Complacency Sets in with Low FX Volatility

Posted by SM-INVEST -
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The month of November 2019 is ending with a whimper. There was hardly much US rates volatility across November. 3M US Libor was stuck in between 1.8-1.9%. Additionally, the FED succeeded in building widespread consensus for the neutral rates outlook for the rest of the year. With US rates not in a hurry to head anywhere, FX volatility also dried up.

In addition, the two key global event risks are on the back burner for now. Brexit is on hold till post the UK election on December 12th. President Trump continues to talk up the US-China trade negotiations. Multiple reports from both sides sources suggest that a partial deal could be reached by the end of the year.

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Volatility outcome

All these means leading to volatility for Majors continued to drop as spot drifted along in tight trading ranges. The EURUSD registered some of the narrowest trading ranges of the year. Overall, FX volatility for the Majors started the year nearer to 8% and lowered towards the 5% handle.

GBPUSD implied volatility, but it also collapsed after Brexit saw another delay until January 31st. Japan’s continued lacklustre economic performance and a sidelined Bank of Japan has depressed JPY implied volatility further.

Overall, the 3M implied volatility for the USD Index (DXY) has fallen to about 4.39%. Financial markets do go through the occasional spell of volatility drought. These volatility droughts can have very long tails, i.e. they can last for a very long time. Those positioned for long gamma or long volatility need to have the steely conviction to sit through the persistent needling of daily time decay.

The previous spell of volatility drought occurred in 2014. That came to an abrupt halt after the FED signalled that it would start lifting rates from zero. To highlight this volatility drought, we focus on EURUSD volatility chart. From a technical perspective, note that extremely low volatility is untenable. It could also be the harbinger of multi-year explosive price action.

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Better trading days to come?

Key advice for traders is simple. Volatility droughts breed complacency. FX and rates implied volatility have now surpassed 2014 lows. Do not be complacent just because markets are not signalling a strong directional move at the moment. That certainly doesn’t mean that this environment will extend forever. Markets pose risks ahead with the UK election polls already suggesting a narrowing of the current UK governments lead over the Labour party. GBP traders will be paying close attention as an upset similar to the Brexit referendum or President Trump’s shock victory in 2016, could see GBP volatility rocket higher. Equally, we are only ever one tweet away from President Trump, that can deteriorate the China trade situation rapidly. Stay vigilant in this low volatility environment, as more experienced traders know it won’t last forever.

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