Time for Currency Traders to Start Hedging Midterm Election, BofA Says

(Bloomberg) -- With the North American summer drawing to a close, Bank of America Corp. strategists are urging investors to plan ahead for the U.S. midterm elections.

The bank recommends owning three-month dollar-yen implied volatility heading into November, when Democrats will attempt to wrest the House of Representatives and even the Senate from Republican control. Implied volatility in dollar-yen appears “cheap” relative to the rest of the Group-of-10 at the moment, and the yen’s flight-to-quality characteristics make it attractive heading into autumn’s risk events, according to FX strategists Alice Leng and Vadim Iaralov.

Time for Currency Traders to Start Hedging Midterm Election, BofA Says

“U.S. election risk tends to be underpriced in FX historically, with a sizable rise in volatility around the election date,” they wrote in an Aug. 30 research note. Owning three-month dollar-yen vol is a way to “hedge against a mid-term election shakeup, potential deterioration of trade issues with China and fallout from North Korea denuclearization talks.”

Three-month implied volatility in dollar-yen currently sits at 7.35 percent, down from a peak of more than 10 percent back in February. Volatility in major developed-nation currencies remains below its one-year average, according to a JPMorgan Chase & Co. gauge based on three-month at-the-money forward options.

The outcome in November could change that. Should Democrats retake both chambers of Congress or secure a large majority in the House, markets might begin to price in the possibility of a full Democratic sweep in 2020 -- when President Donald Trump is up for re-election -- and potentially the repeal of his tax-reform package. That would give way to much broader turmoil, the analysts wrote.

“Post-election, our biggest concern is whether a complacent market can handle a rise in volatility,” Leng and Iaralov said. “In those scenarios, volatility could rise significantly as policy uncertainty takes hold, an outcome that is being priced only as a tail scenario.”

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