Excell with Options: USD trends and the debt ceiling
Executive summary
In this report, Rich looks for opportunities in the foreign currency market among continuing conversations about the U.S. debt ceiling as a possible catalyst.
Last year may be considered more of a “macro” year vs. the previous year in which the cheap cost of capital was driving risk taking across many asset classes. We can see this most clearly when we compare the measures of risk across various asset classes. For this exercise, I looked at the JPM VXY global FX implied volatility index, the VIX Index for stocks, the MOVE Index for bonds, and credit spreads as calculated by the Moody’s Corporate Baa yield vs. Treasuries. These measures of risk historically move together, leading many to refer to the risk-on/risk-off type of nature to markets. However, in all of 2022 – despite heightened measures of risk in FX and U.S. sovereign bond markets, the more macro markets, and the measures of risk in the idiosyncratic – single securities markets of equities and credit did NOT see any meaningful uplift in levels. These measures do not stay disconnected for long, and we are beginning to see the macro measures start to move lower, potentially looking to re-align with the sanguine views in the idiosyncratic markets.
Image 1: JPM G7 implied volatility index compared to VIX, MOVE and credit spreads
It is somewhat interesting to see these macro markets showing a decline in implied volatility right before we have perhaps one of the bigger macro catalysts of the year – the U.S. debt ceiling standoff. However, there are other drivers of FX rates that we should perhaps consider trying to understand what is driving the flows. One of the first I like to look toward are the interest rate differentials. I use the 10-year yield spreads because this is the more “investable” part of the curve where I believe sovereign wealth funds, insurers, and reserve managers tend to focus. If we compare the spread between Bunds and Bonds to gauge European vs. U.S. levels, or the spread between Bonds and Japanese Government Bonds (JGBs), we can compare to the broad Dollar Index (DXY) so get a sense if there are any dislocations. On this front, the DXY does stand out vis a vis European vs. U.S. bond spreads but not compared to U.S. vs. Japanese spreads.