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SNB Action Leaves Risks Sky-High Ahead of Critical ECB Decision

SNB Action Leaves Risks Sky-High Ahead of Critical ECB Decision

David Rodriguez, Head of Product
  • Swiss National Bank decision sets the stage for substantial forex market volatility
  • Risks are especially elevated ahead of the critical European Central Bank decision
  • Trading on leverage especially risky, traders are advised to limit position size ahead of ECB

NOTE: FXCM Inc, Parent Company of DailyFX, will raise margin requirements given volatility risk.

The Swiss National Bank sent shockwaves across financial markets as it unexpectedly dropped the Swiss Franc’s peg versus the Euro. Further volatility seems especially likely ahead of the highly-anticipated European Central Bank monetary policy announcement due January 22, 2015.

Largest Single-Day Currency Swings Since the Inception of the Euro (1999-Present)

SNB Action Leaves Risks Sky-High Ahead of Critical ECB Decision

Data Source: FXCM Execution Desk Pricing Data, Chart Source: R. Prepared by David Rodriguez

Rammifications of the unexpected Swiss Franc move were felt far and wide as the EUR/CHF and USD/CHF exchange rates posted the largest single-day move in over two decades. It’s fitting to note the next-largest absolute moves for any major currencies occurred on September 5, 2011 as the Swiss National Bank shocked markets in initially pegging the Euro versus the CHF.

We have to go back to the heights of the financial crisis through 2008 and 2009 to find remotely comparable moves in non-CHF pairs, and indeed the nearly-unprecedented moves have markets on edge. Our DailyFX Volatility Indices, which meaasure implied volatility prices paid/received in FX options markets, have surged to their highest since the so-called “Flash Crash” in May, 2010.

Forex Volatility Prices Surge Following SNB Move, Ahead of ECB Decision

SNB Action Leaves Risks Sky-High Ahead of Critical ECB Decision

Data source: Bloomberg, DailyFX Calculations. Chart source: R

Stage is Set for Major Volatility on Key European Central Bank Decision

Today the Euro fell nearly100 pips on mere rumor that the European Central Bank will announce unprecedented sovereign debt buying through the coming meeting, and strong Euro reactions seem near-guaranteed on any surprises.

Dow Jones Newswire sources claim the ECB Governing Council is discussing approximately 1 trillion euros’ worth of easing through 2016, and indeed this may set market expectations for the potentially significant decision. Would this amount be enough to sink the Euro to fresh lows? Extremely stretched EUR positioning will put traders on edge, and it’s critical to rememember that fear is a much stronger emotion than greed.

If traders fear an aggressive Euro bounce, many speculators may head for the exits and force dramatic rallies across EUR pairs. And though we certainly can’t rule out further Euro declines, current data suggests there are relatively few traders left to sell. Risks seem uneven and may favor the topside.

Any especially strong reactions could likewise result in limited FX liquidity and cause significant liquidity risk. Traders should limit trading leverage—particularly in EUR pairs—ahead of the key decision.

Swiss National Bank and European Central Bank Actions Have Broader Rammifications

The Swiss National Bank’s decision to abandon its aggressive policy may be remembered as the first time a major central bank “blinked” in the face of clear market pressures in the post-QE era. Investors have grown accustomed to aggressive policy from the ECB, US Federal Reserve, Bank of England, Bank of Japan, and others in response to financial and economic difficulty. Yet markets and specific assets can only be kept artifically high (or low) for so long.

Given clear economic distress in the Euro Zone, can the European Cerntral Bank reasonably be expected to cure the ills of the world’s largest single-consumer market? Hyperaggressive policy from the US Federal Reserve has been successful in keeping interest rates artificially low—not only in the US but abroad. Indeed, expectations of European Central Bank bond buying helps explain why German and French Government Bond yields trade near record-lows.

Hyperactive Central Banks Lead Forex Volatility to Record-Lows, but For How Long?

Extremely small interest rate differentials between major currencies on artificially low yields also helps explain why currency volatility hit all-time lows through Q4, 2014. Yet the recent uptick suggests markets are far less settled, and reactions to the Swiss National Bank decision leave markets on edge.

It is little exaggeration to claim that the SNB may have set us on a path for considerably higher FX market volatility, and the effects may be especially clear on the highly-anticipated European Central Bank decision and beyond.

Traders should use caution in trading the Euro pairs especially ahead of the ECB and trade with lower leverage until volatility declines.

NOTE: FXCM Inc, Parent Company of DailyFX, will raise margin requirements given volatility risk.

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com David specializes in automated trading strategies. Find out more about our automated sentiment-based strategies on DailyFX PLUS.

Contact and follow David via Twitter: https://twitter.com/DRodriguezFX

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

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