One of the central focuses of the currency market at the moment is volatility. With volatilities reaching record lows, many traders have taken advantage of the markets tighter ranges while others have suffered greatly.
The big boys of the currency market, who tend to be trend followers have not fared well with the Barclay Currency Traders Index reporting a year to date return of 2.2 percent and the Stark Currency Traders Index reporting a year to date return of 4.9 percent. In the past, the average daily range of the most liquid currency pairs such as the EUR/USD, GBP/USD and USD/JPY would be anywhere from 70-100 pips. These days, intraday action has been all but reduced to a relatively narrow 40-60 pips. With volatilities at such low levels, the question on everyones mind is, how long can this possibly last. In basic math, we have all learned about mean reversion, which is that eventually all anomalies will revert back to average and as such, the current volatility environment raises the risk of a major shift as low volatilities can and often do precede a spike in activity. In order to understand how long this condition can last, we have to understand how we got to this point. There have been 3 main factors that have encouraged the recent drop in volatility central bank activity in the markets, the predictability of monetary policy and the one-sided action by hedge funds.
Central Bank Acting Like Market Makers
Central banks have been more active in the currency markets than ever these days. From reserve diversification to worrying about the value of each others currencies, government officials have been keeping a close eye on exchange rates. On one hand, central banks such as China and Russia are moving to diversify out of dollar based assets and into the currencies like the Japanese yen and Euro. Diversification makes sense especially with the possibility of downward pressure on the US dollar in the near term. However, countering these forces are the central banks from the countries in question. Both Japan and the Eurozone are export dependant nations who are always more comfortable with a weak currency than a strong one. With each of these countries having deep pockets, the two way pull and offsetting flow is working to keep the markets range bound. This is the perfect type of market for central bankers who have always preferred a lower volatility environment than one that is subjected to aggressive speculation.
Narrowing Interest Rate Spreads
Additionally contributing to the slower pace of market activity is narrowing interest rate spreads and the predictability of central banks. Global inflation fears stemming from advancing commodity prices and rising growth have led policy makers to continue tightening rates in some industrial nations. A good example has been Australia and Europe. Both economies were at a standstill at the beginning of this year, however, with rising energy and metal prices, both regions respective central banks have had to consider higher interest rates. The Bank of England this year has raised rates twice, with the market considering the possibility of another 25 basis point hike in 2007. European counterparts are also on the hawkish prowl as the ECB has already raised rates and have alluded to more tightening in the near future. This trend has narrowed the spread differential between the US dollar and many other majors throughout the year. Once offering a spread advantage of 75 basis points, the US dollar against the pound sterling now is offering almost no advantage as British rates have climbed to almost equal to US rates. Ultimately, narrower rate spreads will lower demand for carry trades as the payoff becomes smaller, contributing to reduced fluctuations in the market.
Market Volatility Remains One Sided
With implied volatility at extremely low levels, hedge funds and larger institutional firms have found themselves all piling into long volatility trades as the risk remains low. However, with everyone and their neighbor trying to get a piece of the action, the bet has become very one sided. As with any other market, once market interest and bidding rises to an extreme, little momentum is left at the end, setting the market up for a landslide of participants wanting out if volatility does not pick up soon and continues to drop. With the year coming to an end, some traders may be looking to square up their books and if we begin to see a liquidation of long volatility trades, others may follow suit.
How Long Will It Take Before Volatility Perks Up?
Starting as early as 2004, volatility across the currency market began a clear downtrend. The underlying trend remained relatively unnoticed, however, as currency pairs continued to post sizeable price movements until the second half of 2006. Seven months of falling real and expected price volatility has pushed the subject into the headlines, especially after we have seen the largest declines in nearly five years. The underlying trend has many yearning for a return to extended price moves. If history tells us anything about what we can expect, it is only a matter of when?not if?volatilities will bounce from recent lows.
Like many other aspects of currency trading, volatility has historically been cyclical in nature?with extended declines met with later reversions to longer-term trends. In other words, volatility in and of itself tends to move within a given range?never remaining extremely high or low for long periods of time. Though overall trends show that volatility has in fact moved lower over the long run, the process has been considerably more gradual than that seen in the past year. One only needs to look at historical instances of exceptionally low volatility to see that they are subsequently followed by strong gains. The latest example occurred in 2002, when traders pared bets on volatility and sent implied percentages into single-digits for only the third time since the introduction of the Euro. The 8-month drop proved unsustainable, however, as a subsequent plateau gave way to a major rally. These occurrences seem remarkably similar to those of the current calendar year, with implied volatilities showing a double-bottom in recent weeks.
Indeed, the charts below look like near-replicas of one another. An initial peak in volatilities at the end of 2001 subsequently led to a 4.5 percentage point drop in expected annualized price moves within the following months. This coincided with the EURUSD trading within a progressively tighter range through mid-2002. In fact, much like in recent times, its monthly trading range dropped to record-lows before a subsequent retracement in volatility. The one clear omission from the 2006 volatility chart remains the reversal. If, like in 2002, expectations of price instability establish firm support for implied vols, this bounce may occur sooner than one would otherwise expect.
Of course, one example does not establish theory as fact. But upon examining previous volatility movements, one can just as easily find similar instances to show that persistent declines cannot last. In fact, the year 2000 showed that volatility moved progressively lower for once again, a full eight months before moving convincingly higher. With striking similarities to both 2001 and 2006, expectations peaked towards the end of the year only to shift lower in the medium term. Of course, an almost inevitable reversion to trend meant that it was only a matter of time before a rebound. This is exactly what occurred in June of 2001, when implied volatilities regained as much as 2.5 percentage points to 13.5 percent annualized change.
A Break at Year End?
Whether or not volatility can subsequently make a similar rebound in the short term remains critical. Based upon the last two instances of a major drop in volatilities, we may have one more month to go. However this is far from a guarantee as there are many new reasons for the recent contraction in trading ranges. Periods of low volatility demand specific types of trading strategies that differ from those most profitable in average trending markets. This frustrates many traders who depend on extended price swings for consistent profits, but boosts the viability of more conservative trading strategies. Therefore the smart way to go may be to tailor your trading to the current environment. For those who did so this year, they would not have had to sit through seven month of pain like some of the big boys on the street. Indeed, following the broad dollar strength at the turn of the calendar year, the EURUSD, GBPUSD, USDJPY, and USDCHF have all stayed relatively unchanged recently.
As such, given fairly predictable trading ranges across these currencies, it has been most profitable to buy currencies at support and sell them at expected resistance?betting against a breakout in price over the past year. A clear example can be found in the EURUSD, which has stayed firmly within stiff support at the 1.2500 mark and a firm price ceiling at 1.2900.
Though it is often profitable to trade breakouts of well-established support and resistance levels for extended gains, times of low volatility make such moves entirely less likely. This was exactly the case when traders bought Euros on a break of a previously tested price ceiling at 1.2835?only to see the previous 1.2900 handle bring an abrupt halt to a further advance.
Questions remain as to whether this range trading is to continue. If implied volatilities continue at recent lows, one can expect that the EURUSD will have tremendous difficulty passing previously impenetrable resistance. If, on the other hand, we see the bounce in volatility that history predicts right around the New Year, we could certainly see the currency break from its 7-month trading range.
