Views From the Floor – The Currency Domino

What happens if the US dollar weakens?; and despite everything, the VIX is still grinding down.

The Currency Domino

The dollar is overvalued, right? 

Well, if you think the greenback is too rich, we’d hate to hear what you have to say about other major currencies.  

Figure 1 shows the US dollar against a basket of its peers in trade-weighted terms, adjusted for inflation – i.e. the real exchange rate. While the dollar is close to the top of its 5-year range, it is only 3% away from its average since 1994, and 15% lower than its all-time highs. In contrast, the Chinese yuan is just 3% away from its highs in real exchange rate terms, and 27% above its average since 1994. 

These FX valuations do not seem to be supported by current account balances: China’s current account balance has deteriorated from a 10% surplus in 2006 to 0%, even as the yuan has strengthened (Figure 2). In contrast, the US deficit has halved, from 6% to 3%. 

So, if the dollar does weaken, in our view the yuan would likely weaken even more. In fact, dollar weakening would not just hit the yuan. Since China represents the biggest trading partner for most emerging markets, EM currencies would most likely weaken as well.

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Source: Bloomberg; as of 29 March 2021. 

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Source: Bloomberg; as of 9 April 2021. 

And Still the VIX Goes Lower…

After a month in which we have seen a bond selloff, extreme price swings in the tech stocks and a series of major banks exposed to the collapse of Archegos Capital Management, one would expect volatility to be elevated. 

And yet it isn’t. The CBOE VIX Index is back below 20, with trailing 1-month volatility also falling back. More importantly for hedgers, longer-dated volatility – which had reached a historically high spread to the VIX and realized volatility in February – has started to normalise (Figure 3).

In the short term, the volatility markets seem to be taking cues from rising equities and perhaps looking back to the very low volatility regime of 2010-2020 as a benchmark for where volatility may head. However, as long as tech stocks remain heavily weighted in the S&P 500 Index, the economic impacts of the pandemic and vaccines are not entirely known, and the uncertainty around the evolution of rates and potential Fed tapering persists, we believe that equity volatility will be supported. Investors may consider entry points for hedges and long volatility strategies should implied volatilities in equities continue to decline. 

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Source: Bloomberg; as of 9 April 2021. 

With contribution from: Phil Yuhn (Man GLG, Portfolio Manager) and Peter Van Dooijeweert (Man Solutions, Managing Director).