As London was going home on Tuesday February 3rd, EUR/USD had almost hit 1.1500 – that’s up 3.5% from its post ECB QE lows. Prior to that, it had fallen almost 5% from the moment just before Mr Draghi stood up to give his press conference. It took 2 days to fall and 6 trading sessions to back up. No wonder most FX participants are feeling queasy. The trouble is, fx is caught between the negative impact of lower European interest rates, but the massive flow impact that the ECB’s policy unleashed into European equities. Those equities have now caught up with the performance of the S&P, if we measure it from when the ECB first moved to negative rates in June last year:
Here’s the latest data from BAML on European equity inflows:
The potential for a correction kicked in on January 27th and the trouble is that the equity story is now dominating the interest rate one. Markets need new catalysts to continue a trend, and right now we are in a kind of hiatus. We know the ECB are easing policy, but so is everyone else (note Australia joined in last night, moving to a cut after sitting on the fence for over a year). The big question is whether the Fed really are diverging? Friday’s payroll report may give us some more clues on that but the latest US data is not encouraging with the bellwether ISM Manufacturing index moving down to 53.5 from 55.1. It may not truly become clear until Yellen gives her semi-annual testimony in a few weeks – will she want to indicate that they need to move off emergency levels or policy? Or that disinflation buys them time to wait and see if the better labour market data finally feeds into wage increases?
While this is all going on, an important new trend continues. Blondemoney has been warning about the return of volatility, and one of the big themes of this year should be that FX volatility stands out from other asset classes. Not just because of monetary policy divergence, but also the shift in commodity prices and the reallocation of global assets. Oh yes, and political risk too. Bonds and equities remain skewed by the ongoing monetary injection into the world, whereas FX can act as the pressure release valve. Here’s a chart of just how much fresh liquidity is being injected courtesy of the ECB and the BOJ, despite the pullback from the Fed:
Going back to our favourite cross-asset vol chart, FX vol is still sitting where it usually does, somewhere between rates and equity vol:
This is unlikely to persist. FX vol should rise from here. Some might say that it already has, given the shocks we have had from central banks so far this year. Indeed, global FX vol is rising – but only back to its long-term average. Here’s the JP Morgan measure of global fx vol, where the average is 10.68 since 1992, and we are currently at 10.90.
Of course, it feels awful, because back last summer we were making new lows sub 6%. An almost doubling in volatility is going to feel pretty significant. As you can see from the long term chart, the last time we lurched like this, it was the end of 2007 going into 2008…and yes, back then, FX vol was higher than equity vol:
Bond vol was high then too, but we all know the credit crunch originated in the debt markets, so that’s no surprise. This time around, it’s FX that will be the focus, given how liquidity is just trying to find a return wherever it can.
Blondemoney would argue that the price action since the ECB is not a one-off. It will come to be normal. Retail flows were wiped out by the SNB debacle; fixing scandals and regulatory change mean that banks can no longer offload positions or warehouse risk; and there is an awful lot going on this year to move the market around.
EUR/USD daily high frequency vol has moved higher, but only back to the levels of the end of 2011:
Again, it feels a big move because we are coming from such low levels.
But if you just look at the candles on EUR/USD in the past 6 months versus those of the last time we were up at these vol levels, at the end of 2011, you can see that price action was pretty choppy back then – the y axis has been adjusted so that both are on a similar scale:
Looking in more detail, we can see that the daily ranges in EUR/USD were indeed bigger back then. The average for the past 6 months has been 96 pips (i.e. one big figure), whereas in the 6 months to the end of 2011 it was 170 pips:
Now you might argue that at the end of 2011 we were still muddling through the Eurozone crisis. In fact, we were nearing its end, with five out of the 17 eurozone countries already seeking aid. Just 6 months later, in mid-2012, Draghi announced he would do “whatever it takes” to save the Euro.
This time around it’s not about a crisis for one part of the world. It’s a systematic shift in how foreign exchange is operating between global economies. Corrections are about to become more savage – and that long dollar position might have some time to wait before the interest rate story provides a renewed catalyst. Here’s the extent of that position:
And here’s a chart of the key tech levels we are sitting on in the dollar index:
A 1 month EUR/USD straddle costs around 280 pips at 11.1 vol.. If we’re moving back into a higher vol regime then we should get used to 3 big figure moves over the course of a couple of days, not a whole month.
Hold onto your hats….