Currency volatility for a return

After more than a year of sleep, currency volatility is about to come to life.

From Nomura International Plc to Rabobank, banks are recommending cheap protection against exchange rate (FX) fluctuations, which have so far been stifled by a liquidity barrage and historically low interest rates.

The premise is that as growth picks up and central banks begin to telegraph the end of any stimulus triggered during the pandemic, traders caught off guard may need to recalibrate their positions, paving the way for some jolts. sudden.

Investors are “ready and willing to pull the trigger,” says Neil Jones, head of currency sales to financial institutions at Mizuho Bank Ltd., who recommends traders buy currency hedges for up to one year. Last week, JPMorgan Chase & Co’s gauge of currency fluctuations fell to the lowest level since March 2020.

While there have been many false dawns on a rebound, the latest calls indicate a significant shift in the disposition of the market. Unlike the long end of bond curves, which suffered large losses as inflation accelerated and economies opened up, currencies are sensitive to changes in short-term rates which remain firmly anchored by central banks. .

That’s why traders are now looking for clues that policymakers might tip the scales. On Tuesday, the New Zealand dollar jumped to a three-month high after the central bank predicted interest rates would start rising next year and were more belligerent overall than expected.

“The market is not ready for any serious surprises from central banks at this time,” Jones said, referring to any unexpected cuts in their bond purchases. “The next 12 months suggest a plethora of minefields.”

Among the potential triggers are the European Central Bank (ECB) meetings in June and July and the Federal Reserve symposium in Jackson Hole in August. Julian Weiss, head of currency options at Nomura, is catching up with the one- to three-month volatility of the euro-dollar pair, contracts that capture all three events.

“Volatility is too cheap,” he says. “We are seeing more and more countries easing lockdowns, and we believe the rebound in global growth has yet to be fully assessed by currency markets and the dollar in particular.”

The three-month implied volatility of the Euro-dollar crossover is currently trading around 5.85%, below its year-to-date average. The relative premium on the tenors, as shown by the spread between implied and realized volatility, is close to parity, suggesting that options are not overvalued.

Hedge funds have also recently added long positions in euro volatility, expiring around ECB policy meetings in June and July, according to two Europe-based traders familiar with the transactions who asked not to not be identified because they are not. allowed to speak publicly.

Meanwhile, Jane Foley, head of foreign exchange strategy at Rabobank, believes that now may be a good time to buy the three-month volatility of dollar-yen or dollar-Swiss franc crosses, safe haven currencies that have fallen behind. compared to all of their G-10 peers. over the past six months, thanks to the risky mood of the market. “Abundant liquidity is like a medicine for the markets and can make price action much less sensitive,” she says.

Some, like Ned Rumpeltin of the Toronto-Dominion Bank, remain cautious, saying the summer will likely be calm.

“I don’t know if buying six-month volatility on a ‘fire and forget’ basis is a foolproof idea,” said Rumpeltin, the company’s European head of currency strategy. “It’s probably best to buy three-month volatility in three months.”

It wouldn’t be the first time traders have missed the mark. As discussions about cutting the Fed swept through markets earlier in the year, there was a short-lived rebound in volatility that faded once policymakers downplayed the outlook.

Yet few people doubt that the market is moving. “It won’t take too much for investors to worry a bit and be afraid of how the situation will change,” says Weiss of Nomura.

—With help from James Hirai, Robert Fullem, Susanne Barton and Namitha Jagadeesh.

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