Today’s generally low volatility currency market environment could be “positive for risk-seeking, yield-hunting trading strategies,” an HSBC report out Wednesday said. There is one trade staple, maligned in certain quarters, and one currency sector that could benefit from a new volatility regime.
Volatility regimes, like price persistence, are ever changing
While some in the managed futures CTA space take the cyclicality of market environments as a document-able fact, there are those who are just now embracing the concept. The technical market environment of volatility is known to trigger numerous systematic strategies and create opportunity for discretionary and relative value traders as well.
Looking at the currency regimes over the last few years, the market environment for volatility has seen major swings. Mark McDonald, Head of FX Quantitative Strategy at HSBC, and David Bloom, Global Head of FX Research, note that which is causation for a volatility regime to come and go cannot always be precisely documented, there are logical causes to consider.
“Some suggest that these regimes are related to positioning, others believe that confidence in the ability of central banks to come to the rescue is the key, whilst many believe that these regimes are simply an emergent property of the market,” the pair wrote in a report titled “Keep calm and carry on: A new FX vol regime.”
In the research piece they not only document the change in volatility regimes from 2014, but provide analysis of the current regime and how it could impact certain trading strategies.
2014 was an extremely low volatility period… oddly so
The summer of 2014 was quiet. Very quite.
It was the age of central bank stimulus at its most potent point casting a spell over bonds and related markets such as stocks and currencies – both of which peg value based on sovereign interest rates. When rates move lower, the value of stocks moves higher, for instance. Higher interest rates increase currency values, as the US dollar is currently discovering as the US Federal Reserve delicately withdraws stimulus from the markets.
“The market was puzzled by a low volatility conundrum,” McDonald and Bloom write. “Volatility was close to all-time lows in many asset classes and many regions. This low volatility environment was a source of great consternation and worry” as many traders “were genuinely worried that they would never see volatile markets ever again.”
In 2014 when they compared implied volatility to realized volatility it painted a picture of markets put to sleep. During that period “the majority of G10 currency pairs had negative Volatility Scores,” which impacted certain trading strategies. “Realised volatility very low at that time, the outlook being priced into the options market was that realised volatility would continue to be lower than usual.”
Those who study technical market environments over longer periods of time – 20 years, for instance – know that volatility, like price persistence, relative value divergence and mean reversion, have a history of coming and going. It was just a matter of time before they returned and 2015 was that year.
2015 FX volatility was almost a mirror opposite of 2014
Volatility in 2015 was odd in several respects.
It most poignantly manifested itself in the August stock market crash. For certain quantitative analysts this was benchmark in part because it was the first time a flash crash was partially predicted. Fundamentally driven long-short strategies such as Balyasny Asset Management had been looking at a potential rate hike in September of that year and, before the August crash, pulled in their risk to ride out what was logically seen as a potential market storm approaching.
When interest rates have potential to move – or even the expectation is that interest rates could move – stocks and currencies are likely to follow. Currency traders who in 2014 were decrying the lack of volatility were, in the summer of 2015, about to get their wish.
Comparing the HSBC FX volatility charts from the two periods is like looking at an entirely different movie, going from “Mary Poppins” to the “Terminator” in the blink of an eye. The HSBC analysis, using more dulcet tones, reflects this reality.
Volatility, defined by market surprise, increased and remained at levels “higher than usual,” the report noted. In fact, when both implied and realized volatility were low it did not predict forthcoming volatility, the statistics rather painted a pastoral market picture.
2016 is a balanced volatility
The two extremes in volatility leads to the 2016 market environment, where, based on HSBC Volatility Scores, the environment is “much more balanced.”
But even in this environment there is surprise, particularly given the fundamental outlook on the world.
“This is astonishing in light of recent events – in quick succession we saw (i) the UK vote to leave the EU; (ii) an attempted coup in Turkey; and (iii) the BoJ massively disappoint market expectations of so-called ‘helicopter money’. Any one of these events had the potential to lead to a significant risk-off period,” the report said. “However, the market has mostly shrugged off this news.”
What are the implications?
The carry trade, which has been maligned in certain circles as picking up nickels off the street but getting rolled over by a truck, might find a positive environment, as the report authors note:
Carry trades follow a natural cycle whereby good carry returns contain the seeds of their own destruction: When carry performs well traders increase carry exposure. Eventually positions become so large that the strategy becomes unstable – at which point a carry unwind becomes quite likely. However, carry trade positions are far from this point at the moment. Given the dramatic moves seen in EM over 2015 there still is reluctance amongst many market participants to enter into long-EM FX exposure. So enjoy this positive time for carry whilst it lasts.
Enjoy it while it lasts, the market environment is likely to change at some point.