(July 10): Currency traders are starting to buy protection against bigger exchange-rate swings after months of calm, as banks warn that shifting Federal Reserve expectations and elevated geopolitical tensions could be about to jolt markets.
A gauge of expected volatility in major currencies over the coming month has edged higher in recent weeks, though it remains only slightly above five-year lows touched in June, and well below this year’s average. Similarly, one-year euro-dollar implied volatility has ticked up from 2022 lows, though one-month euro-Swiss franc volatility remains at the lowest in more than a decade.
Yet the backdrop is anything but calm. The Fed under its new chairman Kevin Warsh is stepping back from offering markets a clear roadmap on interest rates, leaving traders hostage to each data release. At the same time, renewed clashes between the US and Iran threaten to shatter a fragile ceasefire in the Middle East.
Barclays Plc strategists say the disconnect can’t last. A team led by Marek Raczko says the bank’s models suggest volatility is set to rise and recommend buying instruments that will pay off if euro-dollar price swings pick up later this year.
“Low FX volatility has been driven by low market conviction, rather than low macroeconomic uncertainty,” they wrote in a note.
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Fast-money investors and interbank trading desks appear to be reaching a similar conclusion. With hedging costs low relative to the risks, leveraged investors are exploring trades that profit from a pickup in volatility, according to FX traders familiar with the transactions, who asked not to be identified because they aren’t authorised to speak publicly.
There are some signs a shift is already underway. Short-dated hedging costs on the euro and the pound bounced off their lows this week as options began to capture next week’s US inflation report — a reminder that, with the Fed offering less guidance, individual data points carry more weight than they have in years.
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The inflation report could swing interest-rate bets in money markets, which currently price at least one quarter-point Fed hike this year.
A sustained pickup in volatility would reverberate well beyond the options market. Calm currency markets have been the foundation of one of this year’s most profitable FX strategy: the carry trade, where investors borrow in low-yielding currencies such as the yen or Swiss franc to buy higher-yielding ones, including those in emerging markets.
The strategy has returned about 8% this year, beating global bonds and gold. Goldman Sachs strategists say wide interest-rate gaps and subdued volatility have created the most compelling backdrop for carry trades in more than two decades.
The catch is that the second driver could be about to disappear. Carry trades earn their returns slowly but a sudden burst of currency swings can wipe out months of accumulated income in weeks. As investors rush for the exits, their selling can amplify the very moves they had been betting against.
For now, markets continue to price in a benign outlook. If volatility returns, the trades that have thrived on calm conditions could unwind quickly.
Uploaded by Evelyn Chan
