FX Update: FX trying to get boring again, but it won’t be able to
Head of FX Strategy
Summary: FX volatility, especially as measured in implied volatility for FX options, has declined sharply over the last few weeks as central bank liquidity shock and awe have worked their magic. But too many important questions loom for markets to return to their pre-coronavirus abject complacency. The most pressing issue this week is the EU council meeting on Thursday.
While daily trading ranges in FX remain rather elevated in many places, unprecedented central bank and government policy action, particularly from the US Fed, have worked their magic for the moment and brought far more liquid trading conditions and stabilization, crushing options market implied volatilities relative to their recent highs. The broad 1-month Deutsche Bank options implied volatility has declined from over 16% at the mid-March peak to under 8.5% now, with the 3-month implied index peaking at 13.5% and now at around 8.5% as well. In mid-January, the two were near record lows of sub-4.5% and 4.75%, respectively. A classic risk indicator like a USDJPY, 1-month, 10-delta risk reversal spiked beyond -17% (the premium for 1-month, 10-delta (or deep out of the money) put options relative to call options) and is now at -4.5%. Meanwhile, a risk proxy currency pair like AUDUSD first hit the level it is trading today (around 0.6350) seven trading days ago and hasn’t done much since. It certainly feels like the world has been administered a major shock and we are all looking around and wondering what to do next.
Supposedly, the narrative is shifting back to the pace of normalization from here. But is it really, or is the state of this market merely a reflection of the policymakers’ overwhelming mobilization of liquidity and de facto “suspension of the fundamentals” for now, which keeps the bears reluctant to “fight the Fed” and the opportunistic bulls buying as they monitor the huge positive shift in liquidity. It’s a treacherous environment in the near term for either view.
This has us taking a step back to look at the key questions that are hanging over the market and will either allow or prevent a further decline in volatility and any return to normalcy that we believe will be very difficult to achieve. Among those for the moment are:
EU existential risks – this is the most pressing and immediate issue because a very ugly EU council meeting this week – for example, Italy walking out – would immediately trigger massive fallout (not our prediction, but simply the most clear-cut event risk) As we discuss on today’s Saxo Market Call podcast, some sort of technical fudge on the rescue package is likely, one that both avoids conditionality for the rescue funds extended to the hardest hit nations (most important for Italy and Spain) and avoids any labeling as “mutual EU debt” or “coronabonds” (most important for Netherlands and Germany). But our interest extends far beyond the technical aspects and more towards the sense of whether the EU is moving in the direction of solidarity or away, and how close we are to the EU’s moment of truth, as French President Macron forcefully called it in a seminal FT interview last week.
Covid19 pace of recovery – the narrative is that we can look forward to an imminent recovery of economic activity, but I don’t think the average investor or company is buying this narrative. The v-shaped charts from AUDUSD to the Nasdaq 100 are not the economy – they are a product of policymaker shock and awe. The economic recovery is going to be a tough slog – even if some portions of the economy do experience a v-shaped bounceback, the legions of failed SME’s will take longer to reform and rehire. Also for the longer run, even assuming a rather rapid resumption of economic activity, scrutiny of listed company risk buffers will be intense and attitudes toward savings may experience a once in a century shift in the wake of this crisis.
Geopolitics – the finger pointing over blame for the coronavirus outbreak has started and we are in a US election cycle. I don’t want to speculative what form this takes, but the danger of a protectionist backlash from all of this has increased dramatically and the US-China trade deal from mid-January looks rather like ancient history with new hostilities a major risk.
The unknown chain reaction insolvency trigger – the Fed in particularly has mobilized a multi-trillion USD torrent of liquidity measures and backstops to prevent companies, banks, and even via swap lines, countries from going under. But somewhere out there is the risk of a major insolvency or default event that the Fed or other actor (for example EU if Italy chooses default) can’t prevent and that proves too large for manage the fallout from. Think Lehman in 2008, for example, or Credit Antalt in 1931 in Europe. This could also come from the oil sector or EM sector (remember Russia in 1998, for example.)
Social – not to much speculation here on the shape this takes or the immediate market fallout, but the “culture war” in the US is taking on a dangerous tone and we have a US President who is tweeting “Liberate Minnesota” and “Liberate Michigan” and assault-rifle toting protestors walking around the Michigan capital building and miles-long queues at food aid stations. And clearly in the US case, the official response is doing far more to help the big liquid, share buyback adoring major listed companies than any other actor in the economy. Even if the intentions are merely to prevent an immediate lurch into depression, the moral hazard is a clear and present danger to the social fabric.
The Brave new world of FX – this was a concept I coined in a post last week. In short: If we suffer something between a U-shaped and L-shaped recovery, we risk a world of long-term zero rates and massive money printing across all economies to get ahead of the juggernaut of past debts and the social spending exigencies this recession (New Depression?) is creating. With central banks in cahoots with governments to peg the entire yield curve close to zero – a world of YCC – what is the escape valve. It will be currency exchange rates unless a new global reserve standard is created.
Given the above, the only counterargument to all of these risks is that central banks and governments are able to stay ahead of all of the above points and maintain asset market prices while avoiding all major defaults, manage to engineer a steady US dollar devaluation and then begin a financial repression regime of pushing inflation steadily higher than . That eliminates possibly many of the above, if not the Brave new world of FX – again, unless some new non-USD reserve asset is identified – which would see all FX devaluing rapidly against that asset – gold? Bancors? SDR?.
EURCHF looks hopelessly manipulated via SNB intervention even if it could still respond to a new EU existential crisis worsening from here. We prefer to look at EURJPY over the next week and more of the EU council meeting and its aftermath, also because of the major 116.25 level that has yet to give way for this part of the cycle (the lows for today's bar in the chart below are due to a misfeed - the low on the day is above Friday's low).
Economic Calendar Highlights (times GMT)
- 1230 – Canada Mar. Teranet/National Bank Home Price Index
This Week’s Calendar Highlights
- TUE: Australia RBA Minutes, Australia RBA Lowe Speech, UK Mar. Jobless Claims Change, Germany Apr. ZEW Survey,
- WED: Turkey Central Bank Rate
- THU: EU Council Meeting, UK Mar. Retail Sales, EU Apr. Flash PMI, US Weekly Initial Jobless Claims, US Markit Flash Apr. PMI,
- FRI: Germany Apr. IFO, Russia Central Bank Rate Announcement, US Mar. Durable Goods Orders, US Apr. Final University of Michigan Sentiment