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Why Doesn't VIX Equity Volatility Spill Over to FX?

Why Doesn't VIX Equity Volatility Spill Over to FX?

2018-04-17 03:42:00
John Kicklighter, Chief Strategist

Talking Points:

The equity-based VIX exploded through the first quarter as extreme inactivity led to a normalization to the same extreme extent

The equity-based VIX exploded through the first quarter as extreme inactivity led to a normalization to the same extreme extent

Key catalysts such as political risks are good for black-and-white readings of risk-reward, but more complicated for FX

See how retail traders are positioning in the FX majors, indices, gold and oil intraday using the DailyFX speculative positioning data on the sentiment page.

An Explosion in Volatility to Match the Extreme Quiet

In the opening quarter of 2018, we have seen a dramatic reversal in the activity levels for the capital markets. From the S&P 500, two dramatic dives in February and March reflect an extraordinary change in tack for a bechnmark that had spent the previous 12 months with a singular drive in bulls' favor. The charge in activity falls squarely in the realm of expectations however. The degree of inactivity that preceded the drama of the past months was both long and extreme. The second half of 2017 reflected a persistence of VIX that is unprecedented in the series' history. It wasn't the readings below 10 that stretched belief - indeed, we have had a few readings at this extreme in the previous decades - but rather the duration. The number of readings below this milestone in just latter half of the past year was unpredented even compared to the total number of days below 10 in the historical records for the measure. An extreme quiet of this depth and breadth earns a balance of equivalent intensity. The jump in VIX at the beginning of February was the largest swell in percentage terms on record.

FX Market Volatility Measure Extremes

Despite the intense rise in equity-based volatility - and an impressive rise in other risk-based assets - there has been a notable disconnet in FX markets. We can register the lack of traction in both the lack of intensity in range swings much less the absence of trend for a benchmark like the EUR/USD. The world's benchark currency pair has refused to throw conviction behind an extended bull trend above 1.2600 or a reversal back below 1.2150. I like to refer to an equally-weighted implied volatility for the 1-month tenor options on the liquid majors. Yet, I know that data is difficult to pull together for the average trader. The CBOE's Euro-based volatility index - the EVZ - is a reasonable stand in. Whether we look at my synthetic or the concentrated standard bearer, we have neither surpassed the extremes set in the Summer lull of 2014 nor is the activity of the past months even evident in the data.

The Catalyst for a Reversal in Volatility Matters

Extremes beget more extremes. For the equities-based VIX, the unprecedented low registered readings earned the record-breaking increase in the months that followed. If this were an isolated development that found its roots in uniquely targeted assets, we may not readily see the spill over. However, the swoon that befell risk assets and the subsequent charge up the flag pole by VIX puts an intense spotlight on FX and other asset classes. Fear of deleveraging that originates with some of the favorite sentiment measures poses one of the greatest risks to capital market structure in years if the situation turns sceptic. Political risk is an effective, all-consuming theme given how fluid the current situation is and the fact that diplomatic back channels are now conducted on the presumption of a reliable weigh in. We would certainly see it register for the currency market at its height, the impact wasn't nearly as severe or persistent as what was registered for say equities.

How Fundamentals Can Cause Conflict

When it comes to geopolitical threats like a trade war, economic pace killer or even outright political wars; it is easy to establish the impact it will carry on general investor sentiment. Adding arthritis to the financial system will result in curbed speculative capital deployment and thereby lead capital markets lower. Should it improve, the tide simply lifts all vessels. The FX market is different. Is a trade war more a risk to the Dollar or Chinese Yuan, or perhaps the most direct fallout its in an ancillery market. What happens when economic and financial troubles befall two economic counties/regions? We are left determining the best of the worst and the worst of the best. Certain market benchmarks will fly and collapse more aggressively than others. This is where the trouble with keeping tabs on consistent risk moves has become so precarious in recent months. If we are to see the charge in the VIX spread to the EVZ and broader fear measures, expect a more decisive and fundamental trend to potentially get under way. We discuss the gap between the VIX and FX volatility in this weekend Strategy Video.

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