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11 Mar 2013
Forex Flash: FX volatility will eventually increase - Societe Generale
Sebastien Galy, Senior FX Strategist at Societe Generale believes that FX volatility will eventually increase.
He sees the main risk as the back end of UST yield rises is that the cost of funding US dollar funding for EM positions will force a correction leading to a brutal increase in EM/US dollar FX volatility. He notes, “This is the main portfolio position globally and as such is very sensitive to a setback.”
Galy quotes an unnamed portfolio manager whom he has spoken with, who points out that if you have an unhedged $100bln position simply hedging $10bln in illiquid EM currencies can lead to pressure on EM/USD which then forces other investors to hedge, thereby creating a negative and fairly brutal feedback loop.
He writes, “This EM/US dollar position is so large because it is a side effect of global imbalances. Many EM countries previously fought against the inherent strength of their currencies relative to the US dollar. This forced them to build large US dollar reserves invested all along the US Treasury curve, helping to pressure it lower. US investors already discouraged by low UST yields sought more yield in EM countries. This created higher capital flows into EM which were then partially reinvested by the local EM central bank back into US Treasury, creating a self sustained feedback loop.”
Furthermore, Galy notes that as this system encouraged cheap funding, it tended to encourage economic activity and hence higher export volumes. These exports naturally created more US dollar inflows for EM economies. In terms of portfolio positions, Asia is exposed, while Mexico is the most at risk in developed Latin America. He finishes by noting that with the risk of rising instability, funding currencies such as the Yen and CHF have already seen sizeable moves leading G10 FX volatility to rebound close to lows last reached in 2007. He finishes by writing, “EM FX volatility is yet to be moved from its ultra-low levels and is consequently at risk of a large correction in the coming months.”
He sees the main risk as the back end of UST yield rises is that the cost of funding US dollar funding for EM positions will force a correction leading to a brutal increase in EM/US dollar FX volatility. He notes, “This is the main portfolio position globally and as such is very sensitive to a setback.”
Galy quotes an unnamed portfolio manager whom he has spoken with, who points out that if you have an unhedged $100bln position simply hedging $10bln in illiquid EM currencies can lead to pressure on EM/USD which then forces other investors to hedge, thereby creating a negative and fairly brutal feedback loop.
He writes, “This EM/US dollar position is so large because it is a side effect of global imbalances. Many EM countries previously fought against the inherent strength of their currencies relative to the US dollar. This forced them to build large US dollar reserves invested all along the US Treasury curve, helping to pressure it lower. US investors already discouraged by low UST yields sought more yield in EM countries. This created higher capital flows into EM which were then partially reinvested by the local EM central bank back into US Treasury, creating a self sustained feedback loop.”
Furthermore, Galy notes that as this system encouraged cheap funding, it tended to encourage economic activity and hence higher export volumes. These exports naturally created more US dollar inflows for EM economies. In terms of portfolio positions, Asia is exposed, while Mexico is the most at risk in developed Latin America. He finishes by noting that with the risk of rising instability, funding currencies such as the Yen and CHF have already seen sizeable moves leading G10 FX volatility to rebound close to lows last reached in 2007. He finishes by writing, “EM FX volatility is yet to be moved from its ultra-low levels and is consequently at risk of a large correction in the coming months.”