Interactive Brokers Weekly FX View by A Wilkinson

Watching the markets slowly prod for answers on Monday following the federal rescue of the mortgage market twins, Fannie and Freddie, was interesting. Within a heartbeat equity investors had decided that the annihilation of those two share prices was what was needed to restore a sweeping confidence on Wall Street. Mortgage backed securities rallied and mortgage rates did decline. But the immediate knee-jerk reaction in both bond and currency markets proved to be wrong. The dollar declined in response to the bailout, while bond investors were wrong-footed as they pushed bonds lower and yields higher. It wasn’t long before the dollar made fresh multi-month highs as bond buyers stepped back into the fray. The sanctity of treasuries remained intact. Of all the major world currencies only the Japanese yen is stronger when compared to one week ago.

Watching the markets slowly prod for answers on Monday following the federal rescue of the mortgage market twins, Fannie and Freddie, was interesting. Within a heartbeat equity investors had decided that the annihilation of those two share prices was what was needed to restore a sweeping confidence on Wall Street. Mortgage backed securities rallied and mortgage rates did decline. But the immediate knee-jerk reaction in both bond and currency markets proved to be wrong. The dollar declined in response to the bailout, while bond investors were wrong-footed as they pushed bonds lower and yields higher. It wasn’t long before the dollar made fresh multi-month highs as bond buyers stepped back into the fray. The sanctity of treasuries remained intact. Of all the major world currencies only the Japanese yen is stronger when compared to one week ago.

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Currency futures traders accelerated position building across the board. The rally in the yen meant was perhaps the reason that appetite for fresh yen futures positions was lax rising just 1.2% on the week. However, it is key to note that rising open interest was most prominent in those currencies losing most value since one week ago. A 5% slide in the Aussie dollar was accompanied by an 11.4% rise in futures open interest. The continued loss of appetite for commodities as a hedge against a declining dollar has put the Australian central bank on recession watch as export demand is now expected to slow.

A 3.6% decline in the euro, which today broker through $1.40 in the December contract, saw a groundswell of 14,813 fresh futures positions for an 8.8% weekly gain. The initial Monday reaction was to buy euros in exchange for dollars based on the view that the global horizon was set to clear. Therefore, traders incorrectly speculated, the recent frenzied selling spree of commodities for fear of a global slowdown, could now resume. If that occurred, the flight to the safety of the dollar now held no substance. Traders quickly corrected the mal-concept and reasoned that the Fannie and Freddie rescue package was little more than a band-aid on a gaping wound.

The decline in the Swiss franc was unusual and it dropped 2.4% on the week against the dollar. This was possibly behind a 12.9% rise in open interest in the franc futures.

The continuation of the dollar’s bull run has slowly but surely been gaining in acceptance of late. Last week we noted a surge in options implied volatility on currencies, which to an extent made perfect sense given the aggressive nature of the dollar rally at the time. The unit was breaking fresh ground against most competing currencies and the few brave souls that would make a market in providing options hedges were only prepared to do so at a price that suited them. Hence implied volatility became elevated.

This week the situation has reverted back towards something a little closer to home. There were declines of around 20% in volatility for the pound, Canadian and Australian dollars and the Swiss franc.

The Japanese yen is a really curious position. Many forex participants are now expecting the yen to rise primarily because of the ferocious bouts of carry-trade unwinding show no sign of stopping. Such reasoning is well-founded as global equities continue to suffer bouts of maladies. What is perhaps more curious is the fact that the Swiss franc – the partner in crime of the yen – has been in freefall. That means that the yen has a spirit of its own and we’d point to the failure to build speculative short positions as evidence that this is the one currency where currency investors see potential upside.

While the yen strength may have recently been little more than a sideshow while investors watched the main event, which has been the ascent of the dollar, its rise has been extremely transparent in its cross rate against the euro. This week the euro slipped to 150 against the yen from 170 as recently as late July.

We witnessed supportive volume in currency options over the past week. The notable trend has been an increase in investors demand for puts, where put open interest increased on all units except the Swiss. Call open interest increased by less in all instances. However, in several currencies, call positions were closed leading to declines in call open interest on the pound, the Canadian dollar and the Swiss. This trend compounds the view that investors are no longer keen to waste premium in the hope that the dollar’s strength is purely temporary. The loss of time value is clearly not worth it and positions are being shut closed fast, while at the same time investors are eager to reach for puts. This has been such a notable feature that with the exception of the yen and the Swiss, all currencies now have more puts outstanding than calls in terms of open interest. Last week, this was only true of the euro where bearish positions were building.

We conclude this week by noting that although implied volatility has declined it is still high relative to the historic volatility displayed by the movement in the underlying futures prices. The fact that options are currently priced at an inflated premium some 40% above historic volatilities tells us that currency activists think that hectic action will persist for some time to come.

Andrew Wilkinson

Senior Market Analyst ibanalyst@interactivebrokers.com