We noted last night that, for now, it appears there is no contagion to other asset-classes from the explosion in equity volatility expectations…
While rates, FX, and oil vol has picked up, it remains notably low (and well below longer-term averages).
Credit Agricole’s Valentin Marinov explains why and what happens next…
FX volatility gauges have clearly lagged behind other vol measures like VIX during the latest bout of escalating risk aversion. Indeed, whereas the VIX has recently hit its highest levels in almost seven years, our index of G10 USD-crosses implied volatility has barely managed to scale its highs from September 2017 and has remained well below its long-term averages.
In addition, a look at the relative G10 performance since last week would highlight that the biggest losers were the European currencies like EUR, GBP, NOK and SEK rather than the ‘usual suspects’ AUD and especially NZD. At the same time, USD emerged victorious even against safe havens like JPY and CHF. It seems therefore that a positioning unwound rather than the FX sensitivity to risk aversion could explain the moves.
Does the above discrepancy indicate that the FX markets are lagging the equity markets so that investors should turn even more negative on risk-correlated and commodity currencies?
We think that cautiousness is certainty warranted and as a result we maintain our relatively bearish outlook for AUD and NZD in the near-term. That said, there are other factors that make us think that the FX volatility may continue to lag the equity volatility. The main reason seems to be the relatively subdued correlation between USD and US rates and UST yields. This has been attributed to the flattening of the UST curve that has been in place for most of 2017. In turn, this reflected investors’ belief that the Fed tightening cycle how now matured so that any future rate hike would have less of a positive impact on USD. All this also implies that the recent surge in UST yields is less positive for USD than it is negative for US stocks.
There has been some contained bear steepening of UST curve since the start of February and this may explain the renewed recoupling between USD and the elevated US rates and UST yields that helped the dollar regain some ground across the board in the last few days.
The question for us is whether this correlation will grow in intensity so that higher yields result in stronger USD, trigger more unwinding of USD-funded carry trades and thus fuel realized and implied FX volatility.
That may indeed be the main risk in the near term especially if the Fed officials or a potential US government shutdown trigger further bear steepening of the UST curve. Over longer-term, however, the UST curve may resume its flattening trend and this should, once again, deprive USD from any US rates or UST yields support.
As a result, the moves in the USD-crosses may remain relatively more contained than in the stock markets and the FX volatility may continue to lag the stock market volatility.