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By Jamie McGeever
LONDON, Feb 7 (Reuters) - The explosion in volatility that sent stock markets into a tailspin this week is a wake-up call for investors who had grown far too complacent that the “Goldilocks” good times would never end.
But talk of “crisis” is premature. For that to unfold, currency and bond markets need to be rocked by a similar surge in volatility. And so far, that hasn’t happened.
Real market crises tend to be characterized by financial stress that sparks strong demand for U.S. dollars and U.S. Treasury bonds. Foreign exchange and interest rate volatility shoot up, just as we saw this week with equity volatility.
That’s how it played out in the dotcom bust, Lehman’s collapse and the euro zone debt crisis, the last three occasions where Wall Street fell 20 percent or more, episodes which arguably justify the label “crisis”.
But although Wall Street had its biggest fall since 2011 and the VIX index of implied U.S. stock market volatility had its biggest rise on record, that’s not how it has played out this week.
U.S. bond market volatility rose to its highest since April last year as the 3-month Merrill Lynch ‘Mermove’ index jumped 4.4 points on Tuesday, its biggest one-day rise since December 2016. But to put that in context, it has risen by that magnitude 28 times in the last five years.
Similarly, dollar volatility hit its highest level since September with the biggest one-day increase on Tuesday since May last year. But the rise of 0.48 points was hardly uncharted territory for investors, who have seen it on no fewer than 37 other occasions over the last five years.
Perhaps even more significant was the complete lack of churn in the cross currency basis market. This measures the cost to companies and financial institutions of swapping foreign currency into U.S. dollars without the exchange rate risk, and is widely seen as a key gauge of banking and financial stress.
In times of stress, such as 2008 or 2011, a surge in demand for dollars “widens the basis”. But in the last week, even though speculators and other investors are heavily short dollars, the dollar/yen basis barely moved and the euro/dollar basis actually narrowed.
As UBS analysts point out, the equity market volatility of the last few days failed to spark a rush to cover these short dollar positions.
“Neither options skew in (funding currencies) like the yen or Swiss franc, nor basis swaps are deteriorating, as they do in periods where growth or funding fears deepen. Volatility is well behaved across both major and emerging currencies,” they wrote.
Why is this?
It is probably a combination of factors. Banks have reduced their reliance on wholesale funding, which was at the root of the 2008 crash. The world’s major central banks have pumped trillions of dollars of QE stimulus into financial markets since 2009. They’ve also set up dollar swap arrangements between themselves.
Taken together, that may have softened the damage to rates and currencies from stock market turmoil, and made any dollar shortage less acute than otherwise might have been the case.
But as Standard Bank’s Steve Barrow points out, the outstanding amount of FX swaps/forwards and currency swaps in the global financial system is almost $60 trillion, more than 90 percent of which is in U.S. dollars.
That’s a lot of reliance on dollar funding and a potentially huge scramble for dollars should the need arise, which would almost certainly widen the dollar basis.
That’s what happened during the Lehman-triggered crash in 2008, when Wall Street plunged 50 percent between Sept. 2008 and March 2009, and the 20-percent slide in stocks in late 2011 when the euro zone crisis was at its zenith.
Implied 1-month volatility in the euro/dollar exchange rate also jumped during those episodes, reaching 26 percent in 2008 and topped 18 percent in 2011.
The period that saw the third highest level of euro/dollar volatility in the single currency’s 19-year history was the dotcom collapse in late 2000, when it hit 17 percent. It did rise this week but no higher than 9 percent.
So far, market tremors have been confined to stocks. But investors could do worse than keep a close eye on FX and fixed income volatility for signs a broader earthquake is coming.
Reporting by Jamie McGeever; Editing by Andrew Heavens