After resigning ourselves to months of range trading thanks to low volatility, the currency market has finally broken out with the EUR/USD rallying over 500 points and the GBP/USD rallied 600 points in the past two weeks. The initial breakdown in the US dollar was brought on by nothing more than pre-Thanksgiving holiday liquidation, but the size of the break caught most traders off guard and triggered a number of stops.
The move extended even further as US economic data began to deteriorate, particularly in the manufacturing sector which raised the concern that a recession may be a growing a possibility. The following GBP/USD chart illustrates the strength of the break and the minimal retracements that we have seen since then. The most obvious question to ask then is how much further can the US dollar fall against both the Euro and British pound. To answer this question, we examine previous periods of low volatility and calculate the size of the breaks that we saw in the weeks afterwards.
Volatilities Rebound: What Can Traders Expect?
In the first of the volatility series that we published in November, we talked about how long volatility can remain low. In this part of the series, we examine how far breaks could extend once the market begins to exit out of a low volatility environment.
In 2001, we saw a strikingly similar rebound in implied volatilities that we are seeing currently. Just as it did over this past year, expected volatility saw a substantial decline from late 2001 to mid 2002. This coincided with the EURUSD trading within a progressively tighter range, as is evidenced by the wedge formation in the chart below. At the same time, implied volatility began a swift and pronounced retracement. When the currency did breakout, a strong new trend emerged. From the breakout point in mid April to the peak in late July, the EUR/USD rallied from 0.8750 to a high of 1.01, which represents a move of 15% or 1250 pips. ,
The price movements were scarcely limited to the EURUSD dollar, as correlations with other major currency pairs led to similarly extended moves.. The following chart shows that the same move occurred in the British Pound. Nearly identical in nature, the Pound followed the euro into a range through the middle of 2002. We also saw the same retracement in implied volatility that kept moves in the GBP/USD limited. When the break did occur, albeit a little later, the GBP/USD rallied from 1.48 to 1.58, or approximately 7 percent in less than one month.
For a more recent example, we need only look to 2004 to see that rallying volatilities can force extended currency price movements. From mid to late 2004, volatility started to drop in a very similar fashion as we have seen through the past several months. When volatility finally made a comeback, we saw the EURUSD come back to life as it rallied to all-time highs against the dollar. After breaking previous range highs at approximately 1.2400, the EURUSD gained over 1200 points to its early 2005 peak, which was close to a 10 percent move.
The GBPUSD posted a nearly identical rise in the month of October to 14-year highs. The currency rallied from 1.79 to 1.9550, which was about 1650 pips. Though volatility did not retrace to 2004 levels, price action nonetheless continued to trend as the US dollar declined against major world currencies. In net terms, the Pound added nearly 8 percent against its North American counterpart.
So What Does That Mean?
This means that even though the moves in the EUR/USD and GBP/USD may seem very large to us at the moment, compared to prior breaks, we have only captured half of the previous moves. A similar move of 1000 pips in the EUR/USD would put the currency pair at 1.38. If we look at it on a percentage basis and take the smaller percent move from the more recent year, we are still looking at the possibility of the pair reaching 1.40. As for the GBP/USD, the magnitude of previous moves suggest that we could easily see the exchange rate move beyond 2.00.
Triggering the Breaks
Previous breaks in volatility have come for a variety of reasons. Through 2002, the shift was largely a product of swiftly declining US interest rates, with the US Fed dropping the overnight lending rate by a whopping 50 basis points in October of that year. Though US interest rates are a full 400 basis points higher than they were through the end of the 2004, questions still remain as to whether relatively high yields will continue through the medium term. In fact, futures traders have already priced in at least 2 Fed rate cuts through the end of 2007?indicating that risks clearly remain to the downside.
If we look to 2004, broad anti-dollar sentiment led the greenback to significant lows against the majors as markets broadly claimed that a ballooning trade deficit weighed on the Greenbacks valuation. Of course, we have subsequently seen that the US dollar has managed to retrace a large portion of previous drops despite deficits at all-time highs. It serves to reason that this in and of itself is not enough to drive the currency lower. The main culprit for US dollar weakness was instead mounting dollar-bearish sentiment. Exact triggers are difficult to identify, but a clear turn occurred through the final quarter of the year, with rallying volatility forcing extended moves in underlying spot prices. This instance highlights risks of the unknown: previous turns have occurred with little fundamental reasoning to power a reversal. If we are to predict any such moves in the future, we must examine possible reasons for similar shifts in the coming months.
Trigger Points:
US Growth A Constant Concern
The most obvious of all the reasons that could trigger a potential breakout would be a pullback in the worlds largest economy. Although economic data has been supportive of this notion for sometime already, visible confirmation through a revised gross domestic product survey or significant downturn in manufacturing or consumption report will lead to overwhelming bearish speculation. Not only will the downturn in productivity and consumption signal slower growth, but most importantly, it will reflect a likelihood that Federal Reserve officials will heavily consider making cuts to benchmark rates in 2007. If this is the case, it will cause foreign investors, who are already heavily into long positions in dollar based assets to considering paring back or even dumping these positions in what may be a mass exodus out of carry trades. The shift will have grave effects for the dollar, injecting a lot of volatility and causing wider fluctuations in the majors.
Geopolitical Instability
Similar to previous years, bouts with geopolitical risks are likely to weigh on major currency action, propping the market up for volatility and potential breakout scenarios. Situations involving any contention that may be damaging to the economy, or any trade relationships, can be expected to heighten concern over the stability of the corresponding underlying currency. In this respect, situations involving China, Iran, and Iraq are still expected to weigh over the markets with any increase in risk, either through statements or definitive actions, will result in a shift in capital. With all three still involving the US dollar, the shift is likely to take place against the dollar and turn favor to other major currencies or commodities that have been considered safe havens.
How To Keep On Top
Like in any trading condition, keeping abreast of the situation and current economic conditions will allow traders to be fully anticipate the above scenarios. Utilizing tools available on FXCMTR and DailyFX.com will not only increase the knowledge of the trader but also allow for plenty of anticipation for when the market environment shifts. There are daily and weekly reports on the economic health of individual countries on DailyFX.com and instant analysis on FXCMTR.com.
