Falling cross-border flows due to a lack of divergence between countries/regions has pushed expected FX volatility to lows. We watch China and regional credit growth for currency vol trading.
Why is FX volatility so low?
As the implied volatility for some currencies like EUR and AUD trade close to the lows of 2007, we thought we would address the most common client question – why is FX volatility so low? We see FX implied volatility as a function of 1 ) global risk/equity volatility expectations and 2) country divergences. Both forces have played against FX volatility in the past year, with a higher weight on global divergences (or the lack of them). Without a large growth, inflation or money supply differential, cross-border asset and trade flows have fallen, putting downward pressure on currency volatility.
No global differences: Assuming little change in the equity volatility perception (VIX), we focus on global country divergences. If there are growth differentials then a global asset allocator or corporate is more likely to invest in that region with higher expected growth or return. The money flow (from low to higher return) could in theory require a currency transaction and thus support FX volatility. This year there has been little divergence in returns, as represented by equity indices between the US and average in DM (Exhibit 1). We think European equity indices need to outperform the US for USD to weaken and currency volatility to pick up.
Exhibit 1: DM equity markets need to start outperforming the US for USD to weaken/FX vol to pick up
Broad money supply growth rising in a region can be an indicator for better risk demand and thus potentially higher growth and inflation expectations. However when we constructed a chart of US versus DM (DXY-weighted) broad money supply growth, we were surprised to find that there was no difference since March 2017, despite varying monetary policy (Exhibit 2). This was also around the time when EURUSD 3m implied volatility was peaking and has since halved from 10 to 5. If the two data lines start to diverge then we would expect larger currency moves.
Exhibit 2: US versus DM money supply growth no longer diverges –> lower FX volatility
Why watch China credit? A recent study by our global banks analysts showed that 59% of the world’s loan growth in the past year has come from China. This is a large proportion so makes us take notice when considering volatility assets that could move based on prior credit expansions. China’s previous export growth produced a large current account surplus and thus a growing pile of currency reserves. We find that in the past decade when global currency reserves grew or fell rapidly then this was accompanied by periods of higher FX volatility (Exhibit 3). Today the growth of currency reserves is close to zero because of a lack of global trade imbalances, i.e., one region of the world is no longer selling lots of products to other regions. Where could this type of divergence come from next?
Exhibit 3: Little change in currency reserves (i.e., fewer global imbalances) has depressed FX volatility
Which currency still has a volatility premium? FX implied volatility has collapsed across curves and mostly irrelevant of the currency. Even in LatAm where shocks have led to US dollar strength versus the whole region , expected future volatility has continued to fall. This is unusual, and is a sign that we are in a period where a late-cycle dynamic meets central bank currency commentary or actual intervention.
We screen G10 and EM currencies for the current level of implied volatility out to 1 year tenors versus what is recently realising, the steepness of the curve and skew: 1y RUB and ZAR and 3m TWD screen as high in EM, 3m GBP and SEK 3m screen as high in G10. MXN and CHF are relatively low versus realised. 1y RUB and ZAR currency skew – whether markets expect a large depreciation or appreciation move – is depressed for EM and DM even when adjusted for the low level of volatility.
Exhibit 4: Where is there currency volatility premium versus what is realising?
FX trade ideas: We expect DM FX volatility to remain relatively muted until some of the global growth divergences appear or US equity markets start to underperform. We still propose long NZDUSD via 1×2 call spreads. Our analysis of household credit in Japan suggests that prior excesses have led to higher volatility with a lag. This is why we like to buy forward volatility in currencies like USDJPY in 6m1y to 1y1y tenors. Selling 3m 25D gold calls and buying 3m 25D USDJPY puts also make sense from a relative value basis.