Thursday, May 10, 2007

Foreign Exchange Powerball

Well, the central bank hoe-down went pretty much as expected. The BOE took the middle ground, hiking by 25 bps, while the ECB announced a June rate hike through Trichet’s linguistic semaphore. Of slightly more interest was the US trade deficit, which registered its widest reading since September, largely as a function of higher petroleum imports. This was wider than either the market or the Commerce department anticipated, and could lead to Q1 GDP being revised down to an o-handle.

So of course, the dollar’s rallied.

In fairness, the jobless claims were strong, confirming the recent trend and perhaps suggesting that the labour market isn’t as bad as last Friday’s data might suggest. Nevertheless, the FX market appears to be in full on pain mode, hunting stops (USD/JPY shorts have now left the building), with more lurking in EUR/USD below 1.35. Macro Man’s EUR/USD stop is at 1.3450 for €15 million. Only the Russian central bank appears to stand in the way of further euro weakness.

This calls to mind something that Macro Man addressed yesterday, the collapse in long term implied volatility in the currency market. Structured product supply of implied vol has taken the entire EUR/USD curve onto a 5 handle from 1 week to 20 year, with lots of trading in the 10-20 year sector around 5.5% in recent weeks. While it may make economic sense to sell the in the context of a multicurrency structured product, it just looks like the wrong price from a purely FX perspective.

US corporate treasuries should really sit up and take note. Unlike most speculators or funds, they can be virtually guaranteed of knowing they’ll still be in business and having currency exposure in a decade’s time. At current levels of implied vol, US exporters can lock in EUR/USD breakevens in excess of 1.30 for each of the next twenty years through the purchase of a strip of at the money forward EUR/USD put options. Simply put, these guys can lock in an uber-competitive rate from here until far beyond the forecastable horizon.

For the speculator, the valuations are equally compelling, though of course there is no guarantee that one will be around to reap the benefits of a 10 year, 1.46 straddle for 12.2 big figures at expiry. For this reason, one touches with payout at touch look a lot more compelling. Consider that a 10 year 1.20 one touch can be had for 26% of the payout....and we were at that level little more than a year ago! Macro Man reckons that fair value for EUR/USD is 1.10. The 10 year one touch at that level costs 13%. In other words, the options market is giving you slightly less than 8-1 odds that EUR/USD will trade at fair value at any point in the next decade. Try getting odds like that in Vegas!

Now it is of course the case that volatility has been trending steadily lower over the past few years. While 5.5% might look a bit cheap today, might it not represent a credible estimate of future volatility over the next decade? Let’s have a look.
10 year historical vol in the post-Bretton Woods era has averaged 10.5% for USD/DEM and EUR/USD. If the next decade looks anything like that average, ultra long term vol is the steal of the century at current levels. The current historical 10 year vol is lower, of course- it’s 9.0%, having trended steadily lower since late 1993. If the next 10 years resembles the previous ten, the current 10yr vol remains a steal. Ah, I can hear you say, but what are the chances of that? Over the past 10 years we’ve had the Asian crisis, Russia/LTCM, the tech boom and subsequent bust, September 11, Enron, and Iraq. What chances that we see such a sorry collection of mishaps over the next decade, especially now that we’re all so clever?

Probably better than you think, given the human bias towards overconfidence when forecasting the future. However, even if recent trends continue, 5.5% 10 year vol looks at worst fairly priced. Extrapolating the trend in EUR/USD 10 year historical volatility since 1994 over the next 10 years, we arrive at a regression forecast of 6% 10 year historical vol in May 2017. So unless you think that vol will decline even more, buying now looks to be of some value, with a nice cheap call on future volatility.

Macro Man has a bias for downside one touches, given that that is the direction in which his and most people’s perception of fair value lie. He therefore buys a strip of 10 year 1 touches:
* 10 year 1.20, $5 million payout, for 26%
* 10 year 1.15, $5 million payout, for 19%
* 10 year 1.10, $5 million payout, for 13%
* 10 year 1.05, $5 million payout, for 9.5%
Call it foreign exchange Powerball. Macro Man has another trade lurking in the wings, but he’ll save that one for tomorrow.


Dale said...
This comment has been removed by the author.
Dale said...

The dollar rallied because the retail sales figures indicate recession, which would mean fewer imports, which would mean fewer dollars being sold against foreign currencies.

Where do you get your fair value of $1.10 for the euro/dollar?

Anonymous said...

U forgot about Turkey ... U have a position there

Macro Man said...

Dale, that's on the basis of my own calculation. The OECD has a PPP fair value rate that is broadly similar.

While the EUR/USD breached 1.35 on those chain store numbers, it traded lower almost immediately after the trade figs, which was somewhat perverse, given the usual fixation with global imbalances...

Caravaggio said...

Hi Macro Man, I don't suppose there's a public site on the net where I could track long dated currency vol rates?

I believe you really have something of value with this observation. Personally, I also favour long-term EUR/USD downside, but at these prices a 10 year straddle looks the most attractive. The market looks like its priced to perfection.

Macro Man said...

I don't know of any public site that has historic data on implieds of such a long tenor.

The spate of selling the very back end really seems to have accelerated in the very recent past; for the right kind of institution (corporate, pension fund, family office, or, dare I say....central bank), this represents an absolutely tremendous opportunity IMHO. For the rest of us, it's more or less a nondecaying lottery ticket for the next few years, which ain't bad either.