Currencies remain stable despite equity market downturn

Last week saw global equity markets continue their recent slide amid political uncertainty and the ongoing threat of tighter monetary policy from Central Banks across the globe. The Nikkei led the way with a 5.6% drop, closely followed by the S&P 500 which fell 4.1%. European indices fared slightly better (CAC 40 -3.1%, FTSE 100 -1.5%, DAX -1.1%) but still closed the week in negative territory. In isolation, these numbers aren’t too alarming, but a look at the wider picture and performance over the past four weeks highlights an ongoing theme of nervousness and risk aversion.



Unsurprisingly, the VIX (the CBOE Volatility Index, often referred to as the Fear Index) has risen sharply over the past four weeks.


The chart below shows volatility in the S&P 500 (orange, left y-axis) compared to the volatility in EURUSD (blue, right y-axis). Historically, the two have been far from perfectly correlated, but nonetheless, it is unusual to see one (in this case SPX) dramatically more volatile, relatively speaking, than the other.



In recent years, we’ve come to expect falling equity markets to be accompanied by a strong dollar as investors seek the safe haven appeal of US Treasury Bonds. However, in recent months, the US currency has been range-bound, albeit close to the top of its range.


Is the risk on / risk off trade in the currency markets dead?


The simple answer to the question above is no (well, not in our opinion anyway) but there are three key points worth consideration:


  1. In the aftermath of the financial crisis when all the central banks had cut rates to zero, risk on / risk off prevailed in the currency markets as investors sought out safe-haven assets. However, with interest rates now on the rise and increased risk appetite amongst investors, the search for yield has been the main driving force in the currency markets.
  2. Risk on / risk off is still evident in many emerging market currencies. Looking solely at G5 currencies gives a distorted view.
  3. Many analysts have long seen the equity markets as being overvalued on various metrics and hence concluded that the recent dip is simply a correction as opposed to a major change in trend. The fact that the equity market sell-off hasn’t spilled over into currencies reflects the point that ‘panic’ is yet to kick in.


Regardless of whether the risk on / risk off phenomenon remains a driver in FX markets, recent volatility elsewhere offers a reminder that we shouldn’t become complacent. EURUSD volatility remains close to record lows and while GBPUSD is slightly more elevated (unsurprising given the uncertainty surrounding Brexit) 1-year volatility is still below 10%. From a risk management perspective, we should remain cautious about the growing risk of a spike in volatility. Whether its Brexit, European politics, Trump, Trade Wars or Terrorism, there are plenty of factors which could change the landscape in the FX markets very quickly.


Author: Marc Cogliatti










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