FxWirePro: Confluence of trios to propel VIX in 2018

It has taken a monumental VIX shock for the realization to dawn that the low volatility patch of 2017 is now history. Front-end FX vols had been climbing for the better part of the New Year on heavy demand for USD puts and firm realized vol due to swift dollar declines.

From a flow standpoint, much of this year’s rise in front-end volatility has been driven by directional demand for USD puts, primarily against EUR and Euro-proxies in G10 as well as a myriad of EMs. The currency catalyst and the vol response are both reminiscent of the first phase of the Euro rally in 3Q’17, but unlike then, the breadth and intensity of the dollar sell-off this time around is sustaining levered interest and keeping vols supported even when the Euro itself has been sidewinding over the past two weeks, also helped in part by replenishment demand for delta/vega lost from a knockout of sizeable 1.25 barriers. It is difficult to see this directional demand for EUR calls ebbing anytime soon should the Euro resume its uptrend as investors attempt to milk the European cyclical upswing theme to the maximum.

Second, Italian election risk premium in FX options has continuously compressed all year, and discounts fairly tame overnight spot moves relative to last year’s French elections. Perception of tail risks are obviously radically different in the two cases, but with the elections now within the 1-month option expiry window when market focus on buying event hedges tends to ramp up, it will take a fairly large shift in the polls to push event premia lower in a way that causes front-end Euro vol to sag.

Third, it will be difficult for realized volatility to crater to 2017 lows as the heightened sensitivity of macro markets now to US inflation data, the dollar’s large disconnect to rate differentials and one-sided short dollar positioning preserve the risk of intermittent position squeezes. In sum, the set of conditions that can lead to a sharp subsidence in EUR vol over the next few weeks appears quite narrow, and to the extent that large parts of the FX option world anchor vol curves off EURUSD, firmness in the latter should place a floor under the former.

A confluence of other factors, none perhaps individually potent but meaningful when taken together, suggest a shift towards a higher FX vol world is here to stay.

VXY has now climbed more than 2% pts. off the dead lows of early January –a third of that this week alone –after an initial sluggish response to the equity shock. This is par for the course. FX vols tend to react to VIX spikes with a modest lag of a day or two that it takes for natural contagion channels to activate but thereafter tends to last for the 1-2 week.

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