Forex: Is Low Volatility Good for Carry?

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Daily FX Market Roundup 04-07-14

Forex: Is Low Volatility Good for Carry?

EUR: Risk of QE is Low

GBP: Lots of Data but No Surprises Expected

AUD: Rise in PMI Construction Provides No Support

CAD: Extends Gains Despite Drop in Q1 Business Outlook

NZD: Unfazed by Slower House Price Growth

JPY: Watch for Hints of Future Stimulus from Bank of Japan

Forex: Is Low Volatility Good for Carry?

The U.S. dollar traded lower against all of the major currencies today with the exception of the Australian dollar. While no major U.S. data is scheduled for release this week, the slide in Treasury yields and decline in U.S. equities discouraged investors from buying dollars. The FOMC minutes is the only notable event risk for the dollar and given that we already know where the central bank stands on monetary policy, the impact on the greenback should be limited. Therefore we take this opportunity to discuss the recent decline in forex option volatility and its implication for carry.

At the start of trading this week, option volatilities in the foreign exchange market dropped to fresh multi-year lows. The volatility for 1-month EUR/USD options has fallen to its lowest level since 2007 and for USD/JPY and GBP/USD volatilities are at their lowest level since 2012. The low volatility environment has a few important implications for currency traders. In the past, we have written that carry trades thrives in an environment of low volatility. This notion is based on the idea that in low volatility environments investors and traders are willing to assume more risk. Unfortunately carry trades are not performing well today and is unlikely to benefit from the low vol environment in the near term because 2 important elements are missing. In order for carry trades to thrive, not only does volatility need to be low, but central banks need to be in tightening and investors need to optimistic. Judging from the 140-point drop in the Dow today, there is still a significant amount of uncertainty within the financial community. At the same time, the Reserve Bank of New Zealand is the only central bank raising interest rates while everyone else is talking about increasing stimulus or gradually reducing it. The earnings season has only begun and if this week’s releases fail to impress, stocks could suffer further losses, taking many of the major currency pairs including carry trades down with it.

Instead, low volatility points to range trading and with no major U.S. or European reports, there’s a very good chance that currencies will consolidate this week. This makes the chance of the EUR/USD breaking 1.36 and USD/JPY rising above 104.50 slim. There could also be further profit taking on long dollar positions.

EUR: Risk of QE is Low

The euro traded slightly higher against the U.S. dollar today on the back of stronger than expected German data and comments on QE from ECB officials. Starting with the data, German industrial production grew 0.4% compared to 0.3% expected. While this increase still marked a slowdown from the previous month, it is consistent with the upside surprise in last week’s factory orders report. The data triggered an uptrend in EUR/USD that lasted throughout the European and NY trading session. The gains were supported by ECB officials who were open but not eager to introduce Quantitative Easing. According to our colleague Boris Schlossberg, “ECB council member Nowotny is a perfect example of this bi-polar approach. While Mr. Nowotny noted that ECB rate cut has not been ruled out, he gave no indication that such move was imminent and while he also appeared open to the prospect of unconventional measures such as QE, he again did not state that the ECB was going to enact such a plan in the foreseeable future.” ECB Vice President Constancio shared these views. While he indicated that the central bank is ready to use unconventional measures, he also felt that the decision should not be made lightly and said no decision has been made on QE. According to council member Coeure, European QE would be different from US QE. The central bank’s stance is probably best summarized by Mersch who said “QE is a theoretical concept that the central bank is a long way from implementing.” In other words, while the European Central Bank is clearly dovish the risk of QE is low, which is positive for the euro.

GBP: Lots of Data but No Surprises Expected

Like the euro, the British pound traded higher against the U.S. dollar today. Compared to other countries, the U.K. has a more active economic calendar. Not only does the Bank of England have a monetary policy decision on Thursday but industrial production and the trade balance are also scheduled for release. Unfortunately no surprises are expected which means sterling will most likely fluctuate between 1.65 and 1.67 against the U.S. dollar. Given the drop in the manufacturing PMI index, both industrial production and the visible trade balance could surprise to the downside. The Bank of England is widely expected to leave interest rates and the size of its Quantitative Easing program unchanged. Based on last week’s economic reports, manufacturing, service and construction sector activity slowed in the month of March and while this gives the BoE reason to keep monetary policy easy, it will not increase their desire to raise QE because each one of these reports remain at elevated levels.

AUD: Rise in PMI Construction Provides No Support

There was very little consistency in the performance of the commodity currencies today. The Canadian dollar extended its gains against the greenback while the Australian dollar traded lower and the New Zealand dollar ended the day unchanged. A rise in the PMI construction index for Australia failed to lend support to the currency and was offset by the smaller increase in job advertisements in the month of March. One of the most important economic reports on the calendar this week is Australian employment and based on the ANZ report and the jobs component of the PMIs, we are looking at a strong possibility of weaker job growth that could accelerate losses in AUD. The New Zealand dollar was also unaffected by a slower year over year rise in house prices and the same could be said for the Canadian dollar which shrugged off a drop in a quarterly business outlook survey. Tonight, Australian and New Zealand business confidence numbers are scheduled for release and on Tuesday, Canada will release housing market numbers. Most of these reports are expected to deteriorate slightly but the impact on currencies will depend on the magnitude of the surprise. After Friday’s blowout jobs number, we believe that Canadian dollar traders will overlook a decline in the housing market report unless it is significantly weak.

JPY: Watch for Hints of Future Stimulus from Bank of Japan

The Japanese Yen traded higher against most of the major currencies today, which was not surprising given the steep 1.7% decline in Japanese stocks overnight and the drop in U.S. 10 year bond yields. The Bank of Japan delivers its monetary policy decision this evening and while they are widely expected to leave policy unchanged, there is a small chance that they will start talking about the possibility of increasing stimulus. Only a few days have past since the consumption tax was increased so it is far to early to tell how much damage it will have on the economy. Although going into the tax hike, data was mixed the markets have been stable. The focus will be on Governor Kuroda and his assessment of the economy. At the last meeting, he was confident that Japan could withstand the tax increase and that economic data has been in line with expectations. If he sounds even slightly less optimistic, his words will have a direct impact on the odds of Quantitative Easing. The central bank has made it clear that they stand ready to adjust policy if needed and a repeat of this verbiage with no additions or changes will have no impact on the Yen.

Kathy Lien
Managing Director

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