Currency volatility takes a step back as Japanese intervention looms
Last week we raised the notion in this column that currency intervention might not be a bad idea to help ease the pain inflicted on emerging market economies in round about fashion following the fallout from a collapsing U.S. housing market. A subsequent round of further currency market volatility allowed for at least three central banks to step in and support their domestic currencies. In addition, the prospect of unilateral Japanese intervention to help loosen the stranglehold on the outlook for exporting companies helped shift investor sentiment into forward gear.
The precipitous decline for most currencies has pretty much everyone tuned into the view that the dollar can’t be stopped anytime soon and this view is in danger of creating further dislocation for economic growth. Now that the British pound has fallen so hard, we’re watching analysts clamor for more downside as further weak economic data emerges. Similarly, the prospects for an implosion in European activity as indicated by confidence measures hurtling so hard towards the ground that even a stuka pilot would be impressed, will be enough to see the ECB cut rates next week. But does this mean that the euro will continue to plunge also?
Heading into Halloween the market is very much in danger of scaring itself half to death for fear of what shadow may lurk around the next corner. While seasoned traders appreciate that nothing travels in straight lines forever, it does have to be said that rarely have we seen this kind of a move before. But when we stop and think about the driving forces, one gets a sense that on a day when fear subsides just a little, sense will prevail. To slam the pound because the U.K. economy is heading south on the recessionary highway fails to understand that just ahead of Britain is the United States. Trying to make sense of the temporary myopia indicating that the state of the U.S. economy no longer matters is just nonsensical.
Central banks actively intervened in Australia and New Zealand apparently to create liquidity. Adding U.S. dollars available in exchange for domestic currency has clearly helped stabilize both markets. Neither relatively high yields nor the prospect of a wider differential should the Fed follow through today with a widely expected cut in the fed funds rate have previously helped either unit. The Mexican central bank followed the same routine adding dollars in exchange for pesos to alleviate illiquid markets. Meanwhile monetary agencies in Brazil, South Korea, India and Singapore either intervened to stem dollar strength or at least used the threat of it to create some sense of order.
When the world’s second largest automaker, Honda Motors of Japan, notes that yen strength is hampering performance to the tune of ¥20 billion ($200 million) per quarter from its operating profits, one wonders what this means on the flip side for other Asian nations.
It appears that the threat of even unilateral intervention and rumors of a quarter point rate cut at Bank of Japan was too much for yen bulls to carry. Tuesday’s incredible yen sell off was broad based and could mark a significant turning point in global sentiment. The December yen fell from 109.62 at the start of the week to 102.75. Against the euro the Dec euro/yen contract rose from ¥110 to ¥123.
The world is starting to understand the impact of risk aversion, yen and dollar strength and as it does so it realizes that there is an end game here, which is that at some point all of the rebalancing that investors are having to stomach, all of the dislocation and all of the inexplicable moves that no one ever dreamt could happen will ultimately subside.
What investors need to understand is that the reverse correlation between the value of the yen and the stock market have slightly different driving forces. We are in danger of assuming that a long yen position is taken at the expense of a long stock position. This simply is not true. The subsequent unwinding of risk aversion trades based on what the BOJ might or might not do should not be read as a green light for jumping back into equities. We are only just at the top of the precipitous slope that will reveal some pretty dire economic data in the coming months. Granted, the equity markets have reacted in horror and have sold off a long way very quickly, but we doubt that we have seen the worst of the news unfold for stocks yet. Before a recovery comes a bottom in terms of activity at least.
While this doesn’t guarantee that markets will resume their former glory, it does pretty much ensure that we ought to be prepared for lower option market volatility moving forward. To commence this week, implied volatility on currency futures was at record readings. With the dollar starting to ease off the gas pedal one should expect traders to consider thinking about the positive attributes that each currency has to offer.
Of interest this week is the fresh revelation that the Swiss financial system holds about 50% of outstanding loans to LatAm and other emerging market nations according to the Bank for International Settlements. This compounds established news that UBS and Credit Suisse have written down more bad exposure to the U.S. housing sector between them than the next three most exposed financial institutions put together.
While we are not amazed that the Swiss franc has lost its tarnish in terms of a safe haven status in the same way that the Japanese unit performed, we are surprised to witness its safe haven status remains strong amidst the European currencies. It may well take many years to restore the credibility of the domestic financial system and the activity downturn within Europe will drain the life out of the Swiss economy, which relies on the Euro zone to dump 50% of its exported goods. The chance of a deeper monetary relaxation from the Swiss National Bank than the market has currently priced in could further undermine the Swiss franc looking forward.
Open interest across currency futures declined over the course of the last few weeks. We suspect that this may have been forced liquidation across most contracts. The exceptions occurred in the British pound and Aussie dollar where positions were built by 2% and 8% respectively. It’s harder to judge what the direction of stake building was here since put option volumes also swelled on the British pound. That indicates increased bearishness, which did indeed transpire before a gigantic rebound. Selling short the Aussie and pound has been a really easy play for many traders looking to make a fast-buck. The Aussie was still recoiling from a deleveraging play as risk aversion swelled, while investors chose to compare U.K. data on the one hand to absolutely no other data on the other. The pound was in a lose-lose situation waiting for the tide of sentiment to change, which has happened so far this week.
Currency volatility is certainly off its peak reading found on Monday. The rumored intervention from Japan has allowed breathing space for all currency traders although, as with the stock market fear gauge, the sustained elevated readings on currencies means that currency investors don’t expect any kind of return to normality anytime soon.
Only in the comdols of Australia and Canada did a rise in call open interest exceed the build in put open interest over the last week. This could be due to the absolute decline in the values of each currency against the dollar with speculators keen to play a long position via options rather than risk outright positioning despite the elevated volatility.
Only Swiss franc volatility has eased this week, while that on the yen and pound surged. Both are off their intraweek peak levels but at 29.5% and 27.7% respectively, both jumped by around one-third in comparison to last week. The Aussie retains the crown for being the most volatile currency of the week with implied options volatility reading 42.2%.
Senior Market Analyst
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