When a market moves so unexpectedly and so rapidly that it commands media attention, one instinctively knows that if you dig deep enough you'll find out someone got it badly wrong. The change in the price of the U.S. dollar commands a little less digging to see where investors got it wrong. Over the last six weeks the 11% slump in the value of the single European currency unit and the 12% depreciation of the British pound among other notable examples show the massive mistake that currency traders have made en masse as they continued to underestimate the global impact of events in the U.S. credit markets. The continued unwind of house values has turned the American dream into a nightmare. Trying to assess the collateral damage across the globe has wrong-footed currency players and this week has led to signs of more dramatic movements to come judging by the rising fear gauge across currency options values.
Currency traders have spent too much emphasis on listening to the rhetoric of central bankers and have failed to put sufficient stock in the actions at the Federal Reserve. In so doing they have backed the wrong horse instead of looking at the thoroughbred experience of the U.S. central bank. Both ECB and Bank of England failed to envisage the economic slowdown washing up on their own shores drifting from the American experience. Instead they chose to focus on the rising commodity prices and spent time worrying how inflation might undermine their economies. Judging by the downturn in recent economic data, both banks have called it badly wrong.
Yet still the ECB President fails to see the nature of the problem and would have traders believe that the next move in Eurozone rates is higher. The Chancellor of the Exchequer in Britain now freely admits to Britons that the nation faces the most challenging period for at least 60 years – a view espoused earlier in the summer by the Bank's Governor, Mervyn King. The Bank's reticence to deal with the known economic slowdown rather than the unknown threat of future inflation has seen traders carrying long positions in the pound abandon their holdings with greater fury than Hurricane Gustav could whip up.
Economists in trying to predict the exchange rates using yield curve differentials have found themselves hopelessly wrong too. Just last week one large institution attempted to forewarn of yield curve differentials now favoring the euro looking several months forward using curve spreads. Yet it's harder still to trust a forward curve built upon such rocky foundations as an inaccurate perception from the local central bank.
As the greenback rallied over the course of the last week it would appear that traders are now extending their short currency futures exposure across the major units. Interestingly open interest in both the yen and the Swiss franc futures has dropped by 3%. This is likely due to the continued unwinding of carry trades.
The 1.4% drop in the value of the euro and the 1.9% decline in that of the Aussie over the last week has created the largest builds in futures open interest at the same time. Euro futures open interest has grown by 4% while in the Aussie it has grown by some 6%. The largest single currency move amongst the majors came from the British pound, which slumped 2.8% or more than five cents to $1.7783. Dwindling mortgage approvals and rock-bottom readings of confidence were among the reasons for ditching the unit.
The relatively harmless passage of Hurricane Gustav only underscored another currency misgiving this week as traders who continued to hold commodities at the expense of dollars were joining the selling frenzy. News midweek that Ospraie Management had closed its flagship commodity fund due to year-to-date losses of 38% sent a warning to commodity bulls already reeling from recent pressure on positions that would benefit from dollar weakness. The lack of notable damage to the oil and gas exploration and refining industries witnessed the wholesale dumping of energy positions, whose proceeds ended up in the treasury market.
Weakening commodity prices are good news for inflation. They make light of central bank rhetoric concerning the need to tighten monetary policy and they are ultimately a clarion call for jumping into the safety of notes and bonds because lower commodity prices are a net negative for commodity-related equity prices, which makes the equity markets a bad place to be.
It seems that each resounding event has been bad news for the dollar. The collapse at Bear Stearns in March and the resumption of mortgage-related fear in June and July accentuated the disdain for the dollar. But the single biggest factor that traders missed at the time of each event was the advantage the Fed was building for the U.S. economy. Short dollar positions are being wasted day after day as that view gathers momentum leaving behind a slew of losses as violent price action picks off stale positions day after day.
As if currency traders needed proof over and above the theory that global demand might slow, it was handed to them this week by the Reserve Bank of Australia who cut interest rates. That move was already baked into the price of the Aussie as traders were already watching business and consumer borrowing decline to a six-year low, while new home sales also reached a two-year low. Weakening commodity prices were also weighing on the growth prospects for Australia yielding yet another reason for the traders to bank on more monetary easing later.
The demand for options positions across the currency majors has been skewed towards defensive posturing. Twenty day average put volume has been greater than average call volume in everything but the Japanese yen. While this might support the case that traders are now betting that the dollar will continue to increase in value, it's also noteworthy that a reduction in put open interest on the euro indicates closure of profitable bear-positioning, while at the same time yen and Swiss put open interest also declined. In all cases the recent options volume pattern saw an increase in the put/call ratio of open interest in option positions.
The inaccurate positioning of currency traders and the adjustment of portfolio positions has raised the specter of uncertainty in the currency market. In watching the implied option market volatility it's easier to judge the market's best prediction at where currency paths might tread next. Volatility is a watchword for uncertainty in this regard. During the last week traders have really hoisted the flag as they set sail on choppy seas, with a message that the outlook for both the pound and the Canadian dollar increasingly unpredictable. In both cases implied volatility embedded in options pricing swelled by more than half to stand at 16.2% on the British pound and 15% on the Canadian dollar.
Increased uncertainty for the Aussie saw its implied options volatility rise to 22%, which is a huge move on a 1.65 cent weekly decline against the dollar. That compares to a reading a week ago of 15.2% and likely reflects the fear in traders' minds today that a continued fall in commodity price could accelerate weakness in the value of the Aussie unit as growth peters out. Essentially option prices are telling us that the cost of insurance today is high thanks to twin factors. First is that the run on the Aussie was unexpected. Second is that the forward-looking scenario leaves traders clueless in terms of currency direction and would not have been expected just six weeks ago.
To put this into perspective, consider the cost of an at-the-money option combination just one week ago. The cost of a straddle – a put and call combined – with just nine days to expiration was exactly 1.60 points against the underlying price of the September future at 85.50. The call and put costing 0.8 points apiece indicate no bull or bear bias associated with the price of the Aussie unit. A long straddle can be used to protect against outsized up or down movements in the price of the underlying since at breakeven the cost of the losing call or put is offset by the gain in the value of the winning leg of the trade.
The premium last week would have seen a trader breakeven if the September future rallied above 87.10 or fell below 83.90. Wednesday's low at 82.20 ensured that this would have been a profitable trade, but also highlights exactly why the implied volatility has gone through the roof on currency options. The 0.80 premium paid on the on the put side of the trade is currently worth 2.40 and so three times the value that the market assigned it one week ago.
Once again the market seems to be dishing up lessons about learning to deal with the unexpected.
