Currency Volatility Set for a Comeback on Looming Policy Shifts

After more than a year of slumber, investors are preparing for currency volatility to come roaring back to life.

From Nomura International Plc to Rabobank, banks are recommending cheap protection against foreign-exchange price swings, which have been muffled so far by a barrage of liquidity and record-low interest rates.

The premise is that as growth picks up and central banks start telegraphing an end to all the stimulus unleashed during the pandemic, traders caught off guard may have to recalibrate their positions, setting the stage for sudden jolts.

Currency Volatility Set for a Comeback on Looming Policy Shifts

Investors are “ready and willing to pull the trigger,” said Neil Jones, head of foreign-exchange sales to financial institutions at Mizuho Bank Ltd., who is recommending traders buy currency hedges as long as one year out.

Last week, JPMorgan Chase & Co’s gauge of foreign-exchange fluctuations fell to the lowest level since March 2020. While there have been many false dawns over a rebound, the latest calls point to a significant shift in the market’s disposition.

Unlike the long-end of bond curves which suffered steep losses as inflation started accelerating and economies opened up, currencies are sensitive to changes in short-term rates that still remain firmly anchored by central banks.

And it’s why traders are now scouring for any clues that policy makers might tip the balance. On Tuesday, New Zealand’s dollar jumped to a three-month high after the central bank predicted interest rates will start to rise next year and was overall more hawkish than expected.

Taper Surprise

“The market is not prepared for severe taper surprises from central banks right now,” Jones said, a reference to any unexpected reduction in their bond purchases. “The next 12 months suggest a plethora of mine fields.”

Among potential triggers are the European Central Bank’s meetings in June and July and the Federal Reserve’s Jackson Hole symposium in August. Julian Weiss, head of currency options at Nomura is snapping up one- to three-month volatility in the euro-dollar pair, contracts that capture all three events.

“Volatility is too cheap,” he said. “We’re seeing more countries easing lockdowns and we believe the bounce in global growth is yet to be fully priced by the currency markets and the dollar in particular.”

Currency Volatility Set for a Comeback on Looming Policy Shifts

Three-month implied volatility in the euro-dollar cross currently trades around 5.85%, below its year-to-date average. The relative premium on the tenors, as shown by the spread between implied and realized volatility stands near parity, which suggests the options aren’t overpriced.

Hedge funds have also been adding long volatility positions in the euro lately, expiring around the ECB policy meetings to be held in June and July, according to two Europe-based traders familiar with the transactions who asked not to be identified because they aren’t authorized to speak publicly.

Meanwhile, Jane Foley, the head of foreign-exchange strategy at Rabobank, say now may be a good time to buy three-month volatility in the dollar-yen or dollar-swiss franc crosses, haven currencies that have lagged all their Group-of-10 peers over the past six month thanks to the market’s risk-on mood.

“Plentiful liquidity is like a drug for markets and can make price action far less sensitive,” she said.

Currency Volatility Set for a Comeback on Looming Policy Shifts

Some, such as Toronto-Dominion Bank’s Ned Rumpeltin, remain cautious, saying the summer is likely to be quiet.

“I’m not sure if buying six-month volatility on a ‘fire-and-forget’ basis is a foolproof idea,” said Rumpeltin, the firm’s European head of foreign-exchange strategy. “You’re probably better off buying three-month volatility in three months time.”

It wouldn’t be the first time that traders missed the mark. When talk of Fed tapering swept through markets in the beginning of the year, there was a short-lived rebound in volatility that faded once policy makers played down the prospect.

Still, few doubt that the market is in for a shake-up. “It won’t take too much to get investors a little bit worried and scared about how the picture will change,” said Nomura’s Weiss.

©2021 Bloomberg L.P.

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