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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, but did not grab nearly as much attention as this week's moves because it qualified what one might term as 'good vol' -the sort that aids returns by accelerating the market in the direction of core investments.
That endorphin rush was rudely stopped in its track this week by the return of gravity to equity markets, in the process turning good vol into bad and forcing a re-assessment of the risk/VaR regime that investment programs are operating on even if macro fundamentals are widely considered to be constructive.
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 1-2 weeks; the current episode is unfolding almost exactly along historical lines which suggests it is too early to rush in to fade the spike (chart 1).
What about valuations? The sharp rally of the past two days has eliminated the longstanding cheapness of FX vols to macro correlates. Our workhorse model for FX vol constructed with a global business cycle variable (JPM global PMI), a proxy for growth surprises (rolling 12m std. deviation of global PMI) and a forecast uncertainty indicator shows that VXY Global @ 8.9 is at fair value (chart 2).
While an encouraging sign for would-be vol sellers, we caution against attempting to fade these moves immediately since mean-reversion from extreme model undershoot in this cycle is unfolding tick-for-tick in line with historical priors and has another 3-6 months to run before plateauing at a permanently higher level (chart 3). Courtesy: JPM
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