Despite the unusual dynamics in G7 volatility, the strategist warns that for crowded high-yield emerging market carry trades, the old rules still apply. If the consensus trade is upended for any reason, EM volatility and risk reversals are expected to 'blow up,' making protective options a prudent hedging strategy.
The strategist differentiates the precious metals rally. Gold's rise is supported by structural central bank buying and a broader investor shift to real assets. In contrast, silver's recent surge is a speculative 'overrun' that is already causing industrial demand destruction, making it vulnerable to a sharp correction.
The Euro-USD options market is exhibiting technical fragility, where skews suggest traders are structurally unprepared for a significant rally. This implies that a strong upward move could trigger a scramble to cover positions, creating a feedback loop that extends the rally further and faster than macroeconomic fundamentals might suggest.
The yen's bearish outlook is structurally entrenched and unlikely to change after the election. A majority win for the ruling LDP would mean aggressive fiscal policy, while a loss would create political uncertainty. Both scenarios point towards continued expansionary policy, maintaining downward pressure on the currency.
Contrary to the historical norm where volatility rises with a strengthening dollar (risk-off), the market is now experiencing higher volatility as the dollar falls. This unusual 'dollar down, vol up' dynamic suggests a pro-cyclical market backdrop and has major ramifications for how FX options and risk reversals are priced.
The Japanese yen's decline was much larger following a reported rate check by the New York Fed than after the Bank of Japan's own check. This indicates market participants see the prospect of coordinated U.S.-Japan intervention as a far more significant, though less likely, threat to yen weakness than unilateral action by Japan.