Where’s the action?

Watching the Dow Jones’ tepid flirtations with the 20,000 level has quickly become pretty dull. After almost two weeks of coy approaches, many traders will have been tempted to switch over to the red-hot action in the FX market. We’ve been getting some very decent moves so far in 2017. USDJPY has seen low-to-high ranges of greater than 1% on six out of nine trading days this year; for the EURUSD it’s been five out of nine days. Impressive stuff.

Given these moves, it’s no surprise that option market participants are betting on continued action in FX-land while expecting the major indices to be tranquil. This has led to a pretty rare state of affairs where FX vol is at the upper end of its recent range and equity vol is at the lows.

To get a sense of just how unusual this is, I’ve looked at 3-month ATM vol in the two FX pairs and the VIX since the start of 2014 – thereby missing out the higher volatility regimes associated with the Eurozone crisis and the first year or so of Abenomics. Mid-December last year was the only time we had volatility in EURUSD and USDJPY in the top 20% of observations while the VIX was in the lowest 20%. Another way of looking at it, 3-month implied volatility in USDJPY has only closed higher than the VIX on just over 5% of trading days since the start of 2014. Almost half of those instances have been since the US election.

Thinking through what Trump might mean for the two markets, there’s some logic to it. After years of investors favouring defensive stocks at the expense of cyclicals, the Trump reflation trade in equity markets could well have further to run. As we’ve seen over the past month or so, this repositioning acts as a kind of stabilizer -- the major indices don’t move very much, while money moves aggressively between sectors.

Meanwhile, there’s less reason to expect such stability in FX, where the market is very focussed on the prospect of more pronounced policy divergence between the Fed, the ECB and the BoJ. 

For a Trump sceptic, it’s very tempting to bet on this divergence closing. It’s hard to believe that his reshaping of international relations and policy-by-tweet won’t lead to higher equity volatility. And if you don’t think he can deliver on his tax and spending promises, it’s unlikely that we get the pick-up in US growth expectations needed to move the dollar from here.

Still, I wouldn’t be rushing to sell FX vol and buy the VIX just yet. Given the FX moves we’ve seen so far this year, currency vol actually seems reasonably valued. And while the VIX looks too low, the steep futures curve makes it costly to hold.

This could be one of those disconnects that persists for much longer than anyone would expect.