Eerie calm in FX leaves market vulnerable in more volatile world

[NEW YORK] Foreign-exchange options traders may seem out of step, given that the outlook for currency swings has barely moved despite fears of a breakdown in US-China trade talks sending global shares spiralling and volatility in other assets surging.

Measures of currency volatility have risen only marginally in the wake of President Donald Trump's tweets putting a trade deal in doubt, with the most activity centered on the Chinese yuan. The subdued move contrasts with a sharp jump in equity and interest-rate volatility. Traditional haven currencies also haven't seen large movements.

The eerie calm in foreign-exchange volatility markets even amid jarring macro news has become more commonplace. Some say that's due to structural changes that have made the market more about flash volatility events due to specific gaps in liquidity. Positioning dynamics and recent idiosyncratic forces aside from Mr Trump's rhetoric are also capping fluctuations.

"This could be more of a structural development than a cyclical issue," said Steve Barrow, head of currency strategy at Standard Bank. "What the market tends to experience more now is not a rise when it happens in all assets but instead flash crash episodes. Currencies that are moving, such as those in emerging markets, are due to specific domestic factors."

Among factors keeping a lid on overall volatility is a plunge in implied choppiness in the Australian dollar, after the nation's central bank failed to deliver an expected rate cut this week, according to Alvise Marino at Credit Suisse. Several emerging-market currencies, such as Turkey's lira, were already under pressure prior to Mr Trump's declaration on tariffs.

Mr Marino warns, however, that this calm won't last if US and China trade negotiations completely break down, given their critical importance to the global economic outlook and risk appetite. He's advising clients to add to bullish currency volatility wagers.

And while angst might seem high given the S&P 500 is down about 2 per cent this week, measures of anxiety across all global assets are relatively pretty tame.

The Bank of America Merrill Lynch GFSI Market Risk indicator, a measure of future price swings implied by options trading on equities, interest rates, currencies and commodities, is below its one-year average. A negative reading indicates less stress than normal, while a positive figure signals the opposite.

Morgan Stanley strategist Sheena Shah says a real lift in foreign-exchange fluctuations needs more clear divergence in global monetary policies. Also, speculators are already very long the greenback, subduing volatility catalysts, she said in a note on Tuesday.

"Our public policy team expects a trade deal in the end but markets may experience a bumpy path to getting there," Ms Shah wrote. "Investors wanting to hedge an escalation in trade uncertainty could go long" three-month implied volatility on the Korean won - which is still historically low.

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