Rising Volatility, Euro Out of Step

We have highlighted the contradiction between the low implied volatility and the large number of event risks on the horizon.  To us, it looked like a spring coiling.  The resolution, we anticipated, would be in favor of higher volatility, and we appreciated that there was a directional bias.  Higher volatility would likely, we thought favor lower equities and euro and a stronger yen.  

We have been right and wrong.  The S&P volatility, captured by the VIX has increased markedly.   When we first began building our case, the VIX was trading at the lower end of where it traded this year (near 14%).   Yesterday, it rose above 19% to reach its highest level in nearly 3-months.  This took place as the S&P 500 shed about 4% in four sessions.

It is not just some disappointing earnings, but it is also the poor future guidance that took a toll.  Technically, the uptrend line drawn off the early June low has been convincingly violated.    The 38.2% retracement objective of that uptrend comes in near 1395 now and the 50% retracement is nearer 1370.    On the upside, resistance is seen in the 1433-1435 area.  

The 3-month implied yen volatility has moved higher, but it has coincided with a weaker yen not a stronger one.  The multi-year low in yen vol was recorded on October 10 near 6.55%.  It has firmed nearly every day since then to reach 7.30% yesterday and today.  

The higher volatility coincided with the dollar rallying around 2.6% against the yen to JPY80, a level not seen in more than three months.  Contrary to what we previously thought, if the dollar stalls out here near JPY80, implied volatility is likely to come off as participants recognize the likely persistence of a range affair.  

The euro stands out as the exception.  Three-month implied euro vol hit new multi-year lows yesterday near 8.23%.   Although it is a bit firmer today, the underlying market view seems to be that it is stuck in a range roughly $1.28 to roughly $1.32.  A break of that range may be necessary to see an increase in volatility.  

A few days ago we noted that the correlation between the euro (and a number of other currencies) and the S&P 500 had lessened in the recent period.  We go a step further here and look at the correlation between the VIX and euro volatility.  The 60-day rolling correlation rose to 9-month highs in early September near 0.65  It has since come off sharply, falling below 0.42. 

In the same vein, we draw your attention to the pricing of 3-month euro risk reversals.  Recall, that put-call parity states that puts and calls equidistant from the money should trade for the same price.  To the extent they don't shows a market bias.  

At the low point in mid-May, 3-month euro puts were at a 3.5% discount to euro calls.  At first the buying of euro calls for protection of short euro positions and then the short squeeze in the euro spot market saw euro calls rally relative to puts.  At the end of last week, euro calls were at their smallest discount to euro puts in roughly two years (-0.58%).  

The euro's recent slide in the spot market has seen the risk reversals, well reverse, and now appear to be trending back in favor of puts.  In fact, today the discount for calls is increasing, and may violate the 20-day moving average on a close basis for the first time since early September.  

This dovetails with our view that the relief rally in response to European officials promising to do everything they can to save the monetary union project and the euro has largely run its course.  There have already been press reports indicating that some medium-term investors have already begun taking profits on peripheral bond purchases made on the back of the removal of the extreme tail risks.