The contrast between equity volatility and Treasury volatility been a defining feature across asset classes this year. The MOVE index, a VIX for the Treasury market, is currently (as of July 23) close to all-time lows. But what is more striking is that the ratio of the MOVE index to the VIX has made dramatic history this year – falling decisively to levels never before seen.
While Treasury and equity volatility tend to move (roughly) together, the divergence today is intuitive. The Fed’s policies this year are suppressing not just rates, but rate volatility. Putting aside broader issues like inflation, foreign yields and term premium, the Fed is an extremely powerful force. Equities, on the other hand, have to contend with uncertain earning streams and political risk. While the front half of the VIX curve has fallen post-March lows (VIX spot now at ~24) – the back half of the curve continues to stay well supported.
So if Treasury and equity volatility are diverging – and seem likely to say divergent for some period of time – what about FX volatility? Many classic currency volatilities are still quite low. For example, three-month USD/JPY implied volatilities are just at 5.8% at the moment, which is the bottom five percent of all readings going back to 2004, (again as of July 23).
The Euro has been making headlines and gains against the dollar, but the implied volatility levels have been pretty consistent in the six to seven range over recent weeks. On the EM side, Korean Won and Yuan volatility have been pretty stable in light of the massive issues in the background. Of course the more subdued EM volatility can be attributed to the weaker dollar theme, which the Fed has been central to.
Gold volatility, however, has been jumping higher. This rise in gold volatility certainly speaks to the break-out in gold prices and the growing appreciation for this asset class. But while gold is a commodity, it is also considered a non-fiat currency. If this spike in gold volatility is a harbinger of future FX volatility (e.g. a rise in the Euro to 1.20 / potentially 1.30), then the Fed’s extremely dovish policies will have simultaneously driven down Treasury volatility while at the same time pushed up FX volatility.
In the coming months, we think there are some major reasons to think that FX volatility (beyond gold) will increase. If rates are converging across developed markets (DM), then the FX channel becomes all the more relevant marginal factor in central bank policy. A surging Euro might reflect a better economic condition and lower political risk in Europe, but it also at some point becomes a tightening measure for that economic region. How DM central banks and other policy makers manage FX volatility and the level of their respective currencies will be an interesting dynamic unfolding in the coming quarters.
The implications of rising FX volatility for risk assets such as equities and credit are complicated and there are a lot of specific micro issues depending on the company and the country. But global investors may see a much larger percentage of their returns coming from FX than they
are used to, especially after several years of a stronger dollar. That also means that global equity or credit investors need to start considering the FX dimension of their returns more thoroughly.
In an environment like this, having a global macro investor with expertise across a number of asset classes – such as Harvest Volatility Management – is more important than ever.
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