Traders are no strangers to navigating geopolitical minefields.
And, really, the fact that the geopolitical backdrop has been laughably fraught for the better part a decade hasn’t mattered all that much.
Indeed, the short vol. trade in all its various manifestations proliferated and prospered in an environment of extreme political discord across 2016 and 2017 thanks in no small part to central banks, whose policies and, crucially, effective forward guidance, tamped down cross-asset vol., even as “politicians’ implied vol.” surged.
Now, though, political tensions are running so high that it seems like wishful thinking to believe monetary policy can continue to keep market-based measures of volatility insulated. That’s especially true given how low on “ammo” central banks are after a decade of accommodation.
Recently, some argue that the best long vol. position you can take amid the burgeoning global currency war is in FX. “Right now, the JPMorgan FX Volatility Index is sitting near all-time lows. FX vol is dirt cheap”, Kevin Muir wrote on August 1. “Regardless of your views of the US dollar, buying gamma in FX-land is probably the best long vol. position out there right now”, he added.
Given the set of risk factors currently facing traders, what does history say about how FX is likely to react? Barclays looked at just that recently.
“We look for historical periods defined by stylized movements in financial market variables that correspond with the risks that are currently shocking markets: a significant escalation in US-China trade tensions, a catch-all lowering of expectations of global growth, the Fed under-delivering market’s dovish expectations, and an escalation of political risks in Europe amid the rising probability of a hard Brexit and potential elections in Italy”, the bank wrote over the weekend, in a followup to a May study.
Unsurprisingly, FX vol. does trend higher during these various risk scenarios, but the response is hardly uniform.
“EM Asia currencies are naturally the most sensitive to US-China trade war escalation risks, led by the KRW, IDR and INR [and] outside Asia, BRL, the MXN, AUD and NZD also show high sensitivity to trade-related risks”, the bank writes, before noting that “risks associated with Fed’s hawkishness usually have the largest upward effect on vols across the board”.
This would appear to suggest that the real risk is another accidentally hawkish lean from Jerome Powell.
But here’s the paradox. With each passing trade escalation, the market becomes more convinced of Fed easing, which in turn makes it harder for the Fed to clear an ever higher bar for a dovish surprise. It also makes it harder and harder for the Fed to push back, because the more extreme positioning in rates, the more risky it is to disappoint expectations.
At the same time, the louder the Trump administration calls for rate cuts, the harder it is for the Fed to deliver on market expectations without being accused of having politicized US monetary policy. Additionally, easing from the FOMC’s global counterparts serves to lift the hurdle for what counts as “dovish” even higher.
When you throw in the fact that the US administration is quite clearly using trade escalations to try and compel rate cuts and then consider that the trade escalations are arguably the main factor driving down global growth expectations and thereby forcing other central banks to become more aggressive in their own easing efforts, you’ve got three of the risk scenarios all inextricably bound up with one another.
Good luck untangling those Christmas lights.