FX Market Voice | Are Markets in a Summer Snooze?

The market is seemingly facing an unusually dire array of event risks. The UK’s new Prime Minister has indicated her intent to pursue Brexit, keeping the timing of exit as well as its economic impact as large uncertainties for the market. While US Presidential elections are not normally major market movers, this year is shaping up as a highly unusual contest with substantial implications for the economy. The Wall Street Journal reported last week that a majority of polled economists believe election uncertainty is already hurting US economic growth. Meanwhile, a variety of ongoing issues – China slowdown, potential fracturing of the euro, problems in the Middle East, uncertain outlook on energy prices – remain as potential sources of volatility. Despite all of these sources of potential turmoil, the chart below shows that stock market volatility over the past month seems to be taking a summer holiday sinking to 5-year plus lows. Bond market volatility is also well below the long-term average.

Exhibit 1. Realized 1-Month Volatility for US Equities, Bonds and the Dollar

Source: Eikon

The dollar (broad trade-weighted nominal) is a bit of an outlier. 1-month realized volatility is not historically low – roughly in line with the long-term average – and has recently been trending higher. Indeed, for possibly the first time ever, dollar volatility is threatening to move above equities. The volatility environment raises two questions: why are bond and stock volatilities dropping to historic lows and why is there a contrary move in USD?

Exhibit 2. Seasonality of Realized SPX Monthly Volatility

Source: Eikon

It is tempting to blame the volatility drops to summer market doldrums. It is well believed that market activity declines significantly in August as investors and traders flock to the beach – or elsewhere – on summer holiday. But the chart above suggests this is incorrect. Looking at SPX realized monthly volatility averages for each month of the year going back to 1930; we see that August is not typically a low month for volatility compared to other month’s historic averages. Realized volatility to date for August is far below its normal average and it appears that these depressed levels are not simply a byproduct of summer vacation.

The Drop in Equity Market Volatility is Not Just a Summer Fling

The chart below (Exhibit 3) is more evidence that the decline in equity volatility is not just a summer fling. 3- month implied volatility – i.e., the VIX – has hit multi-decade lows. The equity market is priced to remain in a lowvolatility mode at least through the US Presidential election. The currency market, however, is taking a contrary view once again. EUR and GBP implied volatility is in line with longer-term averages and JPY implied volatility is well above average. Indeed, we are again seeing an unprecedented event; JPY implied volatility is threatening to move above the VIX.

Exhibit 3. 3M Implied Volatility for Equities (VIX) and Select USD Crosses

Source: Eikon

What is Causing the Volatility Crush?

In the 2015 January Market Voice we outlined reasons why the move toward lower yields by central banks across the industrial world was bearish for market volatility:

• Low yields are bearish for bond volatility because while zero is no-longer a lower bound, there is still resistance to dipping into negative territory so bond rates are squeezed into a narrow range as they approach or go below zero.
• Volatility is covariant across markets so anything that depresses volatility in the bond markets tends to weigh on volatility in equity and currency markets.
• Equity volatility is highly directional, rising in bear markets and falling in bull markets. Low bond yields also depress equity volatility as they imply an extension of central bank accommodation which is equity supportive.
• Yield spreads across countries are normally associated with bigger cross border moves which can generate volatility across all markets so the convergence of short-term rates close to zero depresses volatility in all markets – especially currencies.

As shown in the chart below (Exhibit 4), equity market volatility has generally tracked the downtrend in US long-term bond rates – with a hiccup immediately following the Brexit vote – providing further evidence that the global decline in long-term rates has been a dampener of volatility.

Exhibit 4. SPX 1-Month Realized Volatility and 10-Year US Treasuries 1-Month Moving Average

Source: Eikon

Is it Time to Sell FX Volatility?

The fourth item above may explain why FX volatility is high relative to bonds and equities. While G10 rates are generally near zero, expectations on central bank policy are diverging. The European Central Bank and most other European central banks remain wedded to keeping rates low and potentially in negative territory for the foreseeable future. Speculation on the US Federal Reserve, contrarily, remains focused on when rates will be hiked. The Bank of Japan’s failure to deliver expected cuts in their last meeting has left the market uncertain of where its policy is headed. Divergent central bank policy is normally a source of volatility in FX markets and may explain the unusual divergence.

Equity and bond volatilities are at or near all-time lows while currency volatility is more in line with long-term averages. This would seem to imply that currency volatilities should be biased to decline, making them a sell. This is particularly true for JPY implied volatility which is close to moving above the VIX for the first time in history. But the table on the following page taken from the Eikon Foreign Exchange Value/Performance Tracker suggests the market is already priced for a decline in FX vols. The second column of the chart shows the 3-year percentile for 3-month implied volatility and consistent with what is shown in the charts above, most volatility levels are in the middle of the historic range and only two currencies – JPY and GBP – have implied volatility in the upper quartile. But even for JPY and GBP, 3-month implied volatility relative to 3-month realized volatility is extremely low. In other words, implied volatility is already priced for much lower levels of realized volatility. And implied volatility maturity curves, for the most part, are not particularly steep by historic standards, which imply that a lower implied volatility market is priced out as far as 5-year maturities. So despite the divergence in FX volatility with other markets, it is not particularly expensive. Moreover, as long as expectations on central bank policy remain divergent, FX volatility may remain buoyant relative to bonds and equities.

Investors concerned about the event risks discussed at the beginning of this article should be looking to selectively take advantage of low implied relative to realized volatility to establish hedges. Based on the following table, this would already apply to CHF and SEK exposure and will probably soon apply to other currencies if the VIX remains near these historic lows.

Exhibit 5. Relative Value of Implied Volatility of USD vs. G10 Exchange Rates

Source: Eikon