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

Image 1: 	JPM G7 implied volatility index compared to VIX, MOVE and credit spreads
Source: Bloomberg

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.

Image 2: European and Japanese government bond yields vs. U.S. bond yields compared to DXY

Image 2:	European and Japanese government bond yields vs. U.S. bond yields compared to DXY
Source: Bloomberg

Image 3: CVOL Index, skew, convexity and ATM volatilities for the G5 currencies

Image 4: Japanese Government Bond (JGB) vs. U.S. Bond compared to USD/JPY

Image 5: Bund vs. Bond yield spread compared to EUR/USD

Image 6: UK vs. U.S.: Gilt vs. Bond yield spread compared to GBP/USD

Image 7: China vs. U.S.: relative PMI (white), relative stock performance (purple), currency (blue)

Image 8: U.S. 1-month vs. 3-month T-bill yields and U.S. 1-year credit default swaps

Image 9: Major international holders of U.S. government debt

Image 10: Price moves for the major currency pairs around previous debt ceiling stand-offs

Image 11: U.S. dollar compared to the relative performance of EFA vs. SPY and EEM vs. SPY

Image 12: CVOL tool for FX options

Image 13: Implied volatility skew for June 2 weekly options

Image 14: Expected return of a short EUR put spread, long call strategy