I was gearing up to write about how volatility in the fx market had disappeared – something that Simon Derrick ably highlighted on Monday. Even though the yen is very, very weak against the currencies of the advanced economies by almost any measure, the market expected volatility to be lower than it had ever been in the past. Derrick last Friday:
This has seen EUR/USD 3 month implied vol. collapse to a record low of 5.5% (compared to a record prior to last July of 7.93%). Meanwhile the equivalent price in USD/JPY has spent most of this year trading close to levels not seen since October 1996 (and then only briefly). Similarly, the cable implied vol. price is trading close to levels not seen in half a decade.
What is remarkable about the activity in these three instruments, however, is that they are currently pricing in levels of calm in these currency pairs over the next three months that have rarely, if ever, actually been seen in the past. USD/JPY has only fleetingly seen such low levels of volatility in the spot price on two occasions in fifteen years (the start of February 1993 and late October 1996) while in cable the current implied level of volatility for the spot price over the next three months has only been seen once in past decade and a half (mid-October 1996).
Most remarkable of all though is the current 5.5% 3-month at-the-money-forward implied volatility in EUR/USD given that the lowest level recorded for the historical volatility of EUR/USD (or its components prior to 1999) from 1992 onwards was 6.54% (in October 1996). In other words the EUR/USD currency options market is currently forecasting that the next three months will be the quietest on record for this currency pair by some considerable margin. (Emphasis added)
Well, things changed a bit today. On an absolute level, volatility no doubt remains fairly low. However, it is a bit higher than it was – and both the yen and swiss franc rallied after a small correction in the Chinese equity market triggered a general bout of risk aversion.
One interesting point: the dollar didn’t benefit from today’s flight to quality. Fair enough. The currencies of countries with big current account deficits facing a shortfall in private inflows aren’t classically considered the gold-standard by those looking for a safety.
That though is a bit different than last spring, when the dollar did benefit for a while from the flight out of emerging markets in May (more here). I think Macro man probably has this story right: after the April 2006 G-7 communique (the one that briefly made Dr. Roach an optimist) some big players started to bet that the dollar would fall. In practice, that meant that they ended up using the dollar to finance their high-carry bets on Turkey and Brazil. Or to finance their bets on Turkish, Brazilian and Russian equities. When those bets unwound in May and June, the dollar got a bit of a boost. Today, though, it was the yen that got the big boost. Bloomberg:
The yen also advanced 4.1 percent against the Turkish lira, 3.9 percent versus the South African rand and 2.8 percent against Iceland's krona as investors shunned riskier assets in emerging markets following a rout in Chinese stock market shares.
Yet more circumstantial evidence that leveraged bets on the emerging world right now are – or were -- financed not with dollars but with yen and swiss franc.
UPDATE, February 28th: A bit more on the last point -- namely the use of the yen to finance bets in a range of risky assets -- from Simon Derrick:
USD/JPY’s 2.19% fall, understandably enough, captured a great deal of the attention yesterday given that this was the pair’s 6th largest daily decline this decade, dwarfing the somewhat anaemic 0.44% rally seen in EUR/USD. However, it is on the JPY crosses that the really interesting story emerged. GBP/JPY, for example, managed to stage its largest daily decline since May 2001, losing a substantial 2.27% before making a modest (0.4%) recovery overnight. AUD/JPY and NZD/JPY were even more extreme, losing 2.89% (the largest drop since 2002) and 3.72% (the largest daily move we have a record of) respectively. ZAR/JPY collapsed by 4.46% (the largest decline since early 2004) while HUF/JPY dropped a slightly more modest 3.48%. In short then yesterday was not about the USD at all but rather about the use of the JPY as a funding currency to invest in a variety of high yielding (and, in some cases, relatively illiquid) currencies and what happens to these trades when risk appetite declines.
Emphasis added. Derrick goes on to note that even after the correction yesterday, insurance against big moves in the $/ yen is quite cheap. I agree.
NOTE: I edited the first paragraph of this post to clarify that I was referring to the yen's weakness against the currencies of other established economies. All the G-3 currencies are in some sense strong relative to most emerging currencies. Some (the euro) are just stronger than others (the yen).