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Dollar: Return of Volatility Inevitable And With it a Dollar Rally?

Dollar: Return of Volatility Inevitable And With it a Dollar Rally?

John Kicklighter, Chief Strategist
Dollar_Return_of_Volatility_Inevitable_And_With_it_a_Dollar_Rally_body_Picture_5.png, Dollar: Return of Volatility Inevitable And With it a Dollar Rally?

Fundamental Forecast for US Dollar: Bullish

The capital and currency markets alike were extremely lethargic this past week as a drain of speculative interest has pushed volatility readings to multi-year lows and in turn drained the masses’ capacity to force breakouts – much less meaningful trends. Yet there are a few critically important things that we need to consider moving forward: this extreme low in activity cannot last for much longer, volatility is generally attributed to risk, the greenback has held remarkably steady despite the positive risk drift in August, and sentiment is still wedged between a discouraging fundamental outlook and hopes for more external support (stimulus). While some may see a dead market, I see a market on the verge of an explosive return to speculative currents.

Before we delve into the revival factors for risk trend and what it means for the US dollar, it is important to define just how extraordinarily quiet the markets have been so far this month and over the past week particularly. From the FX market, we find the one-week implied (expected) volatility reading for the world’s most liquid pair (EURUSD) dropped to 7.74 percent – the lowest reading since October 2008. For the typically more risk-sensitive AUDUSD, expectations for volatility over the same period dropped to levels last seen back in July of 2007. Capital markets offer similar reports of inactivity. The average daily range of the S&P 500 (my preferred measure of risk appetite) over this past week was a mere 8 points – the slowest period since April 2007. Perhaps even more incredible was the volume tally for the benchmark index topped out at 1.73 billion shares this past week – the lowest non-holiday (and even lower than most non-holiday periods) since 1997.

Yet, it is important not to assume what is inevitable is also immediate. Again, we have to paraphrase economist John Maynard Keynes’ saying: the market’s can remain irrational longer than you can solvent. So, just because a few activity measures are hitting levels last seen before the worst financial crisis in modern history doesn’t mean we will see the same October 2008 reaction. On the other hand, with each day and week that pass at this level of idleness, the more likely it is that market’s mark a return to ‘normal’. What are the catalyst for such a shift? The most threatening cluster of known events (those that can directly affect the gap between current prices and the stimulus / economic outlook balance) comes in the first half of September. Moving forward, those waiting to see whether stimulus expectations have been reasonable or overblown will look to: the Jackson Hole Economic Symposium (Aug 31 – Sep 1) with memories of the QE2 announcement there two years ago; the ECB rate decision (Sep 6); the Fed rate decision (Sep 13); the G20 meeting (Sep 13-14); and EU Summit (Sep 14-15). That is perhaps the heaviest round of event risk that taps into the market’s primary concerns that we have seen all year. Yet, what happens between now and then? Are we simply left to frozen markets for two weeks? It is possible but unlikely. We need to remain wary of the financial headlines for unforeseen developments that exploit concern that markets are ‘too quiet’.

Timing is perhaps the most important and unclear variable to this question. Far less so is how the dollar is likely to react. It is worth noting that over these past few weeks, with volatility draining and risk slowly drifting higher, we have seen the Dow Jones FXCM Dollar Index hold remarkably steady above 10,000. A currency that is strong in otherwise unfavorable markets (which these most certainly are as multi-year lows in volatility and fear undermine ‘safe havens’) holds innate strength - though it could also reflect a general skepticism in investor optimism with the lull in turnover.

Taking the known (that volatility will assuredly pick up – whether slowly or abruptly, immediately or in September), we can apply common market conditions to map out the probably path for the dollar. Given that volatility is associated to risk (that is why the VIX has been dubbed the ‘Fear Indicator’ and draws an impressive, negative correlation to the S&P 500), we have the grounds for a serious driver for one of the world’s most prominent safe havens. As such, we must keep our eyes on the headlines and assess the market’s attitude towards recession and stimulus. Proper timing is imperative to proper strategy. As long as the lull persists, the best strategies are congestion-based; but when activity ignites, breakout and trend approaches should be employed to full effect. – JK

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