Weaker dollar, more expensive hedging: currency volatility sees extraordinary rise

The decline of the dollar is raising the cost of hedging currency trades worldwide, breaking the long-held market belief that costs usually decrease when the dollar weakens. The correlation between the dollar and the widely followed G-10 currency volatility index has fallen to its lowest level in seven years. For most of the last 15 years, this correlation has remained positive.

This structural change indicates that traders are preparing for stronger market fluctuations, unlike the usual stability that typically accompanies a weaker dollar. Options trading has picked up this year, with the daily average volume since January exceeding the 12-month average, according to data from the Depository Trust & Clearing Corporation.

“This is just the beginning, so get ready,” says Andrew Ng, Head of Global Financial Markets at DBS Bank, at the International Swaps and Derivatives Association conference in Amsterdam. “Long volatility trading is likely to be key.”

Spot and options market moves this week show that traders are rightly preparing for significant volatility. On Monday, the dollar strengthened due to a US-China trade agreement, and one-month implied hedging costs dropped to their lowest levels since late March. But in the following days, the currency weakened due to lower US inflation data and speculation that President Donald Trump supports a weaker dollar, boosting demand for long-term volatility exposure, especially for longer maturities.

“Realized currency volatility is high and I think it will remain high for some time,” says Goldman analyst Kamakshya Trivedi on Bloomberg TV.

The moves suggest the currency market is positioning for a prolonged downward trend in the dollar. Bank traders also report increased demand for hedging with longer-term instruments as clients prepare for a regime shift.

This is reflected in the one-year implied volatility of the euro against the dollar, which jumped after bottoming out on Tuesday. The increase this year is the sharpest ever, according to the so-called z-score — a measure of how extreme the move is compared to historical values.

“I am sure President Trump, with his desire to rebuild the global trade framework, is a supporter of a cheaper dollar,” writes Kit Jucks, Head of Currency Strategy at Societe Generale SA, in a note. “This US administration appears ready to do whatever it takes to achieve its goals.”

The Bloomberg dollar index fell as much as 0.4% on Thursday, even though a Bloomberg report said US officials negotiating trade deals are not working on including commitments related to currency policy. This follows news that South Korea and the US are discussing currency-related policies, fueling speculation that Trump supports a weaker dollar.

Source: Vassilis Karamanis (Bloomberg)