Friday, April 20, 2007

A slow-motion crisis

Have you got your bottle of champagne of ice? Or, if you live in the United States, your bottle of California sparkling wine, since true champagne is now unaffordable. This morning EUR/USD has traded up to 1.3638, a scant 32 pips away from matching its all time (post euro launch) high. With such an obvious target so close, a new all time high could literally come at any minute.

Aussie through 0.80, cable through the deuce, and a new all-time high in EUR/USD. What more could you want to signal a dollar crisis? Heck, even The Economist has had the decency to keep the dollar off its front cover, thereby permitting further downside. A funny thing happened on the way to the currency crisis, however. If the dollar really is in the process of crashing, it seems to be happening in high definition, super slow-motion. And if it’s happening in super slow-mo, can we really characterize it as a “crash” or a “crisis”?

How can we define a crash or crisis? Well, a reasonable shorthand definition, it seems to Macro Man, is the attainment of a new price extreme accompanied by a large rate of change (say, over a three month period) and high/rising volatility. And by this measure, the recent spate of dollar weakness (against the euro) bears little resemblance to episodes in the recent past.

EUR/USD has only rallied about 5% over the last three months, which is hardly a signal of impending Armageddon. In the good old days, that could have been a daily range! At the same time, implied volatility has barely moved, remaining close to all time lows. And with good reason- realized vol has also been remarkably low! So while the dollar has weakened fairly steadily, there is absolutely nothing to suggest in the currency episode that global investors are panicking or fleeing the dollar wholesale.
The last two episodes of dollar weakness, on the other hand, tell a different story. In late 2004 the dollar’s three month rate of change comfortably exceeded 10%, one month implied vols traded around 10% (in contrast to the current 5.8%), and there was a sharp uptick in realized volatility.

Similarly, when EUR/USD breached 1.20 for the first time in late 2003 and traded as high as 1.29 in early 2004, there was considerably more sound and fury than we currently observe. The three month rate of change reached 10% (twice!), one month implieds traded comfortably above 10%, and one month realized vol moved substantially as well…
Macro Man can’t really explain the lack of volatility or impulsive price action in the latest bout of dollar weakness. Could it be that the private sector is happy to sell euros to Voldemort and pals at elevated levels? Perhaps, though positioning indicators would not suggest that this is the case. Could it be that the currency market is thrice bitten, four times shy when it comes to throwing risk at trades? Maybe. Certainly currency trader performance has been generally poor over the last few years, partially because of the tendency of developed currency markets to mean-revert. It could be the case that hedge funds and asset managers have just lowered their currency risk budgets and aren’t prepared to trade these markets like they used to. One large FX bank recently reported that volumes have not been particularly high, even with EUR/USD apparently going up in a straight line.

Whatever the reason, the lack of volatility in the current bout of dollar weakness suggests that doomcasts of a US financial market implosion on the basis the dollar remain well wide of the mark. If foreign investors really were preparing to ditch US assets wholesale, surely we’d expect the currency market to exhibit more thunder and lightning than is currently the case.


wcw said...

Nah, we can still afford Champagne. Trader Joe's will sell you several perfectly drinkable NVs around $20, and D&M somehow still manages to stock a few vintages in the $30s.

Voldemort, on the other hand, has been a disappointment this morning. Maybe he's taking a three-day weekend.

Anonymous said...

Perhaps low FX vol has something to do with the threat of the Fed 'leaning into' the entire global FX structure with higher U.S. rates. If the U.S. current account must correct (which it must at some point), perhaps it can do so with sustained higher U.S. rates combined with a protracted but more contained FX slide. Isn't the FX market waiting for the Fed to blink? What if it doesn't? Bernanke may look docile, but he must always have Volker in the back of his mind. Why not risk a recession, if the alternative of avoiding one poses a worse outcome for inflation and the dollar. Interest rates will work on imports as well. Interest rates are the better way out. Same argument holds against doomsday gold bets.

Macro Man said...

Wow. I stand corrected. And people wonder why Ameicans consume so of the US' biggest comparative advantages is that they're the world's best retailers.

As for Voldemort, he was in earlier- helped take EUR/USD to the highs. But clearly they're now in weekend mode.

What was interesting was the georgraphical breakdown of responses to my seems quite clear that Voldemort isn;t really active in the NY market, whereas he runs the show in London...

wcw said...

Then again, US retail also brought you such stalwarts as K-Mart. Still, if you can't find what you want at a fair price around any large US city, you don't know how to shop.

Futures markets do seem broadly to change their tenor as London punches out and New York replaces it, or when Tokyo and Hong Kong open. I haven't made a real study of it, though. I wonder how you'd test that hypothesis.

Macro Man said...

Anonymous, FX vol has been in secular decline for several years. I hypothesize why

I actually think that the Fed is less relevant (which is not to say they are irrelevant) than they've been in a long, long time. It seems to me that the euro's rally has been driven and sanctioned by ECB policy, and could well come to an end by a European resistance to further strength. While US datapoints still seem to matter more from a microterm standpoint, the European policy cycle seems to have provided the catalyst (which evidently caught Voldemort off guard) from a macro standpoint.

WCW, poster Charles Butler has similar thoughts vis-a-vis equities in Europe and the US...

"Cassandra" said...

MM said:
"It seems to me that the euro's rally has been driven and sanctioned by ECB policy, and could well come to an end by a European resistance to further strength."

This may be true to the letter, but I'd argue that in spirit Europeans understands just how much they lost relatively from being monetarily holier-than-thou during the mid to latter 1990s, and as a result, preyed-upon as it were, by the anglo-saxons.

I think they've just weighed up the alternatives and said the [temporary?] parochial benefits (cheap East-Asian goods concidental to robust exports and diminishing unemployment) from Voldemort's and indeed now more-diverse, even-global official USD reserve accumulation - so long as WE (speaking as a card-carrying EC member) - don't have to accumulate them and can dump them quickly to other less-discriminating holders, outweighs [for the moment] any longer-term political and parochial economic benefits from upsetting the proverbial applecart and calling China on the RMB, Japan on the YEN, GCCs on their pegs, and the USA for sheer total utter domestic political spineless and general fiscal stupidity.

BBG Quote of the Day: "Give me liquidity or give me death..." ("P."Buck" Henry)

Macro Man said...

Were the ECB calling the shots exclusively, I could perhaps buy into the view that Europe would adopt a hands-off laissez faire approach.

The concern surely must be, however, that the politicians stick their noses in and upset the apple cart. Tony Blair this week gave the first whinge from a UK politician on sterling that I can remember, and both Trichet and Juncker hit the tapes warning about one-way currency bets today. For the firs time, I had the sense that they wer talking about EUR/USD as much as EUR/JPY.

Moreover, with the French presidential elections kicking off this week (your "homeland", n'est-ce pas?), the potential for stupid statements must be increasing... To my mind, though, resistance to euro strength only becomes a credible threat after the ECB announces the end of the tightening cycle.

"Cassandra" said...

I agree with you, have been frankly surprised that there hasn't been more jawboning from BOTH ECB and populists in capitals across the EU. And in trying to understand why the bluster hasn't been greater, I am just saying that from 10,000 meters up, it looks as if they've got a wonderful free ride in continuing to off-load UDMs etc. to Americaland where by most aggregate accounts said consumers shouldn't at this point be able to afford them and many of WCW's vintages (and perhaps some of the NVs), while still having the benefit of seeing some portion of global surpluses recycled their way, which remains more than the US can, at the moment claim. I reckon they begin to moan loudly about exchange rates should demand from north america wane of its own accord. Until then, they've got a good thing going.

Charles Butler said...

My proclaimed Euro/US equity market 'relationship' has been a little, um, tenuous since the British CPI announcement - requiring most of Friday's excitement to put the spread in the black for the period. My recent, more personal interest, in it does reveal some other transatlantic ideosynchracies, however. Most notable is that the two seem to become disengaged at around 8 PM. The five points, for example, that the S&P added after I bailed out to head for the coast mid-afternoon Friday were not responded to by the Eurostoxx contract after hours. The fact itself seems pretty normal, but the degree does not. Interesting to see how it plays out Monday A.M.

I do believe that these two markets run on distinct rythms - the much noticed (by the conspiracy crowd, particularly, as if it were 10,000 bucks going on an outsider at 30 seconds to post) late day turnarounds in New York being most noticeable, and don't see why it wouldn't extend to FX.

There's a strategy in there somewhere.