|COMMENT – Low FX vols reflect tight ranges…blame it on QE/NIRP|
|Nov 27 2019 08:25 by Divyang Shah|
| The year is almost over but for the two major currency pairs of EUR/USD and USD/JPY it has been a year of largely going nowhere. Just take a look at the yearly range on EUR/USD and USD/JPY going back all the way to when Nixon suspended the convertibility of the dollar in August 1971 and the Smithsonian Agreement later that year. The two charts below show the low range on EUR/USD and USD/JPY since. FX markets that go nowhere special and are stuck in a range provide little incentive to go long vol with it being more attractive being long vol if you want to play for a break. These ranges have persisted despite a range of factors that would suggest ammunition for dollar bulls/bears…US/China trade war, S&P500/tech continued rally, Fed tightening and now easing, short- and long-term rate differentials. There are a lot of factors to choose from but we think it all boils down to central bank policies. |
Maybe the unconventional policies from global central banks, along with a lot of forward guidance, has simply helped to kill volatility more generally. Buy and hold investors have been forced to go from the safety of traditional safe assets of government bonds into higher yielding riskier assets. Those that had traditionally engaged in hedging FX risk are now more inclined to hold that risk for the sake of earning an added few basis-points. The rebuilding of record shorts on the VIX and the record low implied vols on EUR/USD are symptoms of an environment where selling vol helps supplement returns.
FX vols and vols in general are likely to remain low until 1) monetary policy outlook and policy actions becomes less predictable; 2) the universe of safe assets with a positive yield starts to rebuild; and 3) global reflation efforts start to show results. These factors are clearly linked as CB’s adoption of QE/NIRP policies impact the latter and the trend remains toward more central banks joining the ranks. The RBA seems like the most likely to join the ZLB and QE bandwagon next year as it too will find the need to shift from traditional conventional methods of trying to lift inflation. /kl C