The fear factor has gripped stock markets. The pace of the global stock market sell-off has increased this week, sparked by fears about global growth, Ebola and central bank uncertainty. The VIX Index, which measures the implied volatility of the S&P 500, surged to its highest level since February on Thursday. Spikes in volatility typically lead to a decline in equity values. The next level to watch out for in the Vix is the 2014 high at 21.44.
Is the FX market immune to risk aversion?
Interestingly, although the Vix has surged in the last 24 hours and stocks have tumbled, the same is not true of the FX market. Figure 1 shows volatility in EUR/USD and the Vix. As you can see, after peaking in mind-September, EUR/USD volatility has moved sideways, and failed to break above recent highs even when the Vix made an 8-month high on Thursday.
The same is true for NZD/JPY volatility. This cross is considered one of the most risky in the FX space and normally falls sharply during periods of heightened risk aversion. However, as you can see in figure 2, which shows NZD/JPY volatility and the Vix, which has been normalised to show how they move together, volatility in this pair has not kept pace with the Vix either. Although NZDJPY has come under selling pressure in recent weeks, it is still some way off the lows reached in February.
So what is going on? We believe the reason why FX volatility is lagging behind the Vix and stock market volatility, is the dollar. One of the reasons why stocks have sold off this week is because of central bank uncertainty, as Fed expectations swing almost on a daily basis. Since Wednesday’s FOMC minutes, the market has started to wonder if the Fed is getting nervous about a strong dollar, which could lead them to push out their rate-hiking plans.
Due to this, the dollar’s performance this week has not been consistent and it is nearly 1% lower as we move towards the end of the European session. It is not only the Fed who is concerned about dollar strength. This week the Japanese PM seemed to contradict the Bank of Japan governor and speak out against JPY weakness (and de facto USD strength) saying that it was making energy imports expensive.
Market turmoil churns up the market
October was always expected to be a tricky month for the markets as the Fed’s QE3 programme comes to an end. However, as equity markets sell off on the back of confusion and uncertainty about the Fed’s next steps, downside in risky FX could be limited if the Fed continues to show concern about USDstrength.
The recent bout of market volatility has muddied some of the usual correlations that we have come to expect during periods when risk aversion rises. For example, oil has been declining in line with the USD; usually a falling dollar can push up the price of Crude Oil. Added to that, USDJPY has traded sideways even though the Nikkei 225, which shares a close positive correlation with it, is lower on the week.
If the equity sell-off continues, we would expect further declines in the riskier G10 currencies, and we would expect to see the volatility of risky crosses like NZDJPY jump, as these crosses start to sell off. However, how far FX joins in with the sell-off could depend on the dollar. If the USD’s upside is limited due to Fed fears about inflation, don’t expect the FX market to react in the usual way, as a muted dollar could limit the downside for risky FX pairs.
Takeaway:
- • Stock market volatility has surged to an 8-month high, however, this has not been replicated by the FX market.
- • As you can see in figure 1 and 2 below, FX market volatility has been muted in comparison to the Vix.
- • This could be because of uncertainty around the Fed‘s next policy move and concern among Fed members about dollar strength.
- • Thus, even though stocks could continue to sell off, risky FX pairs and crosses like AUDUSD and NZDJPY may not come under as much pressure as one would expect.
Figure 1:
Source: FOREX.com and Bloomberg
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Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.