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Traders Are Dumping Hedges as Currency Volatility Goes AWOL

Traders Are Dumping Hedges as Currency Volatility Goes AWOL

(Bloomberg) -- The $5 trillion-a-day market for foreign exchange is a calm place these days. Perhaps a little too calm.

In an era of almost unprecedented low volatility for currencies, there’s increasing evidence traders are taking out less protection against big moves. That risks losses if the market turns against them, and potentially a cascade effect to other asset classes if they’ve made unhedged investments.

It’s the latest reason for worry in global foreign exchange, where price swings have evaporated this year even as volatility surged in the rates market. The big concern is that the perceived structural nature of the decline could be breeding complacency.

Traders Are Dumping Hedges as Currency Volatility Goes AWOL

“When vol is low, markets become more vulnerable as market participants tend to take more risk,” said Nikolaos Panigirtzoglou, strategist at JPMorgan Chase & Co. “We see this right now in implied volatilities embedding very little premium over realized volatilities.”

As JPMorgan’s Global FX Volatility Index hovers near a record low, the ratio of expected price swings to those which actually occur -- a proxy for hedging activity -- is well below its historical average, according to Panigirtzoglou. Put another way: Because price moves have become so subdued, traders feel less need to guard against future turbulence.

It’s on show for the world’s most-traded currency pair, too. The implied-to-realized volatility ratio for the euro against the dollar is well below the five-year average. A measure of expected price swings over the next 12 months dropped to a record low this week.

Traders Are Dumping Hedges as Currency Volatility Goes AWOL

Sky-high hedging costs are another part of the equation. Despite recent rates moves, short-term interest rates -- which determine the price of currency futures contracts, or forwards -- are much higher in the U.S. than in Europe and Japan. That raises the cost of shorting the greenback, a key hedge for investors in dollar-denominated assets.

The evidence is anecdotal but persuasive. Most notably, Japanese insurers have been open about a reduction in hedging. Prior to the start of it most recent fiscal year, Nippon Life Insurance Co. said that it planned to boost holdings of foreign bonds without currency hedges because of the high cost of protection.

Dead Calm

There is no end of theories to explain the disappearance of volatility across currencies. Chief among them is the competing policies of central banks, who want to keep exchange rates in check in a world of weak growth and tepid inflation. When the Federal Reserve turned dovish this year and the dollar started to weaken against its major peers, it wasn’t long before policy shifted in places like Frankfurt, Sydney and Tokyo.

“Whenever something starts to move, someone else is whacking on it,” said Thomas Stolper, former chief currency strategist at Goldman Sachs Group Inc., now head of his own firm Embankment Currency Research. “There are very, very rare moments now when currencies really move with persistence.”

Stolper also cites the lack of major asset allocation shifts in recent years. It means there are less fundamental flows which he says reduce the potential for currencies overshooting. For others, such as Panigirtzoglu, a dearth of macro surprises is the main reason for the tranquility.

Whatever the cause, the retreat of volatility doesn’t mean the market is now risk free, as evidenced by a series of mini-flash crashes. In January the Japanese yen surged nearly 4% against the dollar in a span of minutes. Closely connected to that move were positions in Turkey’s lira, an emerging-market currency notorious for sudden big moves.

Ripple Effect

That kind of thing hasn’t discouraged even traders of developing-nation assets from eschewing hedges, though. Philippos Kassimatis, co-founder of Maven Global, a London-based hedging advisory firm, said traders who used to protect themselves against moves in currencies like the Mexican peso or Brazilian real are no longer doing so.

Currency swings have in the past sent ripples through global markets, and typically came from unforeseen events. It happened twice in 2015, with Switzerland’s decision to scrap its currency cap in January and then China’s devaluation of the yuan in August. The Asian currency crisis of the late 1990s hit economies the world over, caused then Fed Chairman Alan Greenspan to put off a planned rise in interest rates and sent Treasury yields plunging as investors dashed for safety.

The biggest threat for currency traders right now is arguably the prospects for the global economy as the trade war grinds on. A sharp deterioration in the growth outlook might be just the thing to jump start volatility, reckons Charles Diebel, head of fixed income at Mediolanum Asset Management.

“At the moment everyone is talking about economic slowdown, but not a complete collapse. It’s very hard for volatility to remain elevated,” Diebel said. “If there’s expectation for a real collapse, that could create more divergences and hit all types of asset classes.”

To contact the reporters on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net;Liz Capo McCormick in New York at emccormick7@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Paul Dobson

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