Get-Well Card from Central Banks Doesn't Cure the Underlying Ailment; Forex Remains Volatile

Today’s coordinated cut in interest rates warmed the cockles of investors’ hearts as though they’d received a personal eCard from the world’s bankers, telling them that they indeed cared about investors’ feelings and that they were doing everything they could to make things right again. The sentimental touch lasted all of 92 minutes as S&P futures reversed a 33-point gain before falling back in to the red once more in pre-market trading at least. Yield differentials were maintained following this dramatic round of coordinated intervention from six central banks. Since our last report, currency traders have increased demand for dollars sensing that a dire situation would indeed demand easier global policy while funding pressures across financial balance sheets remained extreme. (Click chart to enlarge.)

Earlier the Australian central bank had seized the opportunity to make an oversize 1% reduction to key rate, while Japan had noted that in such grave times each nation must do what it feels right. With already ultra-low yields, it made little sense for them to join the chorus. Equity market volatility or, more simply stated, the fear evident across investors’ prospect for the economic outlook, has been elevated recently. The 50-plus reading on the VIX takes us back a whole six years to when the last recession-induced selling capitulation peaked. The mood has been so manically sick that it feels as though absolutely nothing can heal the dour investor sentiment.

Currency implied volatility rates derived from exchange traded options have once again surged. We noted last week that they were rising in line with increasing equity volatility. However, the situation is unique in that such elevated readings are unprecedented. Some economists had indicated the increased likelihood of currency intervention to stem the rise of the dollar despite the fact that its strength was presaged with record weakness only weeks ago.

So long as the demand for dollars, via funding pressures, remains strong the outlook for other nations’ currencies shall remain weak. This uncertainty has increased the cost of options, which is reflected by the increased implied volatility. To return to the similarity with equity market volatility, the VIX reading of S&P index volatility has gently risen ever higher to levels that seasoned investors are simply astonished by. There is no reason to expect currency market volatility to die down in light of this development and as such we could be in for even higher readings despite the sentiment implied within the coordinated central bank eCard.

During the past seven days open interest across the currency futures market grew in all cases except against the yen and British pound. The Japanese unit was the only currency to rise against the dollar during the week, finally breaching ¥100 on Tuesday. A 2% drop in futures open interest meant that this week’s 4% build in euro currency futures open interest makes the euro the contract with largest outstanding investor interest.

The demand for dollar saw its value add 3.7 cents against the euro, while the pound declined by three pennies to $1.7413. But the biggest move came from the Aussie dollar as it shed a huge 12.5 cents to 66.30 cents against the dollar. The Canadian dollar, despite a 4.5 cent decline to 90.19 cents has the benefit of already low interest rates relative to its southern neighbor as well as a proximity that lends itself to trading in closer in-line to the dollar. The slashing of Australian rates this week underscored the severity of domestic problems in Australia and highlighted the fact that the central bank has more powder in its keg, which it will undoubtedly resort to.

The impact of surging currency volatility during the last week has in part caused option investors to ditch open positions. Along with the expiration of the October contract option open interest data shows a one-in-three reduction in outstanding call and put positions since one week ago. The impact is to leave only the British pound with a put/call ratio of greater than one, indicating more open bearish positions than bullish call positions.

At a reading of 15.9% the Canadian dollar is the least volatile of the six pairs that we monitor. Had we made this statement six months ago we’d have been laughed at. The commodity dollars are typically more volatile than other units and a reading of between 9-10% is more accurate. Implied volatility rose by 19% since last week.

As for the euro currency, implied volatility at 17.3% is a shade lower on the week. Perhaps traders have a sense that the unit is not quite in freefall – since that honor is taken by the Aussie dollar – and that the strength is a flight into the dollar rather than creating an abyss for the euro.

Demand for options on the yen and questions on when the flight to safety surrounding its demand has sent options implied volatility to 21.7% showing that volatility doesn’t just appear when the underlying commodity is under selling pressure. Meanwhile call implied volatility on the Aussie dollar is above 29%.

Given the immediate failure of the concerted rate reductions to halt selling pressure in the equity arena, it is hard to predict that currency option volatility will decline anytime soon.  We are in a new regime as far as currency movements and flows are concerned. The dollar economy has become the blueprint for what other economies infected by toxic mortgage debt. If local banks haven’t bought into the American MBS market, they surely have over lent to householders making the problem more deeply engrained than any central bank can deal with.