Emerging currency traders are being kept on their toes
Emerging-market foreign-exchange traders are being kept on their toes even as their counterparts dealing in developed currencies might be struggling to stay awake amid the lull of the northern summer.
Implied volatility on emerging-market currencies has surged and is close to its highest level in over a year, according to a JPMorgan Chase & Co. gauge based on three-month at-the-money forward options. At the same time, a similar measure of volatility for major developed-nation currencies remains more than a percentage point below its five-year average. This month saw the widest divergence between the two measures since 2011.
Group-of-Seven currencies have remained relatively muted as central banks from Europe to Japan persist with easy monetary policy, but emerging markets have been rocked over the past few months amid a convergence of global geopolitical concerns and country-specific threats. The outbreak of a trade war between the U.S. and China has damaged risk appetite, shaking investors who flooded into developing-nation assets in recent years in a search for yield. And the recent broad strengthening of the U.S. dollar also poses risks for some developing markets.
“For EM it has been a story of rotating moves, but quite wild ones,” said Alejandro Cuadrado, the New York-based global head of foreign exchange at Banco Bilbao Vizcaya Argentaria SA.
Turkey’s lira came under renewed pressure last week with U.S. President Donald Trump threatening to impose “large sanctions” on the country and the central bank in Ankara shocking investors by keeping its benchmark interest rate unchanged. Argentina’s peso remains the year’s worst-performing major currency after the country obtained a $50 billion credit line from the International Monetary Fund as its economy faltered.
Even China’s yuan, a largely managed currency, has seen an uptick in expected price swings. Traders are grappling with whether an increasingly acrimonious trade war will prompt the nation’s central bank to allow the currency to keep sliding, after it this month touched the lowest level in more than a year.
The resulting increase in turbulence may feel particularly acute given how depressed volatility was at the start of the year, according to Lisa Chua, a money manager at Man GLG in New York.
“The market had gotten overly accustomed to a period of abnormally low volatility, bolstered by the quantitative easing program globally,” Chua said. “Even a small ripple can potentially feel like a tidal wave for those who got complacent with still waters.”
The JPMorgan index of emerging-market FX volatility fell as low as 7.45 percent in January. It rose to as high as 10.14 this month, the highest since February 2017 and slightly above its five-year average of around 9.36. In contrast, the JPMorgan measure for G-7 currencies dropped to as low 6.98 percent earlier in July.
A steadily rising Federal Reserve policy rate is also causing emerging markets to feel the crunch. Slumping currencies and fears of further capital flight last month prompted central bankers in Indonesia and India to call upon the Fed to be mindful of how further tightening could affect global markets.
The requests appear to have fallen on deaf ears. Fed Chairman Jerome Powell raised rates later in the month, and he has said that the central bank will continue to gradually raise interest rates “for now.”
The Fed’s tightening path has helped to buoy borrowing costs this year, with the yield on the benchmark two-year Treasury note climbing around 79 basis points since December to 2.67 as of Friday. The 10-year rate is up around 55 basis points over the same period.
“While a lot of die-hard emerging market investors still want to hang in there, it feels to me that a 10-basis-point move in U.S. yields matters a lot more for EM now than it does in G-10 markets,” said Kit Juckes, a London-based strategist at Societe Generale SA.
Meanwhile, extraordinarily loose monetary policy in other major economies continues to extinguish volatility in their respective currencies, Juckes said. European Central Bank president Mario Draghi last week reiterated his intention to keep the ECB’s deposit rate unchanged through the summer of 2019.
“The ECB isn’t doing anything until next summer and we’re having deep, meaningless arguments about which month in a year’s time they might start,” Juckes said. “That anchor on volatility has just been there, and that’s the same story we’ve had for about 12 months.”
And while rumors have circulated that the Bank of Japan is considering tweaking its yield curve control program, one-week implied volatility in the dollar-yen pair ahead of the BOJ’s July 31 policy announcement is still below the year’s highs.
The fact that geopolitical gyrations haven’t yet translated into developed-market currency turmoil doesn’t mean that the current environment will persist forever, cautions Chase Muller, who oversees about $700 million at One River Asset Management. While the dampened price action of the moment can make it more difficult to find compelling trades, it’s probably not the best time to take a vacation, he said.
“I would feel uncomfortable being away from the desk for a while,” Muller added. “It seems like currencies are becoming more interesting, and the fact that recent volatility in EM hasn’t spilled over to DM doesn’t mean it won’t at a moment’s notice.”