2021 Grey Swan #2: FX Volatility Back In Play

I was taught a simple framework in order to understand all financial markets options.

No, not the ‘right but not the obligation…’ sequence of quasi-jargon stuff that you read in all the textbooks.

Rather, here it goes: an option is a forward with an insurance policy attached.

See how easy that was? Everybody can understand such a simple model. What is more important, however, is that it captures the essence of what drives options:

1. Is the forward price moving? (Determined by rates information.)
2. Do I need insurance? (Determined by uncertainty information.)

So, why can FX volatilities rise now?

First, ask yourself: why haven’t they risen for quite some time? Indeed, more importantly, the volatility of FX volatility is at extremely depressed levels.

I think it’s straightforward.

Highly visible active monetary policy has overwhelmed utterly passive fiscal policy that’s been hiding in the shadows.

All the major (and most of the minor) central banks have implemented an almost identical version of monetary policy as a reaction to highly globalised and correlated economies. Not only that, but the terminal rate of all such policies is as close as possible to zero official rates.

Central banks have been encouraged to take the entire responsibility for the state of our economies. They have become the ‘useful idiot’ of the political class since the GFC. A CB tweak here and a CB tweak there, and as long as the politicians can be left alone to concentrate on the serious business of developing their personal CVs and post-politics careers, all is well. Why change a thing?

Much research indicates that a great deal of the driving force behind currency moves is interest rate forward bias. So with small relative moves in policies or rates or sovereign credit quality. These negligible moves in relative rate drivers, low uncertainty in relative policy drivers, and as for trying to find moves in relative sovereign credit…are you crazy?

Consequently, the current currency ouroboros has been satiated for a long, long time.

There have been no significant movements in underlying currencies and therefore few significant relative moves, driving an almost unbroken decade-long monotonic decline in uncertainty in currency pair outcomes. That’s give or take the odd episode when the sovereign credit Jack-in-the-box made an unwelcome appearance.

That was then.

I can’t think what can have changed in 2020. Oh, that’s right, I almost forgot … almost everything.

Even before the pandemic, central bankers were already forming a consensus that it was time for politicians to bring fiscal policy into play. The single most obvious characteristic of the pandemic has been its ability to act exactly like a time machine, bringing the distant future to our doorsteps right now. What were merely vague ideas to implement fiscal plans over the course of political timeframes (three-five years) are going to be arriving imminently.

So ask yourself, how similar will those plans be between sovereign nations? Actually, probably quite similar in some ways and wildly divergent in others.

They’ll be similar in terms of a universal ‘extend and pretend’ approach. Everybody will probably try to issue a load of debt as quickly as possible and hope that their pension funds are still massively exposed to long-term liability shortfalls (but that’s a whole other story). However, this acceleration in debt is very likely to be divergent across nations. And I would also suggest that the imposition of new fiscal approaches will also encourage their central banks to react with divergent responses.

And new debt burdens in conjunction with less certain capital account and trade outcomes surely leads to increased uncertainty in sovereign credit considerations.

In short, Covid-19 is highly likely to have introduced existential currency uncertainties where they were once dormant.

FX volatility is in play.