The Chinese central bank widened the Yuan’s trading band on Saturday. Could increased USDCNY volatility lead to a more generalized Volatility spike?
On Saturday, the Chinese central bank announced a widening of the USDCNY daily trading band, from +/-1% to +/- 2%. This move did not come as a surprise to most observers, as the Chinese authorities had telegraphed their intention to begin moving towards a more market-based currency regime. In addition, it was widely understood that the Chinese were becoming increasingly unhappy with the market perception that their currency was a ‘one-way bet’ – a dynamic which was becoming increasingly self-perpetuating as speculative investors sought to capitalize on a supposedly risk-free trade – clearly not a helpful phenomenon, especially when countries (competitors) like Japan have been actively and aggressively weakening their own currency (see charts I and II).
Chart I: USDCNY – No longer a one-way bet?
Chart II: USDJPY (Yellow) vs. USDCNY (blue)
While on the surface this move by the People’s Bank of China (PBOC) may be viewed as a ‘local’ event impacting only the USDCNY exchange rate, there is precedent for apparently localized FX volatility translating into broader market volatility, via generalized market contagion.
Five years ago, during the height of the global financial crisis, global FX volatility spiked, as emerging market currencies weakened suddenly, creating FX derivative losses in excess of $30 billion for businesses in Asia, Latin America and Eastern Europe.
Interestingly, this sudden volatility spike was preceded by a period of very low FX volatility, unprecedented in the modern era (see chart). Such periods of market calm often lead to a lethal combination of complacency and greed, as investors and hedgers begin to reach ever more aggressively for additional returns, forgetting that market volatility rarely stays contained for long. (This phenomenon is in many ways a self-perpetuating one just the like the strengthening of the Chinese Yuan mentioned above – aggressive ‘hedging’ activity typically involves the selling of options, in structures like forward extras or target redemption forwards (TARFs) – this option selling serves to depress expected volatility even further).
A report released last month by Morgan Stanley estimated that about $350 billion of USDCNY TARFs had been sold by banks since the beginning of 2013. Even taking into account the fact that a large percentage of these derivative trades will have already been ‘knocked out’, Morgan Stanley estimates that at least $150 billion of these derivatives are still outstanding, an estimate which has been confirmed by Citibank.
This TARF overhang (and exposure to short USDCNY hedging products) could be significant for a couple of reasons:
1. Any negative impact on the Chinese corporate sector (a major buyer of USDCNY TARFs and other leveraged FX hedges) could create nervousness amongst international investors, leading to market fear and volatility; and
2. Speculators, who have been piggy-backing on the rising Yuan and declining volatility, may begin reversing capital flows into China – again, leading to increased FX market volatility.
Whether last week’s move by the PBOC will be a long-awaited catalyst for a more generalized spike in FX volatility is not certain (although it has led to a spike in USDCNY implied volatility, which has already increased by about a third so far this year). However, one thing that history has shown us is that low levels of market volatility are often a harbinger of trouble ahead. Our collective predilection to assume that such periods of calm will last forever leads us to make (initially) self-perpetuating bets (e.g. carry trades, leveraged FX hedges etc.) which continue to work until we push market parameters (interest rates, implied volatility) to their very limits. With interest rates and FX volatility already at extreme lows, especially in developed markets, it is tempting to conclude that we are now very close to reaching this inflection point.
Chart III: Deutsche Bank FX Volatility Index