Oct. 28, 2010: Volatility rose 15% in a matter of weeks, accompanied by an 8% decline in EUR/USD over the same period.
May 10, 2010: Volatility rose 27% in two weeks, accompanied by a 10% decline in EUR/USD extending for four weeks.
Sept. 10, 2008: Volatility soared 146% in eight weeks, accompanied by a 13% decline in EUR/USD over the same period. In each of the four cases, the 55-day moving average rose above the 100-day, leading to sharp rallies in euro volatility and substantial declines in the pair.
One exception was in August 2007, when volatility almost doubled in a matter of seven months, but was accompanied by a 10% rise in EUR/USD. One explanation to such divergence was the contrasting interest rate policies between the European Central Bank and the Federal Reserve, whereby the latter was forced to slash its discount rate while the former was in the midst of raising rates. In fact, the Fed was the only G7 central bank in easing mode at the time, which explained the entrenched downtrend of the U.S. dollar that year.
As of June 8, 2012, EUR/USD one-month volatility has had five consecutive weekly gains — the longest weekly increase since September-October 2008 when the euro started a 22% plunge that lasted three months. Meanwhile, the 55-day moving average of the EUR/USD volatility is 20 points below its 100-day counterpart. Once the cross-over does occur, both averages must continue pointing upward. This would suggest a further run-up in volatility lies ahead, with the 15.0-18.0 in EUR/USD one-month volatility a realistic target.
Traders also will discover that a protracted uptrend in euro volatility is highly likely to be accompanied by a strengthening in the VIX. Using volatility indicators in two of the most heavily traded instruments provides a lucid view of the fear factor in global markets. If the VIX fails to rise (and stay) above the 27.0-28.0 level, then care must be exercised regarding short-lived run-ups in euro volatility.
Using technical analysis such as moving average cross-over and chartist techniques to identify breakouts in euro volatility can serve as an advance signal to the EUR/USD rate, rather than the spot rate itself.
Ashraf Laidi is chief global strategist at FX Solutions/City Index, founder of AshrafLaidi.com and author of “Currency Trading & Intermarket Analysis.”