FX options flag uncertainty before U.S. midterm election; bonds complacent
By Gertrude Chavez-Dreyfuss and Richard Leong
NEW YORK, Oct 19 (Reuters) - Currency options investors are
bracing for increased volatility and possible U.S. dollar
weakness going into the U.S. midterm elections next month.
But in the bond market, investors don't see the midterm
election as a major catalyst for moves in interest rates.
Hedging activity increased in October in the yen, Australian
and New Zealand dollars versus the greenback for maturities as
far out as one year, strategists said.
Control of the U.S. Congress is at stake in the Nov. 6
election. Polls suggest the most likely outcome will be
Democrats winning control of the House of Representatives with
Republicans retaining the Senate.
A divided Congress could mean government gridlock, and this
prospect has spawned some complacency in the bond market.
Investors believe this outcome would not change the underlying
upward trajectory of U.S. economic growth nor the pace of
interest rate increases by the Federal Reserve, analysts said.
It's a different story, however, for the currency market
where investors are pricing in election-related risks.
"There has been a rise in hedging activity across all tenors
for dollar/yen in October from the previous month that may be
related to the U.S. midterm elections," said Alice Leng,
quantitative strategist at Bank of America Merrill Lynch in New
"The sharpest rise in volume is between six months to
one-year. So the market right now is looking at longer-term
risks," she added.
To be sure, there are other factors contributing to a rise
in hedging such as the escalating trade conflict between the
United States and China. Investors use options to protect
positions or simply bet on event risk within certain periods of
The implied volatility or "vol" used by banks to price
one-month options on dollar/yen rose as high as 6.8 on
Friday. The metric reached 7.57 last week after hitting a
nine-month low in September. Implied volatility measures
expectations of increased moves in a currency pair in either
Implied vols on six month to one-year maturities on
dollar/yen also showed a pick-up, data showed.
Barclays in a research note echoed Leng's views on currency
option activity but highlighted that the event risk premium was
smaller than during the 2016 presidential elections.
Expected bond volatility one month from now, meanwhile, is
at the lower end of its trading range for the year. It spiked
earlier this month amid a bond market rout that propelled the
benchmark 10-year Treasury yield to a 7-1/2 year
A measure of one-month U.S. bond volatility compiled by Bank
of America Merrill Lynch was 52.635 on Thursday, up from
Wednesday but below a four-month peak on Oct. 11.
FX OPTIONS SHOW BEARISH DOLLAR BETS
Aside from increased volatility, dollar/yen's one-month risk
reversal, an option market signal used to measure sentiment on
currencies, showed bearish bets.
One-month risk reversals on dollar/yen showed bets for a
drop in the dollar against the yen, although bearish
sentiment has eased a little bit.
Mark McCormick, head of North American FX strategy at TD
Securities in Toronto, said there is a bit of "a skew to the
downside in the dollar" ahead of the elections.
"A divided Congress could see the market start to question
how much longer U.S. assets can outperform the rest of the
world," McCormick said.
He cited the rising correlation between the strength in the
dollar and the outperformance of U.S. equities the last few
months, which he said could be highly sensitive to the U.S.
Hedging volume activity has also picked up in the
longer-term options of the Australian and New Zealand dollars.
Investors buy the Aussie and New Zealand dollar when investors
have a higher risk appetite, and they tend to sell them in times
of market uncertainty.
One-year Australian and New Zealand dollar implied vols have
tracked an upward trend since early August .
"Market participants are engaging in longer-term hedging
activity, in case the election outcome has an impact on the
broader market or the broader economy," she added.
(Reporting by Gertrude Chavez-Dreyfuss and Richard Leong;
Editing by Daniel Bases and Cynthia Osterman)
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