Trump Era, Brexit May Spur Year of Greater Currency Volatility

Donald Trump is making volatility great again. If the reaction to the U.S. President-elect’s first press conference is anything to go by, we are in for big swings in currency markets this year.

One-week implied volatility on the euro-dollar, a measure of the cost of options to protect against swings in the currency, surged the most in a month after Trump’s press conference last week. And that came on the back of no real policy news. A dollar index dropped as much as 2 percent in two days.

With Trump’s policy agenda still uncertain, the theme of greater fiscal stimulus and higher inflation that have driven up the dollar and U.S. treasury yields is not a one-way bet. Divided market positioning means surprises either way on Trump’s promises will add to price swings, causing an increase in hedging costs for investors.

The high degree of uncertainty about what’s in store for U.S. economic policy presents a “wider than usual range of upside and down risk factors,” IMF Chief Economist Maurice Obstfeld said in remarks prepared for delivery Monday.

Many investors from banks, pension and hedge funds are still looking to add long positions on the dollar, while a few are overweight, say traders in the U.S. and Europe, who asked not to be named as they are not authorized to speak publicly. Others have neutral positioning.

There’s room for realized volatilities, near 10-year averages, to steepen. JPMorgan’s index of Group-of-Seven volatility stands at 10.78 percent, compared to 12.79 percent on June 14 ahead of the U.K.’s vote on EU membership.

Uncertainty over Trump isn’t the only political risk factor on the horizon, with Brexit negotiations and European elections coming up this year.

Volatilities in pound crosses have risen to multi-month highs ahead of U.K. Prime Minister Theresa May’s speech on Tuesday, where she is expected to shed light on her Brexit vision. The market has been very sensitive to news suggesting the U.K. is willing to forgo single-market access to regain immigration control, with Goldman Sachs Group Inc. and Deutsche Bank AG expecting a drop toward the $1.10 level in the spot market. 

Even if negotiations through the year point to a ‘softer’ Brexit, a short-pound market may scrabble for the exit and a large short squeeze could lead to a jackpot for those looking for a move above $1.30. Investors may look to hedge against sudden swings by going long vega, a measure of an option’s sensitivity to changes in the volatility of the underlying asset.

The euro area also has to deal with elections in the Netherlands, France and Germany, following a referendum in Italy last month that saw its prime minister step down. There is potential for another round of elections in Greece, since there’s an impasse in a review of the country’s bailout. Markets may be under-positioned against these risks.

While euro-dollar bearish bets, as shown by six-month risk reversals, surged in November, this was because of the U.S. elections rather than European risks. The sentix Euro Break-Up Index, which reflects the probability that one of the euro area countries will leave the common currency within 12 months, stands below its five-year average.

• NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice