When in Doubt, FX Option Market Would Rather Watch Central Banks

Even as frequent data flip-flops heighten global economic and policy uncertainty, the currency options market has found a way around it.

Bank of Japan Governor Haruhiko Kuroda listens during a news conference at the central bank's headquarters in Tokyo, on Wednesday, Oct. 7, 2015.

Junko Kimura-Matsumoto/Bloomberg

All action is now centered solely around upcoming monetary-policy announcements, with traders leaving it to central banks to make sense of the inconsistent numbers. As a result, foreign-exchange implied volatilities are coming off in most tenors except those coinciding with policy meetings, Bloomberg strategist Vassilis Karamanis writes.

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Currency swings have narrowed as recent reports from Europe to the U.S. and Japan signaled authorities will maintain ultra-accommodative policies amid unclear economic prospects. The euro’s one-week implied volatility against the yen fell on Friday to 7.86 percent, the lowest in almost a year.

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The move came after accounts of the European Central Bank’s last meeting showed policy makers seek more time to analyze recent global trends, and the Bank of Japan kept its stimulus unchanged.

Minutes of Federal Open Market Committee’s September meeting, published Thursday, weren’t any clearer, emphasizing the theme of a solid U.S. economy overshadowed by threats from abroad. The Bank of England kept policy unchanged the same day. Fed’s dovish tone last month pushed many investors to the sidelines, leaving most major currencies and weighing implied volatilities down.

As central banks remain on hold and look for guidance from domestic and global data releases, traders expect currency swings to narrow. The decline in implied volatilities is normalizing volatility curves that were previously inverted, with the front-end sliding way below their 100- and 200-day moving averages.

Gauges of expected foreign-exchange fluctuations are falling irrespective of key data releases that are due. One exception to the trend is that volatilities are still resilient in tenors covering monetary-policy announcements.

The euro-yen volatility term structure, which plots expected levels of swings across option maturities, flattened last week even as important euro-area inflation and growth gauges are expected in the following period. Yet, two- and three-week tenors encompassing the next ECB and BOJ meetings have fallen much less.

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The dollar-yen curve shows a similar trend: implied volatilities pick up after the BOJ’s Oct. 30 meeting date, while numerous data releases due over next couple of weeks fail to make any impact. The two-week euro-sterling measure rose the most last week ahead of the European Central Bank’s Oct. 22 meeting, while other tenors failed to keep up.

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The decrease in front-end volatilities may not last as the main reasons that widened foreign-exchange fluctuations this year -- such as illiquid markets, light positioning and increased regulation -- are still present.

Moreover, China-related market risks remain on the radar. Commerzbank Senior Economist Zhou Hao said this month that, after the recent rout in the Shanghai Composite Index of shares, China’s corporate bond market may become the next bubble.

NOTE: Vassilis Karamanis is a strategist who writes for Bloomberg. The observations he makes are his own

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