Michael Woolfolk One area that has yet to see much selling actio

mplications of Heightened Market Volatility (UPDATE)

Michael Woolfolk

 

8/8/2011

After developments this weekend, we would like to update clients on the paper we published at the close on Friday.  Late Friday night, S&P announced that it was downgrading the sovereign credit rating of the US to AA+ from AAA.  On Sunday afternoon, the ECB announced that it was actively implementing its Security Markets Program in order to address "dysfunctional market segments."  The market interpreted this to mean that the ECB would begin buying Spanish and Italian bonds, which was confirmed later in the session.  The impact on global financial markets was predictable: a plunge in equity prices, a rally in safe-haven currencies and further pressure on emerging markets.  As of 11am EDT, the Dow was down -310 points or -2.7%, the Canadian TSE was down -2.9%, the UK FTSE was down -3.3%, both the German DAX and French CAC were down -4.6% and the Japanese Nikkei was down -2.1%.  In emerging equities, the Hang Seng was down -2.2%, the Mexican IPC was down -2.9% and the Brazilian Bovespa was down -5.2%.  Likewise, the VIX Volatility Index continues to soar, hitting a high of 40.96 at 10:37am this morning from Friday's close of 32.00.  Finally, the USD/MXN exchange rate, our EM currency crisis indicator, surged as high as 12.23 this morning from Friday's close of 11.99.  As we warned on Friday, as risk aversion continues to rise amidst heightened market volatility, EM investors are becoming far more selective.  So far today, the BRL has dropped as much as -1.1% against the USD, the KRW has fallen -1.6%, the ZAR has fallen -2.4% and the RUB has plunged a remarkable -3.1%.  As long as equities continue to fall, we expect EM currencies to remain under selling pressure through US Labor Day as investors seek the safety of cash and safe-haven currencies.

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FX COMMENT: Implications of Heightened Market Volatility
August 5, 2011 (5:30pm EDT)

Heightened uncertainty amidst the seasonal illiquidity of August, has caused volatility in global markets to soar to the highest level of the year.  The range in the Dow Jones Industrial Average (Dow) today was 416 points down modestly from the 521-point range seen yesterday.  Not only was the Dow's high/low range today remarkable, but so also was the speed of the price movement.  After falling to a session low of 11,140.36 by 11:57am EDT from 11,554.88 at the open, the Dow proceeded to rally back to 11,550.00 at 12:49pm - less than an hour later.  From there, the Dow proceeded to fall back into negative territory before closing up 60 points on the day.  This price action propelled the VIX Volatility Index as high as 39.25 today from 25.00 at the start of the week and 17.00 at the beginning of the year.   Likewise, one-month, at-the-money implied vols in the foreign exchange market have soared.  The EUR/USD 1M ATM reached a high of 14.83 and the GBP/USD 1M ATM reached a high of 9.58 - the highest levels since July 12.  For its part, the USD/JPY 1M ATM soared to a high of 11.87 - the highest level since March 21.  More tellingly, the EUR/CHF 1M ATM soared to a record high of 19.52 from 15.00 at the start of the week and 12.00 at the beginning of the year.  BNY Mellon's FX Volatility Index, a proprietary, volume-weighted, historical volatility index of the bank's top-20 traded currencies, reached a high of 138.94 yesterday, from 118.23 at the start of the week and 105.56 at the beginning of the year.

The implications of this surge in market volatility are that many investors have been pushed to the sidelines, seeking the safety of cash in safe-haven currencies.  Given the recent debt-ceiling and sovereign credit rating concerns in the US, the USD has become the safe-haven currency of last resort, not first resort.  The CHF and JPY have proven more desirable than the USD this summer, fueling both currencies to record levels.  The USD has fallen 28% against the CHF and 17% against the JPY over the past two years, while the EUR has fallen 28% against the CHF and 18% against the JPY over the same period.  Much of this move has taken place over the past 12 months, with the USD falling -27% and the EUR falling -21% against the CHF since August 5, 2010.  These are truly remarkable numbers.  A study of daily price changes among all major currencies and currency-crosses since 1980 reveals that a -20% decline rarely happens within any 12-month period.  When it does, it is almost always a conscious decision backed by affirmative policy measures.  Examples of this are the coordinated depreciation of the USD and CAD following the Plaza Accord of September 1985 and the exit of the GBP and  ITL from the EMS in September 1992.  Not surprisingly, the Bank of Japan (BOJ) and Swiss National Bank (SNB) have finally declared this week that enough was enough.  The BOJ unilaterally intervened in foreign exchange markets and the SNB cut interest rates and vowed to adopt further measures if necessary to prevent further appreciation.

While financial market volatility frequently increases during the summer doldrums of US Independence Day through US Labor Day, a period when market players traditionally take their summer leave, this year has been unusually volatile.  With the US Dow off over 10% from its recent highs on July 22, a technical correction has been triggered.  Moreover, with global investors unlikely to enter into fresh long positions until the market returns to full liquidity in mid-September, the odds are clearly against a long-term bottom emerging in equities this month.  Consequently, players are likely to be defensive, preferring to remain in cash and safe-haven currencies.  If so, this does not bode well for the SNB and BOJ that wish to stem further currency appreciation.  August could still present surprises on a number of fronts.  One area that has yet to see much selling action is the emerging markets.  EM currencies have been in favor for the last two years, after the collapse of Lehman Brothers sent US interest rates to zero and developed market economies reeling.  With global growth slowing, global equities falling and inflation rising throughout the emerging markets, EM currencies reliant upon the continued inflow of speculative foreign investment are vulnerable.  One such "canary in the coal mine" among the EM currencies is the MXN.  With an economy lacking in the solid fundamentals of the BRICs and Asian Tigers, Mexico has nonetheless benefited from the wave of investment into EM currencies owing in large part to its size and investment grade status.  The break in USD/MXN above the 12.00 level today is not only a warning for the MXN, but also a warning for EM currencies in general.  If risk aversion continues this month amidst heightened market volatility, EM investors are expected to become far more selective.