A Pause in the Dollar's Rebound Creates Currency Options Volatility

After several weeks of the dollar rally, currency futures settled down and in some quarters even reversed direction. Whether that proves short-lived remains to be seen. The slide in appetite for the euro currency evident in the previous week stopped as dollar bulls scratched their heads, but failed to find further rationale for stepping up dollars buying. Implied currency options volatility did move ahead as some profit-taking in the dollar threw a spanner in the works and so added to forward-looking uncertainty. Notable increases in implied volatility rang up in the Australian dollar and Japanese yen thanks to implications in the equity and commodity markets.

 

In the week through Wednesday, there was little change in euro currency futures open interest, which barely budged. That might bode well for a rebound in the euro in light of the dire confidence figures on Tuesday, which highlighted the impact of prolonged weakness in the dollar and the run-up in energy prices and its impact on consumer and business sentiment.

We note the unusual pattern in open interest on the Japanese yen and the Swiss franc. Traders pared Japanese currency exposure and added to Swiss holdings. Both currencies are usual candidates of the so-called carry trade in which these traditionally low-yielding currencies are sold short to create assets in higher yielding currencies. Given the poor state of equity markets at the start of the week it was no surprise to see rallies in both units, but the decline in yen open interest on the week makes less sense to us.

Again the inconsistence is apparent in the reduction in positioning in the Canadian dollar while positioning in the Australian dollar increased. Both of these currencies are underpinned by appetite for raw materials, and the exodus from the Canadian dollar despite its relative stability of late and already low yield is less understandable than the build in futures positions on the Aussie unit.

Both currencies of Australia and its neighbor in New Zealand were punished over the course of the week as a groundswell of views built after the annual Jackson Hole central bank meeting over the weekend. It became a little more apparent to investors that global growth was slowing, that U.S. financial gridlock was contaminating overseas markets, and that the chances of global monetary easing were rising. At this stage investors look to those currencies with the highest yield relative to the dollar, which arguably have most to lose. The kiwi suffered moreso than the Australian dollar, but the nearby trade is to position short Aussie in the clear expectation that the Reserve Bank of Australia will start to cut interest rates next week.

The release of FOMC minutes from the Fed on Tuesday failed to dent the dollar’s armor. The minutes noted that the committee was in broad agreement that rates couldn’t stay low forever but that for now they were appropriate. This pretty much underscores any argument that the Fed will seek to raise rates this year. However, weaker data outside of the United States sought to peel layers off the hitherto thicker skin of other nations.

The British pound was the notable victim. Having traded recently at $2.00, the pound has lost 17 cents to stand at $1.8288 (September basis) by midweek. The latest bout of bad news came in the form of the weakest set of mortgage lending data in a decade. With a housing market that’s got a lot further to correct, the pound really is in trouble. Once again it’s a surprise to see a build in futures open interest with so much clearly stacked against sterling at this phase of the growth (or contraction) cycle.

The put/call ratio in the option markets reflects the expectation for a weaker bias for both euros and pounds. In the case of the euro, this is a clear turn around from the recent dominance of long call positions. In the case of the pound, the balance is much more marginal. Elsewhere, call positioning in Australian and Canadian dollars reflects the expectation of a rebound ahead.

Call implied volatility rose across all currency options during the week with a notable jump in the yen and Aussie units (+14% and 15% respectively). As noted earlier, the Aussie’s recent plunge and dealers jockeying for the best seat in the house ahead of the RBA meeting could possibly make for an extremely good signal that a rebound is just around the corner. When implied volatility surges like this, it indicates a demand for protection in anticipation of higher volatility. While we’re not predicting a surge in the Aussie just yet in the event of an RBA cut next week, we’d assign a significant probability to such an event in light of signs in options prices.

We should also anticipate a further wave of dollar strength if the revelation by the Nikkei on Thursday takes a feverish grip. The Japanese journal noted a potential central bank plot to firm up the dollar as a way to steady global financial markets. This kind of news, if taken seriously, will cause dollar bears to reevaluate their holdings going forward.