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Omicron and Currency Market Crosscurrents - Global Exchanges

FICC Podcasts November 30, 2021
FICC Podcasts November 30, 2021

 

In this week's episode, we discuss the recent sharp moves in EURUSD, USDYEN, and a few other exchange rates.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

Podcast Disclaimer

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Greg Anderson:

Hi, welcome to episode 27 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode, my co-host Stephen Gallo and I will be talking about the recent sharp moves in Euro-Dollar, Dollar-Yen, and a few other exchange rates. The title for this episode is Omicron and Currency Market Cross Currents.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So don't hesitate to reach out by going to BMOcm.com/GlobalExchanges. Thanks for joining us.

Speaker 1:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates, or subsidiaries.

Stephen Gallo:

Okay. It's November 30th, 2021. Thank you for joining the podcast. And following on from your introduction, Greg, the issue I'd like to point out first or go to first is how choppy and volatile both the FX markets and the rates markets have become particularly over the last week. I have a volume weighted three-month implied volatility index which I track covering all G10 currencies and a large chunk of EM currencies. And it recorded a new high for the year on Friday. It's basically sitting at that high today. Now in numerical terms, we can call it a high of eight vols for the index. That is not massive in the grand scheme of things, it's important to point that out, but it is a sizeable increase on average implied volatility from Q3, Greg.

Greg Anderson:

So Stephen, with that noteworthy spike in your FX implied vol index, are there any specific currency pairs that really stand out or is this more of a generalized jump in implied volatility of everything?

Stephen Gallo:

Greg, there are 21 currencies in the index in total and on a week-over-week basis, which is how I'm calculating these changes, the top three increases in three-month implied volatility were in order [Nok, Mex 00:02:33] and Yen. Now I'll let you jump in here in a second, Greg but the first thing that stands out in my opinion is that mostly the pickup in volatility was in G10 with one exception, in this case being Mex. But other than that, I think these vol pickups can be explained by one of three factors, liquidity, positioning, and commodity prices. Particularly oil which has experienced notable volatility over the past week.

Greg Anderson:

I noticed your list of noteworthy volatility uptakes didn't include Euro-Dollar, although it has been quite whippy over the past few days. And it also didn't include Dollar-Canada or Dollar-China. What has happened to implied vol in these currency pairs?

Stephen Gallo:

In this case, Greg, let me cover the last one first, Dollar-China. There's been very little change at all in three-month implied volatility. And if anything, actually a slight decrease in vol on a week-over-week basis. I don't think that's much of a surprise. We've seen very little movement in Dollar-RMB all year long. Price action in Euro-Dollar has certainly been whippy, that's Euro-Dollar spot and swap break differentials have played a role in driving that currency pair. But in both Euro-Dollar and Dollar Canada, there's been only a modest increase in three-month implied volatility, Greg. Nothing noteworthy compared with the other currencies I mentioned. That being said, I don't want the numbers related to three-month part of the curve to detract from the main message, which is that we are seeing a noteworthy increase in implied volatility for reasons that we're going to get into.

Greg Anderson:

I'm really glad that the index we're using is three-month vol and not one-month vol. I will point out that in most pairs, the rise in one-month implied vol over the past few days has been sometimes way bigger than the rise in three-month vols. I would attribute that to the fact that the one month contract had a date premium built in due to calendar year end. That calendar year end markup should get priced back out of one-month vol over the next couple of days because now we're pricing past the turn. But it at any rate, I think we can safely say that the pickup implied vol, this is not a calendar quirk. This is a true increase in uncertainty about the future path of these exchange rates.

Stephen Gallo:

All right, Greg. So let me ask you about implied volatility and the move in Dollar-Yen. [SPA 00:05:00] has basically gone from call it 115.5 to 113 in change now after touching a low for this adjustment of 112.53 earlier today. Do you think positioning has been largely responsible for the scale of the rally in the Yen as well as the spike and implied vol or do we need to look at other drivers here, Greg?

Greg Anderson:

As you mentioned, the market came into what I'm going to call the Omicron Episode quite long of Dollar-Yen. So I'm sure that positioning was one of the factors that contributed to Dollar-Yen dumping basically two big figures. Say from the low 115s to the low 113s on Friday. But it's not just that, the two most critical drivers for Dollar-Yen tend to be interest rate differentials in the price of oil. Where Japan is so heavily reliant on foreign oil, the sharp move lower in oil prices benefits Japan, and that undoubtedly exerted a downward pull on Dollar-Yen. And with regards to interest rate differentials where Japan's rates are basically anchored at zero across the curve, the move lower in US rates caused by the Omicron scare has narrowed the interest rate differential, which also pulls down out on Dollar-Yen. Or at least it did until Powell spoke a few minutes ago.

Greg Anderson:

What Powell said in some comments before the Senate Banking Committee was that the FOMC will evaluate at its December meeting, whether it is appropriate to speed up its taper process by a few months. That comment chased Dollar-Yen from I'll call it 112.60 to 113.60 in a span of less than a half hour. Where Powell was actually pretty noncommittal about whether that taper might get sped up. And he mentioned Omicron as a risk factor that might cause him to conclude that they have the right taper speed for now. I'm surprised that Dollar-Yen moved a whole big figure on that, but I guess it goes to show how uncertain things have become regarding the monetary policy outlook. So maybe the vol market is right to assume that this type of whippiness is going to persist for a few months. Hey Stephen, while we're on the top of potentially changing paces of bond purchases, what's the latest on the ECB and how might that influence Euro-Dollar?

Stephen Gallo:

Right Greg. So just to bring it back to the topic of the podcast cross currents, it seems to me that the duality of a possible slower recovery from Omicron along with the hit to the oil price and central bank simultaneously in a more hawkish posture, particularly the Fed is how I would describe the fundamental picture behind a backup in implied volatility or these cross currents. You asked about the ECB, the ECB has been on an entirely different more dovish plane altogether. And you'll recall Greg from client conversations that we've been involved with together, I've been mapping out two plausible scenarios for the Euro stemming from the ECBs policy stands over the next one to three months or so. The first is a continuation of dovishness while other central banks tilt more hawkish resulting in general downward pressure on the Euro. The second scenario, which I've been characterizing as more of an outlier is one in which the ECB is forced by the inflation backdrop into, I guess, call it an abrupt hawkish u-turn on policy perhaps involving an earlier end to its bond purchase program that it's currently flagging.

Stephen Gallo:

Now I've been describing that second scenario as an outlier, which I just indicated, but with inflation in Germany running at a 6% annual pace and the SPD candidate for the chancellor Olaf Scholz supporting action from the ECB, if inflation does not moderate, the outlier scenario is one I think we should at least be discussing.

Greg Anderson:

Stephen, as I understand it, the official communication regarding the ECBs bond purchase program states that the emergency program will end in march, which would result in a sort of a cliff edge where QE drops off dramatically and the ECB's QE could end up being less than the Fed's QE at that point. But is that what is priced into Euro-Dollar or is there a market assumption that is different from that?

Stephen Gallo:

Greg, that's a really insightful question because the ECB plays such a vital role in soaking up issuance in the Euro area. Look, my best judgment is that the FX and rates markets are assuming that the ECB will continue with outright purchases and reinvestments in some form throughout next year. The only unanswered bit or I guess you might say the big question is what modality those purchases will exist in. Will the ECB taper the emergency program into March and scale up the flexibility of the standard asset purchase program from March or will it essentially rename the Pandemic Emergency Purchase Program and let it operate in a reduced form from March? And if so, how much will it reduce net asset purchases by? These are big questions, but my best judgment is that the financial markets assume the ECB crutch will be there in some form all of next year. And personally I think that's the right assumption.

Greg Anderson:

So let me paint three relative monetary policies scenarios for you. And you give me the Euro-Dollar exchange rate to the nearest big figure say that would result. And of course we're leaving aside all of the uncertainty related to the European oil crisis, Ukraine-Russia situation, et cetera. So scenario one, the Fed keeps its taper program as previously communicated in the last meeting and finishes QE in June while the ECB modestly scales back its bond purchases as you described. Scenario two, the Fed accelerates its taper timetable and finishes in March, while the ECB no change, basically they keep on cuing at the modestly scaled back pace you described. Scenario three, the Fed accelerates its taper timetable and ends its bond purchases in March while the ECB lets its cliff edge taper happen. For each scenario, give me where you think Euro-Dollar would be in say three months from now and the probability that you'd attach to the scenario.

Stephen Gallo:

Well, Greg, for the first scenario, I would give you a level of Euro-Dollar of 112, and I'd assign that a 60% probability. For the second scenario, which was you had the Fed accelerating, finishing in March, and the ECB modestly scaling back QE, I'd give you 110 in Euro-Dollar and a probability of 30%. The third scenario, I think is the most complex, talk about cross currents. Because on the one hand you have the ECB ending the vast majority of QE pretty abruptly and Euro shorts being forced to cover. But on the other hand, you have the potential for what I can only foresee as a sharp repricing of peripheral credit markets to an environment of less ECB support and higher sustained inflation. That's why I'm not going to go above 115 with my expected level for Euro-Dollar in the third scenario. And I'm only going to give it a 10% probability for now. That being said, Greg peripheral credit in the Euro area has recently been underperforming. So it's possible that wider spreads will start to impede Euro appreciation earlier than the first half of next year. It's just something worth watching, Greg.

Greg Anderson:

It sounds like basically you think Euro-Dollar is a sell up here on a 113 handle.

Stephen Gallo:

Taking all factors into consideration, Greg, including the ECB politics and issues related energy. Yes, I think levels above 113 in Euro-Dollar are decent entry points to sell euros on a horizon of one to three months, shorter term one to two weeks, given the uptake in volatility we spoke about earlier, it's much more of a difficult trade I think Greg. I'm going to toss it back to you now, Greg, on Dollar-Yen and the irony here is incredible. It's currently trading 113.20, which is almost precisely where Euro-Dollar is trading. Is it a buy here at 113.20 Greg, a sell here? Or maybe I should ask you also, do you foresee any wild rations in Dollar-Yen coming?

Greg Anderson:

Darn. I thought it successfully escaped without making a call on Dollar-Yen. I'll just say Dollar-Yen is an exceptionally hard call to make right now. But a gun to my head, I would say that it might be both a buy and a sell at 113 today. Let me go back to scenarios for a bit. Let's suppose our first scenario is the one where the Fed does not accelerate its taper pace at the December meeting and let's assume further that oil parks itself for the month of December, where it is now in the mid sixties. In that case, with position reduction, US two-year yield lower cetera, I think we'd be looking at Dollar-Yen testing 110 by December 31st. So on a one month horizon, I think Dollar-Yen is a sell. Okay. Now let me paint another reasonably plausible scenario.

Greg Anderson:

In this scenario, the Fed does accelerate taper at its December meeting. Then it goes ahead and it finishes the QE program in March and then implements its first rate hike in June. Meanwhile, OPEC Plus regain control of the price of oil and finish what I think was their intended program of pushing it to $100 a barrel next summer. So in that scenario, Fed hikes in June, $100 oil, I think we'd be looking at Dollar-Yen at 120 plus on a six month horizon. So with a six month horizon, I guess I think Dollar-Yen is a buy here at 113. So to summarize where Euro-Dollar and Dollar-Yen are both at 113, ignoring the decimal point, I have some pretty plausible scenarios that I can lay out where Dollar-Yen breaks out of the one-teens and moves either below 110 or above 120. I didn't hear you say anything about a move above 115 in Euro-dollar let alone 20. So yeah, I think Dollar-Yen has got a lot more potent upside potential and at least equivalent downside potential.

Stephen Gallo:

You know what, Greg, it sounds like the options market might have it right based on what you're saying in the sense that it has been chasing up Dollar-Yen vols by and more than it's been chasing up Euro-Dollar vols. I think we've done enough for one day. Greg, let's wrap up Episode 27 here. Thanks for listening until next time. Bye for now.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts bmocm.com/GlobalExchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 1:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Incorporated and BMO Capital Markets Corporation. Together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 1:

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Speaker 1:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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