US equity vol is as 23 year lows, and by the looks of things (already down 0.5%) may test an unprecedented 8 handle later today as CTAs, risk-pars and vol-neutral funds dump more volatility the lower it gets. Turns out it is the same story in FX. As DB's macro strategist Oliver Harvey writes overnight in a note titled "Vol be crazy", "one of the main themes this year has been the fall in vol. We argued three months ago that FX vol looked cheap given elevated policy uncertainty, but a pick-up was unlikely while the global growth pulse remained strong. Vol has since collapsed further."
Indeed it has, and as Harvey further notes, "every G10 pair is now below five year averages, with realized and implied vol in risk-off pairs like AUD/JPY and NZD/JPY particularly low. In EM, realized and implieds are also in large part below recent averages, with USD/BRL and USD/MYR perhaps of most interest given the recent weakness in commodities."
And just in equity markets, so in FX, the question is when will this near-record low volatility finally end. According to Harvey, the answer is soon because "there are increasing signs a turning point is close." Here's why:
First, the global data pulse appears to be rolling over. Our G10 FX carry-to-vol index peaked almost exactly in line with global data surprises in February. (fig 1). Market structure is one factor behind the recent fall in commodity prices, but these too began to turn with the data in February.
Second, positioning is less of an obstacle. A rolling 3m beta of the Parker Currency Index to the CVIX suggests that the market is the least geared to a pick-up in volatility than at any time since before the Eurozone/US monetary policy divergence trade of mid-2014 (fig 2). This reflects a broader lightening in dollar positioning, with the latest IMM report showing dollar longs have been pared to flat against the euro.
Third, policy risks seem underpriced. The market anticipates a slow US hiking cycle, but benign financial conditions could encourage the Fed to be more aggressive. The fall in offshore dollar funding costs also imply a relaxed market attitude towards balance sheet reduction later this year. More important is the recent weakening in Chinese data, as illustrated by last week’s softer PMIs (fig 3). Strong global growth around the turn of the year was largely a lagged effect of Chinese stimulus. It will be crucial whether slowing translates into more outflows or a shift in Chinese authorities FX policy. USD/CNH vol has so far remained very well contained (figure 4), but any pick-up would be much more bearish for the EM FX complex.
While there is nothing wrong with DB's forecast, there is just one problem: it is identical to the dozens if not hundreds of similar predictions that forecast an "imminent" return to volatility, assuming a "normal" market, where mean reversion still works and hasn't be snuffed out by central banks. Furthermore, going back to the familiar feedback of central planning, any burst in FX (or equity) vol will likely be quickly meet with even more central bank intervention - which already is at a record run rate - thereby slamming volatility even lower, and so on. What can break this recursive loop: that's the real $64 trillion question. Until then...