In the market, when volatility rises suddenly, it frequently presages a major turning point
When I was a young man – oh, about, five or six or 25 years ago – my father – still a young man, by the way – taught me several features of the market. One that I remember often and well is that, when volatility rises suddenly, it frequently presages a major turning point.
Since my business is helping companies manage risk and since my clients often think I have a pair of crystal balls, I am compelled to keep looking for turning points in the market, which may be why I call far more of them than actually happen.
In any event, I have noticed for a long time that volatility in most markets has been remarkably low, and I have been watching for signs of change everywhere. And, lo and behold, today, as I wondered about how edgy the euro/dollar has been getting, I looked a little closer and found that the volatility of the dollar index (DXY), at 8.67 per cent, while not meaningfully different than either its five- or 10-year average, has risen suddenly to where it exceeds its short-term (three-month) average by more than one per cent — sorry for all these numbers, but bear with me.
Over the last 10 years, this has happened only 245 times, and each time it happened, the DXY moved, on average, by more than five per cent over the next six months. Now, five per cent may not seem like a lot, but the last time the DXY was five per cent higher than today’s level was back in January, and the last time it was five per cent below today’s level was was way back in April 2008.
Further, let’s remember that five per cent was only the average movement; the most dramatic movement in the DXY was nearly 14 per cent in six months. Applying that kicker would translate to a DXY of over 85 (this level was last seen in June 2010, right after the Greek problem first came to light) or under 65 (this level has never been seen).
While there’s no analytic reason to prefer the higher to the lower level, there is also no reason to assume that the breakout will be larger than average. The single point this analysis suggests is that the DXY is going to move sharply sooner rather than later.
To put some context to all of this, we need to now move to the real world of economic (ha ha) fundamentals, and try to thread this assertion in. Looking around, China has just delivered substantially higher-than-expected growth and US Fed Chairman Ben Bernanke has opened a smidgen of a door to (surely not) QE3. Both of these have pushed commodities higher; gold is also rocking. If this were to continue as the trend, it would argue in favour of the DXY collapsing.
On the other hand – and, there’s always another hand – the European debt crisis is going from strength to strength, and it is harder than ever to see any sort of either short-term or meaningful long-term solution. This is keeping the euro on the ropes and is providing the much-needed support to the DXY.
Returning to the blue corner, the yen has suddenly surged to within spitting distance of its all-time high.
In the red corner, of course, is the continuing bubbling of West Asia and North Africa and other points of geopolitical instability. And, an important one — the US trade deficit grew to a multi-year high as imports surged, suggesting that US growth may not be as terrible as it looks.
Woozy from the battering, where is the DXY to go?
Well, let’s go to one more videotape. If the DXY were to go back to 85, the rupee would likely cross 46, to where it was back in June 2010 when the DXY last crossed 85. If the DXY were to plunge further towards 65, the rupee would strengthen, and very likely cross even 43 to the dollar.
Which of these two broad directions seems more likely? Well, remarkably, despite our political paralysis, foreign institutional investors have been flocking to Indian equity markets of late. But, I note that none of the talking heads on television is calling for a sustained bull market. Granted, global brokers are making a beeline for the Indian market, snapping up personnel from the weakening domestic broking sector, but then, global players are – supposedly – here for the long run.
As you can probably tell, I don’t buy a current bull market.
Which leaves the other alternative —a wobbly Sensex, a stronger dollar and a weaker rupee.
Fortunately, rupee volatility has not yet taken off — BUY OPTIONS OR CALL SPREADS.
In spite of the RBI's rate cut and the Centre's reforms, any recovery will only be half-hearted