BNY Mellon: Low Volatility and High Beta FX Strategies

March 4, 2019

By John Velis, FX and Macro Strategist, Americas, BNY Mellon

• Volatility across asset classes is at historic lows; this is particularly true in FX
• It's a familiar pattern; low vol begets low vol, leading to herding behavior in riskier and riskier assets
• While such low volatility systems seem stable (and while they persist they are), they almost always eventually end with disruptive consequences; the timing is notoriously difficult to identify but there are obvious catalysts to keep an eye on

It’s well known that volatility across markets - but particularly in FX - has seen remarkable compression over the last several years.

With the exception of episodic bursts during which FX vol has jumped (but then recovered to its historically low ranges), the last few years have seen volatility levels continue to stay historically low. (See chart).

Implied Currency Volatility, 2009-Present

SOURCE: Bloomberg

Although it would seem logical that as concerns over global growth intensify, volatility should start to trend higher, we have seen the opposite, in large part because central banks continue to toe an increasingly dovish line at present, and volatility suppression continues.

Under such conditions, higher-beta assets, high-yielding currencies, momentum trades, and spread/credit products remain in favor, generating sustained high returns and rising valuations.

In addition to the acquiescence of central banks, this mutually reinforcing set of conditions has many elements.

For the example, the rise of passive investing and certain asset management strategies exacerbate this cycle. Passive investment products are benchmarkers. As indices rise in value, passive managers are forced to buy more of the underlying assets classes, essentially chasing prices higher, exacerbating momentum and returns such strategies generate.

Pithily, this is called the TINA trade: there is no alternative. Managers cannot afford to fall behind peers, hence find themselves chasing higher returns, forcing them further out the risk curve.

This pattern can also be found in more complicated and leveraged strategies. For example, risk-parity strategies require the taking of additional long positions in an asset class as its volatility falls, required to keep expected Sharpe ratios sufficiently high.

Such cycles are equivalent to “Minsky Processes.” Stable and low volatility creates the conditions for excess risk taking, driving vol ever lower. In FX, these strategies are reflected in carry, EM, and other high-beta factors being rewarded.

If and when the stability of these multi-asset or multi-currency systems break down, accumulated positions become candidates for forced selling (the reverse of the process that exploited and exacerbated the low-vol environment to begin with). Liquidity becomes scarce and asset shedding begets flight-to-quality behavior. Correlations increase (“nowhere to hide”).

It is obviously difficult to time the end of this cycle. Instead we identify catalysts for signs that things are at risk of breaking down:

• Although global growth expectations have cooled, the US continues to be viewed with a relatively sanguine eye; should US economic prospects worsen significantly, this could lead to a de-rating of risk, rising vols and large price reactions
• Political risks: Brexit, US-China trade, US-EU autos, and Italian debt are all still on the table
• Policy errors: most central banks have taken a dovish turn in recent months, however, unintended or unwarranted hawkishness could lead to rising risks