ADVERTISEMENT

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost

(Bloomberg) --

Global markets appear broken yet traders can hedge for wild scenarios at reasonable costs through options.

Trading currencies through the spot market has seemed pointless at times as the coronavirus pandemic evaporated liquidity and resulted in unprecedented moves. Just on Wednesday, a dollar gauge advanced by the most since June 2016, sterling reached its lowest in 35 years and the Norwegian krone had its worst day on record.

The shock-absorbing role of banks as intermediaries has diminished and algo-driven markets, deprived of liquidity, are simply expanding a vicious circle where price availability evaporates as moves get stronger. In this environment, options may present the best choice.

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost

Even though hedging costs have risen, volatility is coming up from record lows. That means in comparison to historical levels and to other asset classes, betting on currency turbulence remains inexpensive on a relative basis. As uncertainty grows about how the pandemic crisis will end, volatility may actually be in the early or middle stages of an advance.

A gauge of swings in the major currencies has risen to its strongest in eight years but is still way off the highs seen at the peak of the euro-area debt crisis or the bankruptcy of Lehman Brothers. And it may not be long until those levels come back into play.

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost

It didn’t take long for the dollar to resume its rally on Thursday, even after the European Central Bank launched an extra emergency bond-buying program worth 750 billion euros ($820 billion). Frantic moves in the cost of borrowing dollars have become a regular phenomenon and speculation is growing about future coordinated intervention to weaken the greenback.

New evidence from Europe and the U.S. suggests that younger adults aren’t as impervious to the coronavirus as originally thought. Countries that are a step behind in tackling the pandemic are seeing their currencies sold off aggressively. Investors have entered uncharted territory and the cash market isn’t the place to take cover.

Read More:

What seemed unthinkable at the start of the year could now be a matter of a few trading sessions. The pound dropping to parity against the dollar is an overlooked bet, as no single trade on such a move has gone through the Depository Trust & Clearing Corporation this month. Yet according to Bloomberg’s options-pricing model, there is a one-in-five chance that it will do so within the next three months.

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost

Similar tail-risk scenarios can be addressed through option structures. That helps explain why traders are paying the widest premium on record to hedge against the wildest ever move in the euro over the next year.

Still, this doesn’t mean that everything in options works in an orderly way. Just a look at risk reversals in euro-dollar, a barometer of market positioning and sentiment, is enough evidence that trading in today’s environment is challenging, especially if the bet is on a currency’s direction. Short-term wagers on the euro went from the most bullish on record to the most bearish in three years just within nine days.

Lack of Liquidity Broke the Currency Market Yet All Is Not Lost
  • NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

©2020 Bloomberg L.P.