Skip to Content
News & Analysis at your fingertips.

We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site. See our updated Privacy Policy here.

Free Trading Guides
Subscribe
Please try again
Select

Live Webinar Events

0

Economic Calendar Events

0

Notify me about

Live Webinar Events
Economic Calendar Events

H

High

M

Medium

L

Low
More View More
Three Factors Warn of Perfect Storm in FX Markets - Caution Advised

Three Factors Warn of Perfect Storm in FX Markets - Caution Advised

David Rodriguez, Head of Product

Share:

- The end of the calendar year typically sees an important liquidity crunch, but this year may be worse

- A confluence of three critical factors warns of especially elevated financial risk

- Traders should be wary of holding or entering large FX positions into the coming two weeks

The End-of-Year Very Often Brings a Liquidity Crunch

The end of the calendar year typically brings something of a liquidity crunch; fewer traders are active during holiday seasons across global financial centers. And—just as importantly—many traders and funds typically close or roll over their trading positions and lending arrangements to coincide with the end of their fiscal and tax years.

In most years this means that liquidity is at a premium through late November and especially in late December. And indeed it was almost exactly 11 months ago we wrote to warn traders of especially high rollover charges in the US Dollar, Japanese Yen, and Euro in particular.

Yet these three factors may make the cyclical liquidity crunch especially severe this time around.

1. Broader market liquidity has fallen—media has focused on Fixed Income, but problem widespread

2. We’ve started to see clear knock-on effects in the FX market

3. Critical event risk in December adds substantial volatility risk, magnifying dangers to traders

1. Liquidity has Fallen Across Global Financial Markets

Run a google news search on “liquidity crunch” and quickly you see reports on dangers across global financial markets from very diverse sources. One result shows a New York Fed warning on a deterioration in US Treasury debt markets —considered one of the safest assets in the world. Another shows the People’s Bank of China has proactively added cash to its domestic financial system ahead of a potential liquidity squeeze through year-end. There’s no direct link between these two examples, but the central implication is clear:

Cash and general liquidity is increasingly scarce for a very wide range of financial institutions and markets.

Most FX traders have remained relatively shielded from the broader drop in liquidity, and that’s especially true for G7 currencies which boast substantial liquidity. Yet we have recently seen the effects of this liquidity crunch extend to the most heavily-traded currency pair in the world.

2. Liquidity Risk has Spread to Even G7 Currencies and Broader FX Markets

A sudden surge in the Bid/Ask spread for the EUR/USD on November 12, 2015 serves as a wake-up call that liquidity risks have likely spread to the FX market. And indeed, an influential industry newsletter in FX Week highlighted these new dangers in an article titled “Fears mount over year-end Liquidity”. This was significant as the first notable public advisory on a risk relatively well-known to institutional FX insiders: available liquidity has fallen considerably in the past year.

It was approximately 08:15 - 08:30 AM New York Time on Nov 12 when the Bid/Ask spread on the Euro/US Dollar pair surged to an almost-unbelievable 10 pips on a major interbank dealing platform.

Spread on EUR/USD Surges to 10 Pips on Major Interbank Dealing Platform on Nov, 12, 2015

Data source: Interbank dealing platform, Chart source: R

There was no unexpected news to justify the sudden plunge in EUR/USD liquidity, and it’s important to note that this pair is the single-most traded unit in the FX market. The Euro/US Dollar globally accounts for nearly a quarter of all FX volume, and the average Bid/Ask spread reported on this platform in the EUR/USD is a paltry 1.1 pips. It is almost inexplicable to see that conditions would deteriorate so rapidly to force such a blowout in spreads.

The FX Week article writes, “Liquidity conditions have been deteriorating this year across fixed income markets, with one head of trading estimating FX liquidity halved since last year.” [emphasis ours]

And the central risk is clear: if the most traded currency pair in the world sees such liquidity gaps, it is likewise clear that less-traded pairs and Emerging Market currencies could be more greatly affected by such market conditions.

This makes the year-end period especially risky this time around, and another key factor gives us a fairly clear timeline for the concentration of these risks.

3. Month of December Sees Especially Acute Event Risk with Fed Meeting, boosting Volatility Risk

End-of-year liquidity risk is significant onto itself, but a packed economic calendar adds volatility risk and magnifies potential dangers for traders. The combination of a contentious European Central Bank monetary policy meeting, Fed Chair Janet Yellen’s annual testimony to the US legislature, and the November US Nonfarm Payrolls report from December 3-4 concentrates volatility risks to an especially short period of time. And indeed, a look at FX volatility prices underlines the significance of the next two to four weeks of critical event risk.

Typically we see investors pay a premium for volatility into the final weeks of the year, but this year’s surge is especially severe. The chart below compares the spread in volatility prices from options expiring from 1 to 52 weeks. In normal markets investors will pay a greater uncertainty premium for longer time horizons because there are far more unknowns. Yet this relationship typically inverts into year-end, and indeed the chart below shows that this is what happened in November, 2014. This nonetheless pales in comparison to the surge we’ve seen for EUR/USD volatility prices in 2015, and this underlines the risks in the coming weeks.

Euro/US Dollar Volatility Prices Surge through Year-End, far Outpacing Typical Moves

Data source: Bloomberg FX options pricing. Chart source: R, ggvis

To further illustrate the significance of these dates we look at the difference between volatility EUR/USD volatility prices for options expiring next week versus those expiring after critical event risk on December 4. The difference in volatility prices for EUR/USD options has literally never been higher.

Difference Between 2-Week EUR/USD Volatility Prices and 1-Week Surges to Record High

Data source: Bloomberg FX options pricing. Chart source: R, ggvis

Volatility and Liquidity Risks Could Create a Potential Perfect Storm

Caution is greatly advised on what could be an especially difficult time for FX traders given clear volatility risk and the potential for a significant drop in financial market liquidity.

Illiquid markets make it especially difficult to exit existing positions at a favorable price. And if these droughts in interbank liquidity occur during fast-moving markets, it may become a self-reinforcing loop where interbank traders are unwilling to make markets and overall trade execution suffers greatly.

The relative scarcity of liquidity can likewise have a marked effect on interbank lending, and this can translate to very high rollover charges across FX markets. This is exactly the dynamic we highlighted this time last year, but the effects could be greater in what could be an especially challenging period across FX markets.

Watch November 23-25 in Particular for the potential of Outsized Market Moves

It seems likely that many traders and institutions will look to avoid the dangers of December trading altogether, and to do so they would look to exit risky positions in the last week of November. It’s critical to note, however, that North American markets will be closed on November 26 and many exchanges will only have a half-day of trading on Friday, November 27.

The tight schedule could concentrate the end-of-year position squaring to the first three days of next week, and we need to emphasize that traders should be prepared what could be an exceptionally volatile end to November trading.

Caution is advised against holding outsized positions into year-end, and the risk of sudden surges in Bid/Ask spreads likewise makes it important to watch market conditions before entering new trades.

In concrete terms, it may be advisable for traders to use Limit orders or “Market Range” orders instead of traditional Market orders to enter a trade during this time. This may offer protection against especially unfavorable execution prices if spreads suddenly surge.

Written by David Rodriguez, Quantitative Strategist for DailyFX.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES