As Nassim Nicholas Taleb writes in his latest book ‘Antifragile’: “It is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it.” While it may not be possible to predict exactly when the current period of relative market stability will end, nor is it possible to identify the trigger event which will bring forth a new era of market volatility, signs that the global monetary system may be becoming less stable should not be ignored.
Ironically, one indicator that currency markets may be increasingly unstable is the current lack of volatility observable in the currency options market. Three month implied currency volatility for euro-US dollar (EURUSD), for instance is currently below 8%, and remains close to its lowest level since 2008. This relative stability is present in a number of other major currency pairs as well: US dollar-Canadian dollar (USDCAD) volatility is currently trading at about 7% and sterling-US dollar (GBPUSD) is only slightly higher at about 8%. Implied volatility is a little higher in US dollar-Japanese yen USDJPY (about 12%) and for certain emerging market currencies, but overall currency market volatility remains relatively contained – at least on an implied (forward-looking) basis. Actual volatility* has begun to pick up recently in certain currency pairs such as EURUSD (see Figure 1 below), implying that the options market sees this increase in volatility as temporary phenomenon.
Figure 1: EURUSD 3 Month Implied Volatility (Black) vs. EURUSD 3 Month Actual Volatility (Red).
Perhaps surprisingly, such low levels of implied volatility can sometimes mean trouble ahead. In a recent International Monetary Fund (IMF) paper, economist Sheri Markose writes: “The financial system looks strongest when it is most fragile…the volatility index, often taken as a proxy for marketrisk, is typically low during bull market conditions. The paradox is that it experiences its lowest point when the market is at its highest point prior to an extreme fall…hence market data paradoxically signals least risk just before a major market collapse.” **
Professor Markose is referring specifically to the equity market (the equity market volatility index, known as the Vix, tends to be low when equity markets are high – see Figure 2 below), but a similar phenomenon is often visible in the FX markets (e.g. EURUSD implied volatility hit its all-time low in June 2007, just before the onset of the global financial crisis).
Figure 2: VIX Volatility Index (Red, LHS) vs. S&P 500 (Black, RHS).
Another signal which indicates that financial markets generally, and currency markets specifically, may be nearing a critical juncture, is the strong reaction in the financial markets to the conflicting messages coming from the US Federal Reserve concerning the future of its quantitative easing (QE) programme. The Fed’s recent comments that it would potentially slow down the QE programme later this year pushed the USD index to a three-year high earlier this month. Subsequently, the Fed appeared to reverse course, sending the USD sharply lower.
The strength of the reaction of financial markets (especially bond markets) to the Fed’s apparent mixed messages (messages which could hardly be construed as being particularly radical – after all, they were talking only about the possibility of a gradual slowing of monetary stimulus) indicates the degree of fragility, and therefore risk, which is currently embedded within the global financial system.
The unprecedented hyperactivity of global central banks over the past five years, in which central bank balance sheets have expanded from about 14% to 32% of global gross domestic product(GDP), has created a number of “known unknowns”, (there are inevitably a number of “unknown unknowns” as well!***) such as:
- How will financial markets (equities, bonds, currencies) react to a reversal of the most extreme monetary policy experiment in memory?
- Will this vast ‘printing’ of global currencies lead to inflation? Or will a reduction and restructuring of public and private sector debt loads lead us down a deflationary path?
- How will emerging market countries continue to be affected by, and react to, the use of unconventional monetary policies by the Fed and others (e.g. Bank of Japan (BoJ), Bank of England (BoE)), which are widely blamed for stoking domestic inflation and damaging competiveness?
It is certainly not inevitable that currency volatility is set to break out of its recent period of relative tranquillity and cause havoc for international investors and corporate treasurers. However, it is important not to confuse a relatively low level of market volatility with a low level of market risk. While volatility amongst most major currency pairs remains near five-year lows, the level of market risk is arguably near its highest levels since 2008 due, in large part, to the increasing uncertainty over the future path of central bank activity. When it comes to managing risk, it pays to use market tranquillity (when liquidity is typically both available and affordable) as an opportunity to implement hedging strategies to protect against future risks. Interpreting a lack of volatility as a sign that overall market risk is low can be a very short-sighted, and dangerous, approach.
* Actual (or historical volatility) is based upon the annualised standard deviation of currency movements, implied volatility refers to projected currency volatility implied by the currency options market.
** Sheri Markose, IMF Working Paper (2012), ‘Systemic Risk from Global Financial Derivatives: A Network Analysis of Contagion and its Mitigation with Super-Spreader Tax’.
*** The idea of ‘known unknowns’ and ‘unknowns unknowns’ comes from a statement by former US secretary of defence, Donald Rumsfeld, during a press conference about the presence of weapons of mass destruction in Iraq in 2002: “There are known knowns; there things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – there are things we do not know we don’t know.”
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