2022 has been a year for macro moves. COVID-19 problems continue. There is a land war in Europe. There are fears of economic slowdown in Europe and the U.S. caused by inflation, which has brought aggressive central bank policy into play. There is a seemingly endless supply of negative or potentially negative headlines. This brings me back to my early days in the market when I started on the CME Group floor trading FX options. I know these markets get the most interesting when there are major macro stories in the world.

The first stop for me was to go to CME Group’s Volatility Index (CVOL) to view how the level of volatility looks relative to the last six months or so. With all these headlines, is a good amount of future volatility being priced in already?  From Figure 1, we can gather that G5 FX –  the major currency pairs – all are seeing volatility levels that are elevated versus the last six months of history, particularly JPY/USD. On the flipside, MXN/USD is at the low end of its range.

Figure 1: CME Group FX CVOL

Figure 1: CME Group FX CVOL
Source: CME Group

Thus, I wanted to look into JPY and MXN, as the levels of volatility relative to their range suggest there could be an opportunity. What if there was a product for which the short-term chart was suggesting much higher levels, but was close to the downtrend of a 30-year channel? You might think I was referring to 10-Year U.S. Treasury Yields. In fact, I am referring to USD/JPY. Figure 2 shows USD/JPY for the last 35 years. I find it interesting because when I first went to Japan for a study abroad program in 1986, I remember thinking how inexpensive everything was. I went back again in 1989 and 1991. Each time, goods were seemingly more expensive. The included chart shows this entire period with some other interesting annotations. The low was at 79.75 in 1995, which I point out because I was short gamma in USD/JPY at that time and actually sold that low price. Nothing like selling the low. I was very happy then in 2011, when a new low was set. I no longer had the record for the worst USD/JPY spot trade in history. You can see in 2012-2014, the USD got quite a bit stronger versus the Yen. This trend coincides with the election of Prime Minister Abe and the introduction of his Three Arrows plan. According to Wikipedia: Abenomics is based upon "three arrows" of monetary easing from the Bank of Japan, fiscal stimulus through government spending, and structural reforms. After that initial weakening, the yen went sideways for the last seven years, and this downtrend line remained intact. That is, until recently. While major central banks around the world are in various stages of tightening monetary policy to combat inflation, the Bank of Japan recently re-confirmed its zero-rate policy. Presumably, this is an attempt to import the inflation from the rest of the world into the Japanese economy, which has been fighting deflation for decades. This news caused the U.S. dollar to strengthen vs. the yen and finally move above this long-term trend line.

Figure 2: USD/JPY

Figure 2: USD/JPY
Source: Bloomberg

This gets me interested. Yes, the level of volatility looks quite high relative to the last six months, but I know it has been higher. The reason I sold the all-time low in 1995 was because I was short yen vega in the 20s. I went back to the CVOL tool to look at yen volatility through history. The current level looks a lot more reasonable on this longer-term view below the mid-point of the range.

Figure 3: CME Group FX CVOL Historic Volatility

Figure 3: CME Group FX CVOL Historic Volatility
Source: CME Group

JPY/USD Ratio Spread example

When asset prices move into a new area it always suggests to me that it is time to get long some convexity for potential profit. There is the risk that this is a head-fake and prices could move back below trend. However, the Bank of Japan (BOJ) is giving macro fund managers the green light to use the Yen as the funding currency of choice for carry trades and for leverage. The BOJ is sending a signal to the hypothetical Mrs. Watanabe, the Japanese retail investor that has been forced to invest in overseas bond markets in search of yield, that there is less risk of Yen strength which would hurt those overseas investments.  In the FX market, skew can move quite a bit so I looked to see what was being priced in at the current moment. I must admit I was surprised to see skew so flat between 25 delta calls and puts.

Figure 4: JPY/USD Skew

Figure 4: JPY/USD Skew
Source: QuikStrike

Figure 5: USD/JPY ratio spread

MXN/USD

Figure 6: MXN/USD vs. U.S. PMI

Figure 7: MXN/USD

Figure 8: MXN/USD call vs put spread