FxWirePro: What Drives Buying CAD And CNH Forward Vols?

FX volatility, especially in G10, has spent most of April retracing from the manic highs of March as a plethora of Fed liquidity programs helped calm nerves in risk markets.

The sharp reversal in the VXY in April has left it screening 0.5 - 1.5 pts. cheap vs. cyclical correlates, which is hard to justify in a climate of worsening growth, elevated oil / commodity volatility and political tails risks in Europe and China.

In addition to upside pressures on vol from the ongoing devastation in global growth, three factors are worth flagging as sources of potential spike risk - the fallout of increased oil/commodity volatility, the rising political temperature in Europe, and the potential revival of US/China tensions. Higher commodity volatility is more impactful for commodity exporting EMs rather than G7 vols – a distinction exacerbated in the current instance by the ability of commodity exposed G10s like Australia and New Zealand to embark of QE on a scale that EMs will be hard-pressed to mimic -- but we are nevertheless still surprised by pockets of G7 resilience such as CAD that we would have expected ex-ante to react more forcefully to negative prompt WTI prices, and which we think are due a catch-up in coming weeks – perhaps if/when the kerfuffle around the May expiry WTI futures contract repeats next month; we buy USDCAD forward volatility this week through one-touch CAD put calendar spreads. Political risks around Europe and China both bear close watching from here. 

On the former, owning EUR vol and/or risk-reversals has typically been a sub-optimal hedge against jitters in the European periphery in the past, so we are on the lookout for better value, higher-beta vol expressions over and above directional exposure already in the macro trades portfolio. We do however buy some CNH forward vol this week to hedge against any abrupt deterioration in US/China relations that turns CNY-stability on its head. Given unchallenging vol levels today, no one should be surprised if some combination of these economic and political tails delivers the risk-unfriendly outcomes May is notorious for. 

Moreover, the Fed also did not provide much in the way of news last night. But on the other hand there was much to report. It sounded more concerned about the medium term risks of the crisis and its effects on economic activity, employment and inflation compared with the March statement. We run you through the above trades well-in-detail in our upcoming posts. Courtesy: JPM