China released a raft of major data on Friday and all of it was weak, at least compared to prior standards.
In the past markets would have thrown the baby out with the bathwater, there was absolutely no reaction. Investors, seemingly, couldn’t care less.
Welcome to mid-2016, a period where nothing seems to be able to shake investor confidence. Risk assets are rallying, volatility is all bar non-existent — a scenario completely the opposite to earlier in the year.
According to HSBC’s FX strategy team, the decline in market volatility seen recently has been “astonishing in light of recent events”.
In quick succession we saw the UK vote to leave the EU, an attempted coup in Turkey and the BoJ massively disappoint market expectations of so-called ‘helicopter money’. Any one of these events had the potential to lead to a significant risk-off period. However, the market has mostly shrugged off this news.
This surprisingly relaxed outlook suggests that we are entering a new volatility regime. Implied volatility is low despite what should have been significant shocks to the market. Implied volatility is low even though the outlook is filled with plausible risks. This suggests that it is likely to take a serious shock now in order to make the market run for cover.
Nothing quite sums up the slide in market volatility than the most liquid asset class in the world, currencies. As shown in the chart below from HSBC, outside of the Japanese yen and British pound, volatility in most major currency pairs is now far below levels deemed normal.
“These are calculated by comparing implied volatility to the distribution of realised volatility,” says HSBC.
“Implied volatility encapsulates the market’s expectations about the future; comparing implied to realised in this way allows us to measure whether the market expects future volatility to be higher or lower than usual.”
At present the chart suggests that volatility in many major currency pairs — already low — is expected to stay that way over the months ahead.
Given this view based off options pricing, HSBC suggests that carry trade will likely perform well in the coming months:
A low volatility environment would be positive for risk-seeking, yield-hunting trading strategies. In FX, this means carry; therefore, we expect carry to perform well in the coming months. And in today’s FX market, carry means long emerging markets (EM).
Carry trades follow a natural cycle whereby good carry returns contain the seeds of their own destruction: When carry performs well traders increase carry exposure. Eventually positions become so large that the strategy becomes unstable – at which point a carry unwind becomes quite likely.
However, carry trade positions are far from this point at the moment. Given the dramatic moves seen in EM over 2015 there still is reluctance amongst many market participants to enter into long-EM FX exposure. So enjoy this positive time for carry whilst it lasts.
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