With volatility plumbing multi-decade lows, traders across all asset classes are starved for volatility, not just in equities and bonds, but also across FX crosses. There is no assurance that Yellen’s Friday statement, which many say has been priced into asset prices, will do much to move the vol needle. Or perhaps it will if one trades those assets which have shown the most sensitivity to Fed surprises.
Conveniently, Goldman’s FX strategist Robin Brooks has prepared an analysis looking at which 3 currencies one should trade to get the highest bang for the vol buck on Friday, or as he puts it: “Which Dollar Cross Responds most to Fed Surprises? “
As Brooks notes, Goldman has run regressions that link each of the G10 Dollar crosses (EUR/$, $/CAD, AUD/$, NZD/$, $/JPY, $/CHF, $/NOK, $/SEK, GBP/$) to the two-year interest rate differential, the Euro zone fiscal risk premium, the VIX as a proxy for global risk appetite and the Brent oil price to proxy for global commodity price trends. Goldman explains its methodology further as follows:
We always express the interest differential as being positively correlated with the exchange rate, meaning that for EUR/$ it is Euro zone minus US interest rates, while for $/JPY it is US minus Japan interest rates. The fiscal risk premium is the GDP-weighted spread on 10-year sovereign bonds on the periphery over Bunds, a variable that was important at the height of the Euro zone crisis in 2012/13. We run these regressions for daily data, linking the daily percentage change in a Dollar cross to the daily change (in bp) in the rate differential, along with daily changes in the other fundamentals. Because events can cause correlations to shift over time – the importance of rate differentials typically goes up when monetary policy is “in play” – we report the conditional correlation of G10 FX with rate differentials for a long sample period from 2006 and for the last three months.
The chart below shows the average response of Dollar crosses to a one-basis-point change in the two-year rate differential from 2006 to today (blue) and for the last three months (red). Based on the results for the last three months, which Goldman sees as a good template for correlations going forward, a 10bp move of the two-year rate differential in favour of the Dollar, say in the event of a hawkish surprise on Friday, could move GBP/$ 1.5 percent lower. In contrast, $/JPY could go 1.3 percent higher on our estimates. As a result, Brooks finds that GBP/$, $/JPY and NZD/$ are three most rates-sensitive Dollar crosses, i.e., they have the largest potential to move should there be a material surprise on Friday. Meanwhile, $/SEK, EUR/$ and $/CHF are the least rates-sensitive crosses, at least based on data for the last three months.
In the next chart, Goldman shows the rolling estimates for the partial correlation of EUR/$, $/CAD and AUD/$ with rate differentials, based on rolling three-month regressions from 2006 to today. It is clear that the rates sensitivity of these crosses has trended up over time, though there is an important reversal for EUR/$ (black line), which Brooks says is an indication that the market has become less interested in the “divergence theme” after a series of disappointments from the ECB. Exhibit 5 shows that the trend higher in interest rate betas is also apparent for $/JPY, GBP/$ and NZD/$, while Exhibit 6 shows that – averaging across all Dollar crosses – the interest rate beta has roughly doubled in magnitude over the last 10 years.
So for all those who are willing to take volatility for a spin on Friday, your best bets are cable, Yen and the Kiwi. Just make sure to pick the direction right…
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