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Daily Market Commentary

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Has FX Volatility Peaked?

Wed, Dec 10 2008, 22:42 GMT
by Kathy Lien

GFT

Has FX Volatility Peaked?

On a quiet day devoid of any major US economic data, the saga surrounding Automakers continue to dominate the headlines. We are inching closer to a formal bailout plan for the Big 3 and as we have previously suggested, regardless of the final outcome, the markets will cheer an end to the drawn out drama. The rally in equities today has driven currencies higher against the US dollar and the Japanese Yen, but it remains to be seen whether the improvement in investor sentiment will last. US lawmakers have agreed to bailout the automakers only in principle but the $15 billion package may have a tough time passing the Senate in its current form. We are walking into a lot of potentially weak economic data on Thursday and Friday that could serve as a harsh reminder of the problems that the US economy faces. The US budget deficit swelled to a record $164.4 billion while wholesale inventories drop the most in 7 years. The only one spending right now is the US government and the latest budget deficit numbers reflect their new stakes in banks.

Fear of Deflation and Depression

The Treasury market is already pricing in the possibility of deflation and depression with yields in zero to negative territory for the first time since the Great Depression. Although year-end seasonality is certainly playing a role in the price action of Treasuries, it says a lot that investors are willing to park their money with the US government for zero return. The US trade balance numbers are due for release tomorrow and given the contraction in manufacturing ISM, we expect exports to falter. Producer prices and retail sales figures on Friday could also resurrect concerns that deflation and depression will hit the US economy. Fed Fund futures are pricing in a 75bp rate cut from the Federal Reserve next week. This would take US rates to 0.25%, making the US dollar the lowest yielding currency in the developed world. Although the greenback has remained weak against the Japanese Yen, if the Fed takes interest rates to zero, we could see more weakness in USD/JPY.

Has Volatility in the Currency Market Peaked?

On Tuesday, we talked about how volatility in the forex market has exploded in 2008. Although trading ranges expanded significantly in October and November, volatility has contracted since the beginning of the month. The following chart from Bloomberg illustrates how far 3 month volatility for the EUR/USD has fallen since hitting a record high in late October. Anyone that follows the currency market on a regular basis can attest to its recent range trading behavior. There are good reasons for the compression in volatility as the year is winding is coming to a close and new positioning becomes one of the last things on the minds of currency traders. It has been a tough year and many funds are closing their books early to lock in remaining profits. If volatility does continue to fall, it would help carry trades recover. However it may be premature to say that volatility in the currency market has peaked because December 16th will be a historic moment for the US Federal Reserve. Not only are they expected to take interest rates to the lowest level this generation has ever seen but they have to figure out how to effectively signal their intentions of taking US interest rates to zero without completely spooking the markets. Thin trading going into the holidays can also exacerbate moves in the currency markets. We remember how the EUR/USD increased 300 pips between Christmas and New Years in 2007 and did the same in the first 3 trading days of the year.

EUR/USD: ABOVE 1.30, SNB EXPECTED TO CUT RATES 50BP

The EUR/USD finally had a meaningful move above 1.30 today but the psychological level is still proving to be a level of contention. The price action of the currency pair is not in sync with the trend of Eurozone economic data and that may be the reason why the EUR/USD is having such a difficult time keeping its head above 1.30. Wholesale prices dropped more than expected in Germany, while industrial production plunged in both France and Italy. The recession in Italy was also confirmed by today’s third quarter GDP data which reported the second consecutive quarter of negative growth. The European Central Bank will be releasing their monthly bulletin tomorrow and there is no reason to expect anything other than a clearly pessimistic tone from the central bank. With that in mind however, Eurozone interest rates are still higher than many other major currency pairs and that may be a strong force behind the EUR/USD’s strength. Meanwhile the Swiss National Bank will be making a monetary policy decision on Thursday. They are expected to cut interest rates by 50bp to 0.5 percent. Even though they have been very aggressive this year with intermeeting rates cuts, the SNB will beat the Federal Reserve in taking interest rates below 1 percent. It will be interesting to hear what they say about monetary policy going forward and whether they will talk about the possibility of zero interest rates.

GBP: WILL THE UK ECONOMY GROW IN 2009?

The British pound continued to sink against the Euro as UK economic data and comments from government officials give traders even more cause for concern. The NIESR estimates GDP growth for the month of November to be -1.0 percent, this was revised from a prior forecast of -0.8 percent. There is no question that UK growth is slowing materially which is why the Bank of England is expected to continue to ease interest rates. UK Chancellor Darling said that he will leave it to the Bank of England to decide whether Quantitative Easing is necessary, but he encouraged the central bank to discuss all options. Interest rate still has a far ways to go before they hit zero but if the BoE considers QE, this suggests that they may be open to taking interest rates to zero. Darling also expects the country to start growing again in the second half of 2009. This is certainly feasible since the BoE has been especially aggressive with fiscal and monetary stimulus. Combined with the benefits of a weak currency, we would not be surprised to see a second half recovery in the UK.

AUD/USD SLIPS AHEAD OF EMPLOYMENT NUMBERS

While the stock market survived a relatively subdued session, oil and gold staged rallies totaling 3.8% and 4.3%, respectively. Such moves, however, have been unsuccessful in boosting the commodity currencies. Even though the stock market is holding onto positive territory, many are still hesitant to put their money behind these ailing currencies. This is a good indication of the still prevalent uncertainty and fear expressed by market participants. An example of this is the nearly 180 pip range in USD/CAD, which ended the day unchanged. There have been few market moving releases today. CAD Labor Productivity was unchanged. Australia showed some signs of strength as Westpac Consumer Confidence increased 7.5% from last month. Home Loans also showed surprising strength. New Zealand will announce later the level of Manufacturing Performance - it is likely to be weak as we are in a manufacturing recession. Tomorrow we will be met with a few important Australian indicators, including Employment Change, Consumer Inflation Expectations, and the Unemployment Rate. The Australian dollar has sold off across the board ahead of the employment numbers. The drop in the employment component of manufacturing, service and construction sector PMI suggests that the labor market numbers will be weak.

USD/JPY: LACKLUSTER TRADING DAY

USD/JPY lacks any conviction in its movement, as the pair remains in a consolidation mode. This range has been spurred by the indirection of the markets today. In response of the condensed volatility, crosses remain practically unchanged. A possible notion that has erupted in response is the hope of normal volatility and perhaps the bottom in USD/JPY and the world stock markets. Though it would be a stretch to make this prediction given the US event risks next week, it is true that we have not seen the moves that characterized the sharp volatility of earlier months. Unfortunately, economic data has not yet warranted the compression in volatility and the idealized bottom. It is possible that once we experience all of the rate changes over the next few weeks, we will have a better indication of where a new move will take place. Later today, we can expect JPY Foreign Buying Japan Stock and Japan Buying Foreign Stocks. These numbers should have no impact on the Japanese Yen.

AUD/USD: Currency in Play for the Next 24 Hours

AUD/USD will be our currency in play for the next 24 hours. We have a ton of economic data this evening. The Employment Change and Unemployment Rate is due for release at 7:30 pm ET or 00:30 GMT while the US will provide us with the Trade Balance and Import Price Index at 8:30 am ET or 13:30 GMT.

The AUD/USD is on the verge of crossing back into the Bollinger band buy zone, but has since lost some momentum. There are several strong resistance levels near current levels. Most notably, there is a strong trendline extending from highs placed on October 14th to highs on December 8th. If this first zone of resistance should fail, the next most immediate level can be found at the recent high at 0.6701, which coincides with the 50-day SMA. This level also failed on its attempts to break-through the trendline. The first level of support is at 0.6293, the most recent swing low from December 5th. A more significant level lies further down at about 0.6079, a very significant low. If this level is broken, we may see a downtrend extending toward lows placed in the early 2000’s.

Published on  Wed, Dec 10 2008, 22:45 GMT