August 17, 2016 / 1:00 PM / a year ago

Currency volatility wanes, boding well for risk-taking

LONDON, Aug 17 (Reuters) - A flood of central bank cash and the prospect of more to come has crushed volatility in the foreign exchange market, prompting investors to seek higher returns in riskier currencies.

The drop in market measures of how sharp exchange rate swings will be has emboldened investors and encouraged appetite for emerging country currencies and, in developed markets, the Australian and New Zealand dollars.

As this graphic shows, tmsnrt.rs/2aV40jO one-month euro/dollar implied volatility is near its lowest in two years at 7.1 percent while for dollar/yen the measure is near five-month troughs.

A key driver of this collapse has been expectations that monetary policy will remains loose for a while yet. The Bank of England and the Australian and New Zealand central banks have cut interest rates in recent weeks and, despite warnings from officials, the U.S. Federal Reserve seems in no hurry to hike.

“Investors who go by macro-economic fundamentals are on the sidelines because there is an expectation that the Federal Reserve will probably not raise until December,” said Manuel Oliveri, currency strategist at Credit Agricole.

If the U.S. rate outlook were to change or political or economic risks jangled investors’ nerves, volatility would quickly return. Until then, they are happy to take risks.

“Sure, political and geo-political risks are lurking, but volatility is lower and that is positive for higher-yielding currencies like the Australian dollar and will keep the dollar capped,” Oliveri added.

The dollar index hit its lowest in seven weeks on Tuesday, while the high-yielding Australian dollar trades near its highest in four months. Even the New Zealand dollar hit a one-year high despite the Reserve Bank’s rate cut last week, highlighting investors’ search for higher yields.

With policy rates in most developed economies like Japan, the euro zone and Britain are close to zero, Australia on 1.5 percent and New Zealand on 2 percent are attractive.

HUNT FOR HIGH-YIELDERS

Analysts say riskier assets and currencies have been performing well since the U.S. payrolls data released earlier this month showed that while the number of jobs indicated the economy was robust, productivity and inflation were subdued.

“The market simply does not believe in the Fed hiking before the November (Presidential) elections,” said Alan Ruskin, strategist at Deutsche Bank, one of the largest currency traders.

Stocks have hit highs while dollar debt issued by companies from riskier and less developed countries have been among the year’s best performing assets. In the past six weeks, investors have pumped $18 billion into emerging debt funds, a record run, Bank of America Merrill Lynch data shows.

For the $5-trillion-a-day currency market, analysts said the low volatility environment would encourage investors to borrow in low-yielding currencies to buy higher yielders - the so-called carry trade favoured by asset managers who follow macro trends, speculators and hedge funds.

“We expect carry to perform well in the coming months,” HSBC analysts said in a note, adding emerging market currencies would do rather well.

Carry trades have generated 5 percent annual returns in the past three decades, according to a study by the Cass Business School released in late 2012.

Amongst emerging market currencies, investors are buying the Mexican peso, South Korean won, the South African rand and the Brazilian real. The rand hit its highest since October 2015 this week, while the Brazilian real is trading near one-year highs.

“The status quo of rising asset prices, low volatility and dovish central banks continues,” said Stewart Richardson, chief investment officer at RMG Wealth Management. “So long as prices are benign and volatility is low, investors will be encouraged to keep on taking risk.”

Reporting by Anirban Nag, graphic by Nigel Stephenson; Editing by Richard Balmforth

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