Things have gotten quiet in currency markets, and too quiet for some traders.
The sense of calm is shown by remarkable stability in exchange rates and the cost of hedging against big swings in them. The worry is that volatility has gotten abnormally low, which could make any future market moves more disruptive.
The suppressed volatility is especially evident in the top-traded currency pair—the U.S. dollar against the euro, which has traded sideways since the beginning of October. A broader measure of volatility maintained by Deutsche Bank , which follows nine major currency pairs, has dropped by a quarter since the beginning of the year.
Meanwhile, the cost of purchasing options to protect against big currency moves, known as implied volatility, has dropped to its lowest since mid-2014. That was a quiet period before China’s 2015 devaluation set off months of wild trading.
“We are now at absolute extremes,” said Richard Benson, head of portfolio investments at hedge fund Millennium Global Investments.
The drivers are varied. The recent shift in tone from the Federal Reserve and the European Central Bank away from tightening policy removes the risk that sudden rate increases will upend markets. Meanwhile, U.S.-China trade talks have put pressure on China to keep the yuan stable.
Another factor: Some analysts say the cheaper cost of insuring against big currency moves is itself artificially depressing volatility.
When investors use options to protect against future currency swings, it is like purchasing insurance against bad weather. Buyers pay a premium; in exchange they get a big payout if a storm materializes. However, financial markets are so interconnected that too much selling of insurance against bad weather can in itself make the sun shine—at least for a while.
This is because there are more investors making bets that volatility will stay low or get even lower than there are wagers that it will go back up, says Julian Weiss, head of forex flow options at Nomura. “Market participants that buy volatility are not there.”
In the absence of other investors willing to bet that it will go up, banks step in and will take that bet. Except banks—who don’t want to keep an open position on which way currencies go—then hedge those bets, a process which can dampen volatility. They do this by trading the underlying currency in the market. They sell it if the currency goes up, and buy it if it goes down. These bank trades thus help serve to smooth out trading in the currency, keeping volatility low.
With central banks standing pat and little else to drive markets, the betting on low volatility itself is helping to drive trading, says Russell LaScala, Deutsche Bank’s global co-head of foreign exchange trading. He calls the situation “self-perpetuating,” adding that “these loop orders control the market absent any events.”
But this can easily be undone. If an economic or political event leads to a market swing, banks can suddenly forgo their hedging activities, looking to profit from any rise in volatility. That would remove a stabilizing force from the market. At the same time, investors who had bet on low volatility would get burned and rush for protection. That in itself would feed further volatility.
The risk is that the current situation proves similar to one that preceded the big selloff in stocks in January 2018 after a long stretch of ultralow volatility. In the case of stocks, investors were selling equity options to collect premiums, in essence betting that volatility would remain low. This pushed the cost of this insurance—measured by the Cboe Volatility Index or VIX—to record lows. When concerns about the economy overheating and rising interest rates unnerved investors, a sharp unwind of those low-volatility bets ripped through the markets.
Even a return to historical levels of volatility in currency markets holds disruptive potential.
And there are signs that the window is closing to make money betting it will remain low. That can be seen in the narrowing gap between actual current volatility in the cash market for currencies, known as realized volatility, and future implied volatility, which is gauged by the cost of hedging in the derivatives market.