscore the magnitude of recent events, had the Federal Reserve intervened to buy the dollar when it traded at $1.60 against the euro at the time of the failure of Bear Stearns in the amount of $10 billion, today it could safely intervene today and realize a $3 billion gain on the transaction. That would be enough to take a 30% stake in an ailing Lehman Brothers before it went down. Imagine the taxpayer getting a free ride from a smart intervention play at the Fed and a stake in an investment bank to boot?
Maybe we should simply assume that nothing will ever change.
None of the six major front month currency futures contract we’re looking at has a call implied volatility reading below 20 this week. Highlighting the fact that things to change, more normal circumstances show these readings would be in the single digits. There were jumps in the reading of open interest on the British pound and Canadian dollar futures by around 15% each. Both the pound and the Canadian dollar stand more than 6% lower today than one week ago and we’d suggest that futures traders correctly added short positions in anticipation of these moves.
The largest rise in open interest is in the Australian dollar where 22% more futures positions exist over a week ago with the overall reading now at 56,960 and the highest since the week ahead of September’s expiration. The Aussie shed 2.8% on the week, its fall cushioned by Armageddon-like activity over the past month. Curiously, there was heavier call buying volume than usual on the Aussie – while options can make a good entry to a longer-term position in the underlying, the high present level of volatility can make them pretty costly. The volume of calls traded over the week is about four times that of puts.
The Swiss franc, which has declined 2.9% over the week to 85.91 (December basis) did not perform in the traditional manner that should be expected of this supposed safe haven. Unlike the yen, the Swiss franc is verging on the edge of a precipice not helped by the performance of its banking sector, where balance sheet damage is substantial. The only unit to add value against the dollar over the last week is the Japanese yen, where once again global deleveraging and unwinding of carry trades earned it a 2% rally against the dollar.
Because of the damage to the Swiss franc, option traders pushed up implied volatility by around one quarter to 21% as the potential for further weakness is clearly on the rise. The largest rise in implied volatility is found in the British pound where plunging confidence measures and announcement of recession are likely to lead to lower interest rates imminently. Only in Australia is there more latitude for outright cuts in interest rates. This week implied option volatility on the pound rose by more than a third to stand at 20.9%. The outright degree of volatility in the Aussie continues to astound us and seems to mirror the performance of the VIX fear-gauge on the S&P 500 index. This week Aussie call volatility is at 41% for a 14% rise on the week.
Andrew Wilkinson
Senior Market Analyst
ibanalyst@interactivebrokers.com
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