INVESTMENT FOCUS-Currency sparks rekindling volatility

LONDON Fri Feb 8, 2013 12:18pm EST

LONDON Feb 8 (Reuters) - Sudden swings in currency rates are refiring measures of future global markets volatility, pushing these risk gauges back towards what some will see as more realistic and even healthier levels.

Many blame fresh talk of "currency wars" between the world's major trading blocs, which have been implicitly or explicitly depressing currency rates for trade and export gains to give themselves an edge in a growth-starved world.

Japan's decision last year to actively weaken the yen was its latest shot, but years of Chinese intervention to cap the yuan and U.S. and British money-printing to offset their financial crises have had similar effects.

A recent surge in the euro, partly reflecting the European Central Bank's refusal to engage in open-ended monetary stimulus despite regional recessions, got a testy response from ECB chief Mario Draghi this week, while French President Francois Hollande made an outright call for euro targets.

Next Friday's meeting of G20 finance chiefs in Moscow will bring developments into even sharper focus.

The effect has been gyrations in currencies that have been dormant for years, prompting some asset managers to reassess relative returns between regions, exporter earnings expectations and the future path of interest rates.

Others are locking into still historically cheap options - priced with reference to volatility itself - to hedge against a bumpier ride for the broadly bullish portfolios assembled over recent months.

"Investors are increasingly worried that government intervention in currency markets will be a feature of the investment landscape moving forward," Bank of America Merrill Lynch chief investment strategist Michael Harnett told clients.

"At the very least, currency markets have become the new 'automatic stabilizer' for growth."

Measures taken last year to stabilise fractious debt markets in Europe and elsewhere had the effect of suppressing asset volatility around the world. But could a shift of policy focus to currencies disturb that?

"This year people will look less at bond yields and peripheral spreads and more at currency moves," said Morgan Stanley equity strategist Graham Secker.

The shake-up may not be all bad. By sobering up markets after January's heady and probably unsustainable surge in global stocks, firmer volatility gauges may better represent the still-fragile global economy and check the excessive inflows now creating their own risks.

"A correction playing out now probably prevents a nastier bout of weakness later, so remain firmly in a 'buy the dip' mindset for stocks," BoAMerrill Lynch said.

VOLATILITY SUPPRESSED

The drop in future or implied market volatility gauges to multi-year lows in 2012 puzzled many, given the proliferation of risks - sputtering Chinese growth, a U.S. election and 'fiscal cliff' standoff, and the still-simmering euro zone crisis.

Wall's Street's short-term measure of implied one-month volatility on the S&P500 index, the so-called 'fear-index', and its European equity equivalents plumbed depths not seen since before the 2007/08 credit crisis exploded.

Equivalent seismographs for currency markets did likewise, with implied volatility in the pivotal Transatlantic euro/dollar exchange rate falling to five-year lows.

The reasoning was that floods of new cash from the big central banks smothered trading and hedging activity by putting an effective floor under financial asset prices, tempering the risk of new economic shocks. Faith in government and central bank policy action swamped all other metrics.

And actual volatility reflected that. Fund manager Vanguard has shown that of the 274 trading days last year, only seven saw U.S. equity indices prices move more than 2 percent, with drops of more than 2 percent seen on only three occasions.

The result was to tempt relatively conservative investors back into higher-risk markets, and 2012 ended with full-year gains in virtually all asset classes - developed and emerging equities, government and corporate bonds, and real estate.

But as investment flows have returned, some of the worst systemic fears have ebbed, and more idiosyncratic national and stock valuations have come back to the fore, volatility seems to have troughed and may now bubble back to more "normal" levels.

Currency restlessness and new policy twists around it may reinforce that, or act as a catalyst. The VIX has already risen from around 12.5 percent in mid-January to nearly 14 percent, although it remains five-year lows and well below its 200-day moving average of about 17 percent.

Euro stocks equivalents have jumped from about 13 percent to more than 17 percent over the same period, although they too remain below long-term moving averages of just above 20 percent. Implied three-month volatility in euro/dollar currency rates has meanwhile risen more than a point to about 8.5 percent.

There is no doubt that implied volatility remains low across the board, with even the 200-day moving average of the VIX having dropped almost 10 percentage points over the past year.

But the picture painted at the start of the year now seems too rosy.

"So what can investors expect? Without a crystal ball, no one truly knows," wrote Vanguard strategist Fran Kiniry.

But "one thing we do know is that periods of low volatility (like periods of high volatility) do not last."

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