The Calm Before the Storm

Where has the volatility gone? Equity markets are making fresh record highs, bond credit spreads are making new lows and the VIX Index a measure of market volatility often referred to as the “fear gauge” is not far from all time lows. Sound familiar? Rewind back to the start of 2007 where the same low volatility conditions prevailed just before the ceiling caved in on markets post 2008!

CBOE SPX Volatility Index – reflects market estimate of future volatility


Similarly today there is a plethora of events around the corner and seasonal risks that could destabilise the markets ranging from the end of Quantitative Easing in the US, to the possible introduction of Quantitative Easing (QE) in the Euro zone and the rising geopolitical risks developing around the world. Is this the calm before the storm for EURUSD? For the past 12 months we have traded a 1.3000 to 1.4000 range and more recently over the last month 1.3522 to 1.3692. This certainly feels like the calm!

EURUSD 2009 to 2014 Trading range (Source: Bloomberg)


And the storm?

Well we may not be facing into a 2008 style crisis but it may be the end of the 1.30 to 1.40 EURUSD range if the events unfold as I discuss below ………..though probably not until the 4Q14!

So what would the catalyst be for such a move? Firstly short term interest rates (yields on 2 year Government bonds) are largely in favour of the US. Rates in the US are nearly twice what they are in Europe (US = 0.49% versus EZ = 0.26%) yet since the yields started to move in opposite directions we have only seen the Euro depreciate a meagre 1.25% against the USD.

Interest Rate Differential US versus Euro zone (Source: Bloomberg)


Secondly the Fed confirmed that they intended to complete the tapering of QE by October, which paves the way for a late Q1/early Q2 2015 rate rise. At the same time the ECB have just cut interest rates to an all-time-low and their balance sheet starts to re-expand rapidly with TLTRO take up set for September. This changes the relative Fed versus ECB balance sheet size dynamic (+ve for USD$ & -ve EUR€).

Finally you also need to consider the Euro zone periphery (that is Portugal, Ireland, Greece and Spain for instance) risk. Year to date we have seen a rally in periphery government bond yields and this has been a significant contributor to Euro FX resilience. Periphery bond yields may yet go down further, signalling the markets confidence in the recovery. But this may be the last hurrah.

Nevertheless as we progress through the summer the Euro is more likely to remain under pressure; its failure to break to the topside against the USD is troubling and with the balance sheet changes expected to play negatively for EURUSD in the 4Q14 a test of the 2013 low of 1.2780 will be the target for Euro bears who will be looking for resurgence in market volatility to see this play out. Given the event risk in 4Q14 I think we can expect an interesting end to the year!



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Wednesday, 17 July 2019
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