FxWirePro: Low vol environment in G10 seems good but beware of indigestion

Please be noted that the above nutshell showing ATM IVs of G10 FX space is sensing the lower volatile environment.

The first half of 2017 turned out to be one dominated by USD weakness, and the outperformance of EM carry, an outcome expected by few at the beginning of the year.

FX vols enter H2 meaningfully cheap versus macro drivers and should mean-revert moderately higher. A U- rather than a V-shaped rebound is consistent with past vol cycles and mixed carry trade positioning. Steep vol curves in G10 should flatten; consider +2M/-6M calendars as subsidized long gamma plays.

In the US – Low vol produces low vol, until it doesn’t, despite the good economic backdrop, equity volatility has moved into oversold territory, and we illustrate this with a number of examples including an analysis of the business cycle. We advise caution in the short vol trade but think a comeback of the reflation theme could extend the low vol environment.

In Eurozone – Fading political risks calls for a benign vol environment, relatively better valuations, improving macro data, fading political risk, slowly normalizing inflation expectations and still-accommodative central bank policy has all contributed to lower vol in European equities. We recommend buying upside through options.

In the UK – Brexit agony yet to start (but this time for certain) but asymmetric across assets With Brexit negotiations due to start, we believe that the pound is more at risk than the FTSE100. The perception continues to grow that large cap exporter will be relatively immune to any currency vagaries. We find that current vol levels under-price the risk and like FX vol over equity vol.