FX Markets Flashing Risk Warning Signal
Via Steven Englander of Citi,
Our risk-warning signals have backed up sharply in the last couple of weeks and especially over the last day or two. The back-up has been so sharp that they have unwound all the easing in risk aversion since September/October. Our indicators are based on implied volatility on currencies that are very sensitive to risk appetite.
We focus on risk reversals among risk-correlated currencies. (light blue line, our risk reversal index is a basket of AUD, SEK, CAD and sign-reversed JPY 1mth 10 delta risk reversals)
Both the pace and backing up of this index point to a sharp increase in nervousness over risk-correlated currencies. Similarly our index of risk sensitive ATM implied volatility (red line, a basket of AUD, SEK, and CAD 1mth 10 delta implied volatility) is back to mid-October levels. The spot index of our risk sensitive currencies (dark blue line, a basket of CAD, SEK and AUD spot) has backed up a bit but not nearly as much as the tail risk indicators have.
To be clear these indications are still suggesting that risk aversion is very low by 2008 to mid-2012 standards, but all of our indicators have backed up markedly, suggesting that despite the abundance of liquidity investors are getting nervous.