Even if very short-lived, market vol episodes as protracted as that of Monday August 5th, demand our attention. In seeking some understanding of the why of successive 10% NKY moves and a 65 pre-open handle on the VIX, it was a pleasure to welcome Oliver Brennan to the Alpha Exchange. An FX vol strategist at BNP, Oliver brings theoretical training in physics to the related but also very different world of option pricing. In setting up the discussion, we first explore a series of past FX vol episodes including the Euro-Swiss break and CNH re-peg in 2015 and Brexit from the following year. At the heart of these events lie economic imbalances and Central Banks that get tested by the market to hold the line.
We shift to a discussion of the setup going into early August in the Japanese Yen. Always an investment currency because of its balance of payment profile, Oliver argues that carry trades had gotten especially extended as dollar/yen trended so consistently higher. Market participants were long calls and long carry, and the dealing community was especially exposed to an increase in both realized and implied vol. He notes the absence of corporate supply as well of Yen vol in this recent event, something that exacerbated the repricing. With the tails especially under-owned, the more than 6% sell-off in dollar/yen caught the market well off-sides.
I hope you enjoy this episode of the Alpha Exchange, my conversation with Oliver Brennan.
[00:00:01] Hello, this is Dean Curnutt and welcome to the Alpha Exchange.
[00:00:05] Where we explore topics in financial markets associated with managing risk, generating return,
[00:00:11] and the deployment of capital in the alternative investment industry.
[00:00:20] Even if short-lived, market-voluposodes as protracted as that of Monday August 5th demand
[00:00:25] our attention.
[00:00:26] In seeking some understanding of the why of successive 10% knee-gay moves, and a 65 pre-open
[00:00:32] handle on the VIX, it was a pleasure to welcome Oliver Brennan to the Alpha Exchange.
[00:00:37] An FX Volatility Strategist at BNP Oliver Brennan's theoretical training and physics
[00:00:42] to the related but also very different world of option-prison.
[00:00:46] In setting up the discussion, we first explore a series of past FX Volatility Sodes, including
[00:00:52] the Euro Swiss Break and CNH Repeg in 2015, and Brexit from the following year.
[00:00:58] At the heart of these events, lie economic and balances and central banks that get tested
[00:01:02] by the markets to hold the line.
[00:01:05] We shift to a discussion of the setup going into early August in the Japanese-Yen.
[00:01:10] Always an investment currency because of its balance of payments profile, Oliver argues
[00:01:14] that caratrades had gotten especially extended as dollar-yen trended so consistently higher.
[00:01:20] Market participants were long calls and long carry, and the deal in community was
[00:01:25] especially exposed to an increase in both realized and implied vol.
[00:01:29] He notes as well the absence of corporate supply of YenVol in this recent event, something
[00:01:34] that exacerbated the repricing.
[00:01:37] With the tales especially under-owned, the more than 6% sell-off in dollar-yen over the course
[00:01:42] of a week caught the market well off sides.
[00:01:45] I hope you enjoyed this episode of the Alpha Exchange, my conversation with Oliver Brennan.
[00:01:52] My guest today on the Alpha Exchange is Oliver Brennan.
[00:01:55] He is an FXVol strategist in the markets 360 research team at B&P.
[00:02:01] Oliver, it's great to have you as a guest on the 5 guests today.
[00:02:04] Hi, I'd like to thank you for having me.
[00:02:06] I'm excited to be here.
[00:02:07] Excellent timing for our conversation.
[00:02:10] We've just experienced a pretty seismic if short-lived risk episode that really flared
[00:02:16] up around the world, probably started in Japan, but absolutely made its way into important
[00:02:22] risk metrics like the VIX and S&P option pricing.
[00:02:27] Whenever something like this happens, it really demands attention and explanation.
[00:02:32] So that'll be a big part of our conversation.
[00:02:35] Let's get underway.
[00:02:36] Let's learn a little bit more about you and your career history.
[00:02:39] Tell us how you wound up at B&P.
[00:02:41] Take us back to the beginning of your career.
[00:02:43] Well, the beginning of my career is very unusual.
[00:02:46] Beginning actually started as a physics teacher at the very beginning of my career.
[00:02:50] And then after taking some time out and seeing the world, my first job in finance was
[00:02:55] actually on the biceite quite an unusual step into finance compared to where typically people
[00:03:01] start now.
[00:03:02] Within the biceite, actually my first day on the FX Trading Desk, well, it was the 15th of September
[00:03:08] 2008 which I'm sure rings a bell.
[00:03:12] So my time in FX was born out of Lehman's ashes.
[00:03:16] And really as a fresh face to Junior at that time, I thought it was little I could initially
[00:03:21] contribute to on a day-to-day basis and the heat of that financial crisis, but it was a great
[00:03:26] seat to be in at the time and instilled right at the very beginning the importance of hard work.
[00:03:34] And especially something which is supported me throughout the career, the importance of evidence
[00:03:38] based research.
[00:03:40] Well, other than listening to and believing in all the hearsay that can flow too
[00:03:45] wound in times of crisis, you've got to do the work yourself.
[00:03:49] You've got to figure it out and you've got to understand what's driving the market and why
[00:03:53] the market's been driven that way and what that means in the future.
[00:03:56] Yeah, it's an interesting set of comments just around how we think about markets and I think
[00:04:03] we're all learning from each other, but boy, there is an inundation of commentary and charts
[00:04:09] there I say click bait out there. So sometimes you have to really filter through the noise.
[00:04:15] It's really interesting to hear about your start date and I've had many guests at this point
[00:04:20] on this podcast are quite a bit older than you and even older than me and sometimes
[00:04:25] I'll hear that a guest first day was October 16th, 1987, today is before the stock market crash
[00:04:32] of 87. Boy, that is quite a start date. I'd love to learn a little bit more about
[00:04:38] your training in physics and of course there's a lot of overlap in terms of the
[00:04:44] modeling of financial assets and borrowing from certain equations in physics.
[00:04:50] And so there's a beautiful connection there but of course what do we learn time and time
[00:04:54] again? And September 15th of 2008 is certainly one of those experiences where
[00:05:00] markets can just do things that the models just can't predict and I think that's going to be a
[00:05:05] theme for us throughout this conversation just given what's happened in the NECA and so forth
[00:05:10] last week. But just tell us about the degree to which you can utilize your academic training
[00:05:17] in physics and then where you have to recognize that markets are markets and they're just not
[00:05:22] governed to any degree like the physical sciences or. That means in principle, there's a lot
[00:05:28] of similarities, large complex systems, large gallop approximations using equations to understand
[00:05:35] dynamics, the laws of motion and thermodynamics and entropy and so on but in practice
[00:05:41] the differences are far greater. The first difference really is
[00:05:45] sciences collaborative, scientists, entire aim is to help each other understand and to gain a
[00:05:52] great understanding. And finally, it's very, very far from being collaborative. It's
[00:05:59] all about gaining an advantage over the next person to try to e-count the possibility of
[00:06:04] profit. So the most important lessons that I take from my background is not necessarily one
[00:06:11] equation or another, it's in the process and it's in the method and it's in using the scientific
[00:06:18] method to continually attempt to understand what's happening and then going through that theory
[00:06:26] hypothesis test theory process over and over again to reach some level at which there's a
[00:06:31] consistent framework and a coherent understanding of how markets may be behaving. And of course,
[00:06:36] every year or even less that understanding is challenged and you have to introduce new variables
[00:06:41] and new understandings to it but it's the process which has really stood me well throughout my career.
[00:06:47] Well I haven't heard it frame that way with regard to this idea that there's wholesale collaboration
[00:06:52] in disciplines like physics and other sciences and you are correct even as the collective
[00:07:00] work in markets across the biceite and the cell-side and so forth is in trying to find
[00:07:06] safe truth in some sense or trying to understand things. They're obviously as a very competitive
[00:07:11] aspect to it. Well let's just do a little bit of review. You mentioned your first day in markets
[00:07:16] as during the unfolding of the Lehman crisis and of course that was a mortgage misprice in crisis.
[00:07:24] It was a leverage crisis but anything that's that large is going to propagate itself out
[00:07:30] and so no asset class is going to be unscathed and there were some just gigantic moves in FX during
[00:07:37] that period and then when we talked before this call, I rattled off a number of other just FX
[00:07:45] valve events that at least for me more of an equity derivative this person certainly pay a lot of
[00:07:51] attention to. We had the euro crisis that ran for years maybe druggy put us foot down in 2012,
[00:07:58] but that brought a lot of uncertainty. China's episode in 2015 of course the unwind of the euro
[00:08:06] Swiss peg in 2015 breaks it brought about a lot of volatility and so there's been a lot of these
[00:08:12] episodes even in developed markets. I would say and so I was just hoping you could reflect a little bit
[00:08:18] on the learning experiences. I know a lot of these are idiots in critic. There's policies
[00:08:24] and economics and even personalities that are at the center of them but I was wondering if there
[00:08:30] were any commonalities that as you step back and you think through your time in evaluating these
[00:08:35] periods, are there any commonalities that stitch these events together whether it's central banks,
[00:08:41] markets, what do we learn from these events of frequency that are greater than the models would suggest
[00:08:47] they should happen? Of course as a UK resident I've been privileged enough to experience some kind
[00:08:54] of political event roughly once every 18 months for the last 10 years so we're well versed
[00:08:59] in UK politics and political vests for the sterling at least. Yeah there's the one commonality
[00:09:06] through all of these events you describe is imbalances and it may be facetious for me to just
[00:09:12] sit here and say oh there was an imbalance of course that would have been some kind of unwind
[00:09:16] and some kind of consequence. The trick or the key really is to figure out where the
[00:09:22] imbalances and how it has developed and therefore how it may unwind. As you said in the Leem
[00:09:28] and Crisis and the GFC there was an imbalance domestically in the US but there was also the much
[00:09:33] raw-day imbalance of Europe and Asia's large services which meant that there was this
[00:09:39] low back to the rest of the world and credit tightening globally. So then if we think about
[00:09:44] these effects events in particular so the US Swiss exchange rate and the dollar China revalluation.
[00:09:51] In both cases there was either a market expectation that the central bank would continue to do
[00:09:56] what it does or the market expectation that central bank wouldn't do something. There was this
[00:10:01] expectation of a continued stance of central bank policy but effects is probably more well-governed
[00:10:08] by random walks than by auto correlation when it comes to this and in each case the central bank
[00:10:14] found their positions increasingly untenable because of economic imbalances. So the Minimum
[00:10:22] exchange rate in US Swiss became economically unviable or the level of dollar CNH in 2015
[00:10:30] was artificially held low and there was increasing outflow pressure which in part was driven by
[00:10:36] for example, large domestic borrowing from foreign lenders. So there was an underlying imbalance
[00:10:41] in both of these cases which created both the initial need for the central banks to act more
[00:10:48] forcefully but then created the conditions for the imbalance in the currency. So then in US Swiss
[00:10:54] example if one market participant is buying as much US Swiss as being sold at any given price
[00:11:01] then it's market tendency to test quite how strong that commitment is and with fairness the
[00:11:08] Minimum exchange rate lasted for a long time until it hit a pressure point and then in dollar China
[00:11:16] the similar dynamic was in place where the spread between the fixing and the tradeable spot
[00:11:22] kept on widening, reflecting demand for dollars from dollar China investors until eventually
[00:11:30] the central bank couldn't pursue that policy anymore. So these two imbalances then led to a
[00:11:36] significant revaluation, extremely significant in US Swiss but I think it's important and
[00:11:42] we'll probably come to this later as well. It's not necessarily that the imbalance created
[00:11:49] the crisis of the fall event is that the imbalance contributed to the magnitude of the response.
[00:11:56] So the convenience kind of events everywhere all the time but these events only become important
[00:12:02] when there's this initial setup, this x-ante positioning setup or an incredible, uncredible
[00:12:11] central bank position which is going to be tested by the economic backdrop. So that brings you
[00:12:16] really where there was, not necessarily an imbalance in positioning but an imbalance in the outcomes
[00:12:23] where there was either a large shock to the domestic economy or no shock to the domestic economy.
[00:12:30] And for the few months, six months or so before the vote happened, actually the market was
[00:12:35] reasonably well pricing to risk. It was pricing and outcome in which sterling either fell by
[00:12:43] 10% all rose by, 10% to it was a 50% chance of either outcome. The problem really was as the
[00:12:50] vote approached and the only information that investors had about the outcome was opinion polls
[00:12:56] which by their nature reasonably uncertain that led to an imbalance in positioning as the
[00:13:02] data approach which they'd not mine very quickly overnight and had knock on effects as well.
[00:13:08] Yeah, that's so interesting. Brexit for me was in experience you can learn a lot from and I think
[00:13:13] watching it from the US and from again an equity landscape and equity derivatives landscape
[00:13:19] and looking at the behavior of British pound ball going into it. I think you learn a lot
[00:13:26] to me a main takeaway there is when you have these date certain events on the calendar referendums
[00:13:33] elections November 5th of this year as an example and the market sees that event coming
[00:13:39] and it can price derivatives with very, very different levels whether the option
[00:13:46] expires before or after the events. And then again seeing the behavior of British pound ball
[00:13:53] just rise so dramatically we're talking into the mid 30s on very, very short dated options.
[00:14:00] To me the statement there is the markets ability to bear risk through the event is wholesale
[00:14:06] compromised. You've really, really got to coke someone into selling you the ball and they're basically
[00:14:12] saying look here's the price I think I can't lose money on it's going to be in the 30s. So there
[00:14:18] is this erosion of the capital base that typically is able to sell convexity and you're seeing
[00:14:25] a similar sort of thing in the vix curve in and around the US election. I think some very interesting
[00:14:31] takeaway there. The other thing I just want to go back to and maybe we can just riff on
[00:14:36] things like Euro Swiss or maybe it's the sort of repague in August of 2015 on DollarC and H.
[00:14:44] You get these trades that are built around the expectation that the central bank will keep its promise.
[00:14:50] And in Euro Swiss at least there was a lot of folks hanging around that peg he can out a very
[00:14:56] marginal amount of carry just with the idea that they felt like they'd shaken hands with.
[00:15:02] I think it was Thomas Jordan. I can't remember who is the head of the SNB but they felt like okay
[00:15:08] there's not a lot of carry here but it's kind of guaranteed and so there were these
[00:15:14] variant swaps and other like instruments of extreme convexity that you could buy for a song.
[00:15:22] The basically pegs currency type variant swaps that just absolutely exploded and so that just
[00:15:28] gets me back to your comment that it's the interaction between what the central banks are doing,
[00:15:34] the policy and maybe the economic and unsustainability but also the trades that get built around
[00:15:39] them. So it's a complex system that's interacting and lived free to reflect on that a little bit.
[00:15:45] So you just to go back as well on my history the vast majority of my career has been on the
[00:15:51] biceite and so some of the ways I think about these events is probably slightly different from a lot
[00:15:56] of people. I don't have that experience of being in a traders desk on the south side.
[00:16:01] I don't have that experience of risk tapping me on the shoulder saying that you may or may not run this
[00:16:06] risk and so when I'm thinking about your Swiss for example, well from an expected outcome perspective
[00:16:13] you would probably make a bit but you might lose a lot. What's the market pricing in terms of the
[00:16:23] make a bit versus lose a lot's distribution and will come to this again later but I think that's
[00:16:28] where FX options distributions can really use for this a huge amount of information there.
[00:16:34] But what we try to do here at B&B power bar is figure out exactly this, what is the market
[00:16:39] what is the potential distribution of returns that you're buying into if you?
[00:16:43] For example, by a variant swap or a salival swap or do a range trade compared to what do we think
[00:16:51] is the potential outcome and that speaks to the centre bank. Do we think the centre bank will
[00:16:55] keep its promise? Do we think the market thinks the centre bank will keep its promise? And not always
[00:17:01] and in not all the comments but there's often somewhere where there's a mispricing where there's this
[00:17:08] balance where there's the opportunity to take a positive expected value trade even if it might
[00:17:15] look unlikely on the Facebook. And these examples were great ones and they had very large
[00:17:22] spots driven outcomes but there's always these positive expected value trades which are available
[00:17:27] which may not make the head lunch, they may not be the biggest spot moves in one day or they may
[00:17:32] not be the biggest of open winners or voters at the time and then they're kind of opportunities
[00:17:36] which look most interesting when it comes to using falls. Well, you're an expert in trade
[00:17:42] construction and understanding how these complex products work in mapping the various Greek profiles
[00:17:50] across time and spot space for various currency pairs through derivatives and mapping the
[00:18:06] economic side at the NP, the folks that are covering very, very directly the central banks. What's
[00:18:12] that information exchange and interaction look like? Sure as you may know with your background
[00:18:19] options and derivatives can be quite esoteric especially when you talk to the man in the street
[00:18:25] they don't actually care what vaguas like, lone fan or vulgar or any of the other higher order
[00:18:32] so this is where part of my previous experience comes in as well. It's actually been really useful
[00:18:36] having been a teacher, one of the key jobs in my role is not only to figure out some interesting
[00:18:42] dynamics in the market but it's able to talk about them and to be able to engage and talk about
[00:18:48] them in a way that the vast majority of market participants can engage with rather than being
[00:18:55] extremely niche and extremely esoteric and that example there well if we're talking to
[00:19:00] economists on the team it's extremely valuable to talk about expected distributions
[00:19:07] or the market pricing is where the market distribution may differ from ours. It's extremely
[00:19:14] invaluable to talk about third and fourth order Greeks in terms of an options position. My job
[00:19:22] when it comes to interacting with the rest of the team is to think about where the market pressure
[00:19:27] points may be particularly if we think a market forecast or an eco forecast may be significantly
[00:19:34] different from where the market is pricing. Well let's focus on dollar yet because obviously that's
[00:19:40] a huge part of the pretty seismic if short lived risk episode that began or we could go and
[00:19:46] feels like it's settling down I was just looking at the mix it took the mix fully two days to double
[00:19:51] it went from something like 18 to 38 and as of the time I'm saying these words it's basically
[00:19:58] gone in half it's now back down to 19. That's got to be one of the shortest round trips
[00:20:04] of a doubling and then a halfing that we've ever seen. I'm trying to think back they might be
[00:20:09] a couple that compete with it but boy that came in one pretty quickly. The yen is a fascinating
[00:20:14] currency. It's got these really interesting risk properties associated with it for the longest time
[00:20:22] if you map the correlation between the yen and the mix it would be at least $1.00 yen
[00:20:29] first of the mix it would be negative so VIX UP stronger yen so it was this haven currency for the
[00:20:36] longest period of time. You had episodes like the nuclear reactor meltdown I want to say that was
[00:20:43] 2011 which brought a giant move in the mix and an incredible rally in the yen so you had these
[00:20:50] periods but those correlations can come and go over time share some of your thoughts on just
[00:20:56] the risk characteristics of the yen and I think that'll bring us into that setup for how
[00:21:02] folks have been exposed to the yen and how that exposure is interacted with the other assets
[00:21:08] in our ecosystem text arcs and so forth but just give us a big picture how do you frame out
[00:21:14] our process on the yen? Yeah so the risk property of a currency is a really interesting question.
[00:21:21] One's prior I think you from a scientific perspective is that no single currency should behave
[00:21:26] any differently in any environment than another but the reason FX strategy just exists to the
[00:21:38] this word again imbalance there's an imbalance in supply demand within any countries balance of
[00:21:45] payments there may be more aggressive buyers than sellers for local equitets and that may push
[00:21:51] the currency higher and then there may be more people going on holiday and coming back which needs to
[00:21:57] sell the pound in a summer so there may be more sellers and buyers and certainly falls and
[00:22:01] well FX strategy is effectively figuring out QS sticks to try to figure out what those
[00:22:06] balances are and how they behave we only ever get balance of payments data best one month
[00:22:12] lag to worst three months or longer lag so the risk characteristic of a currency really comes from
[00:22:17] analysis of the balance of payments and specifically which components of the balance of payments
[00:22:24] drive the currency performance so yen is a great example here for the longest time it's been
[00:22:30] investment currency currency and a country in which there's a huge local investment industry
[00:22:36] like this pension funds and so on whose desire to see yield has pushed lots of investments
[00:22:44] overseas so if we're thinking in terms of balance of payments that means there's a lot of
[00:22:49] domestic capital outflow two foreign assets some of it may be hit FX Hage some of it may be not
[00:22:56] FX Hage but it means that during good times during risk on periods the most likely path of
[00:23:02] dolly any's higher as Japanese investors buy foreign assets during bad times risk off periods
[00:23:09] the most likely path of dolly any's lower as the same investors begin to repatriate
[00:23:14] either to cover local losses or to stop loss on foreign investments or for any other reason too
[00:23:19] for local liabilities and then on top of this if you like fundamental behavior
[00:23:26] is all the speculative behavior of the speculative community in which everybody else thinks through
[00:23:34] this process and thinks well the yen behaves like this funding asset during risk on periods
[00:23:41] and like a safe safe asset during risk off periods so if one were to think the current
[00:23:47] period is risk on one should sell the yen and buy foreign assets and buy other currencies
[00:23:52] and then if one were to think this period is risk off one does the opposite thing so this balance
[00:23:57] of payments behavior becomes magnified by the speculative community effectively doing the same kind
[00:24:02] of trade as locals so then dolly and becomes this very high beta risk currency pair and over the last
[00:24:11] 12 months of up to two or three years this has been exaggerated and the yen has been a funder
[00:24:19] while bank of Japan policy is remained it's there a well interest rate elsewhere have risen so
[00:24:25] the expected return of using the yen as a funder while investing elsewhere whether that
[00:24:30] be in the dollar or anywhere else has simply increased so it's attracted an increasing amount of
[00:24:35] total into this yen funder counter trade yeah and that's a really interesting backdrop and perhaps
[00:24:42] leads to the next area we could explore I was just created a chart of Nvidia since 2022 obviously
[00:24:50] it's up a gigantic amount and then I just did a Nvidia in yen next to it and it was up in even
[00:24:57] more gigantic amount and so this idea that the yen was a one-way train lower for such a long
[00:25:06] period of time and it's just hard to get away from the extent to which central banks are wrapped
[00:25:11] around this idea that yen is in this permanent state of deflation and they'll never get out of it
[00:25:17] and they're the very last to even contemplate exiting zero interest rate policy and so with
[00:25:25] that as a statement and you start to peel away the onion in terms of what happened last week
[00:25:32] the severity of it I guess is really what's on my mind because you'll always have an
[00:25:36] instance where there's a risk often the yen is a currency that funds the risk rallies on the
[00:25:43] risk off but something different happened here and I just be curious maybe just from your standpoint
[00:25:49] set it all up for us from the FX strategy standpoint with respect to positioning going into it
[00:25:56] give us the big picture of what's on your mind as we survey the damage from last week.
[00:26:02] Yeah that's really a good point the central banks contribute to these and balances
[00:26:05] central banks don't necessarily control the markets but they certainly
[00:26:08] compush them in their directions and then we can have these shocks as we said earlier these
[00:26:14] shocks may happen and there may not be large reactions to it but if you have the imbalanced
[00:26:19] leading into the shock then you can certainly have an exaggerated reaction and so for the
[00:26:25] yen trade it's been a super charged carry position not just this year but for the last two
[00:26:30] to three years effectively since that original break of 115 or 120 where everyone was right at
[00:26:35] the start of the feds tightening cycle but it's not just being in spot and that's probably the
[00:26:41] thing here it's been a long carry position expressed through long doly and spot,
[00:26:46] long cross share spot, make share and long video yen, short gamma positions in FX options,
[00:26:52] short wall in FX options. There's a imbalance in spot there's an imbalance in option space
[00:27:00] and also rightly or wrongly these trade worked as you say the video end was bottom left to top right
[00:27:08] a lot of PV was then invested in these positions middle towards the middle and the end of
[00:27:14] July so in the normal course of markets you may get a drawdown but if that drawdown takes place at a
[00:27:23] time when investors have a lot of money that could be lost and there's a concentration in positioning
[00:27:29] in spot space an option space and derivative space then you've got all of the ingredients for
[00:27:36] unwind to be more powerful than usual, more supercharged than usual. One of the things I think's
[00:27:43] interesting and I'm sure this is a big part of your work is understanding spot-volved dynamics in
[00:27:50] FX and I'm just going back to Abidomics that interesting, interesting period of just a whole
[00:27:57] sales shift in the philosophy that Japan was going to embrace to try to get themselves out of deflation
[00:28:03] and so that really created some unique dynamics on the ball front it really created a very strong
[00:28:11] inverse correlation between the yen and the nek as an example but as I look back at the last
[00:28:17] couple of years just thinking now just about the yen in the way in which the level of the yen
[00:28:24] interacts with let's just say pick a number one month implied vault on the end. You've had periods
[00:28:30] where a rapidly declining yen was associated with a decent bit of all pretty strong increase in
[00:28:38] implied vault. Some worry that they were going to lose it, that this thing was just going to be
[00:28:42] off to the races you couldn't get a back type of thing and then of course the opposite is also
[00:28:48] just recently been proven true you can get a ferocious rally in the end and that could be
[00:28:54] volanducing as well. So you sort of get both sides of it in some ways very different than an equity
[00:29:00] index the SEP goes out typically the ball goes down vice versa.
[00:29:05] Look to have you talked to us out loud about just yen spot vault dynamics
[00:29:11] what you expect from here how they've shifted recently how should investors understand that?
[00:29:17] Yeah that's a really good point. The yen's hopeful correlation is typically expected to be negative
[00:29:22] like it is expected to be an equity. And so in full policy in FX policy we call it the risk of
[00:29:27] vessel and the risk of vessel is typically bit for puts. So calls dolly yen calls typically
[00:29:32] trade below dolly inputs and usually high delta dolly in calls also a trade below the out
[00:29:38] the money for but the characteristic of the last two years has really challenged that as you say.
[00:29:44] Then we have to look at these in separate instances because there's been the two years rally
[00:29:48] from on 2020 to on 60 and then there's been this behavior now. So let's take the last two years first
[00:29:53] and then we'll take this behavior. Some of the analysis that we do at the MP powerbast, some
[00:29:58] of the analysis that we look at every week in the FXV strategy team is we collate options traded
[00:30:05] that are reported to the DTCC, the central repository and we analyze that data to figure out what
[00:30:12] options positioning looks like across all currency pairs but particularly in these highly
[00:30:19] traded pairs like Dolly yen. And if we rewind all the way back to the start of the
[00:30:24] tightening cycle, what we would see is what we usually see a concentration of options positioning
[00:30:32] around the prevailing spot rate. So this is where physics actually does come in a bit and the
[00:30:37] law of large numbers also applies. All else equal, the options mark it settles down in a Gaussian
[00:30:43] distribution around prevailing spot. That's a steady state for the options mark it for there to
[00:30:49] be a reasonable amount of gamma-hatching and position balance between an upside and downside.
[00:30:55] But then there were these occasions when we see the options mark it unsatled and imbalanced around
[00:31:01] where prevailing spotters and it often happens when the spot rate reaches the edge of a prevailing rate.
[00:31:08] So every big figure or every five big figures, 120, 125, 130, 140, 150, 150, 150, 150,
[00:31:16] what we've seen in this Dolly yen options and Alice just because it's strike map. What we see
[00:31:21] in the strike map is an absence of positioning, an absence of options owned above the highs.
[00:31:28] And so partly that speaks to a an unwillingness to anticipate yet another wave of the end appreciation
[00:31:38] when it's already depreciated so far. Market participants have a lot of memory, a lot of
[00:31:44] history to trade against as well and the idea that the yen keeps on breaking new lows over and over again
[00:31:49] is cognitively quite hard to get over. But because there's been this absence of positioning,
[00:31:55] every time spot has risen towards a high we've had this positive spot of all correlation.
[00:32:01] As soon as the high gets broken the market is compelled to buy calls to rebalance its positions
[00:32:06] for the prevailing spot rate and then the market breaks in you high and it rebounds its
[00:32:10] positions for the prevailing spot rate. So due to the markets positioning going into The Dolly
[00:32:25] where one month or less gets bid every time that's a break but then one month does not go
[00:32:30] bid in those periods where Dolly and Consolidates before the next break. So that's really
[00:32:35] been the character of Sigourhol, the way up to 160 that the most profitable strategy every time we've
[00:32:40] got to the high in Dolly yen was to buy a call past the highs because the most likely outcome
[00:32:46] would be a break in high volatility. That changed significantly well really after U.S. CPI,
[00:32:52] this combination of CPI, the fair the BHA and the softened expected payrolls, a did buy the rapid
[00:32:59] move lower its bottom at the time. So if we think about the Dolly and positioning when we were
[00:33:05] between 155 or 160 that was largely long options, long call spreads, long carry type strategies
[00:33:16] which earned money in a benign low volatility environment. It specifically wasn't a setup
[00:33:23] in which the market owned convexity and by convexity I would mean 165 calls or even 145 puts
[00:33:31] there was little ownership of low delta options hedging or positioning for a big move one way or another
[00:33:39] in Dolly. So when a big move did come the market was called wrong sided and then we get this
[00:33:49] typically, empirical negative spot for correlation, Dolly and goes down and Dolly and Volk
[00:33:54] goes up. There was the period from say 165 where it wasn't clear exactly which way we would go
[00:34:02] but one of the important dynamics at this time when we moved lower was the absence of corporate
[00:34:10] supply which through most of the previous rally has been there to sell some volatility on
[00:34:18] every dip almost for the same reasons that speculators needed to buy some volatility on every rally.
[00:34:24] Corporate importers who needed to continually buy dollars at better levels, every time there was
[00:34:30] little dip it was opportunistic to effectively sell some pumps to improve head rates of the
[00:34:36] long run but then the changing dynamic over the last month coupled with the fact that that
[00:34:41] flow didn't emerge led us to get through this gap in positioning and then see this positive spot
[00:34:48] for correlation emerge. So Dolly and Lower Volk higher correlation emerge and it happened at the
[00:34:55] same time as Dolly and Spot fell into a gap in positioning into a place where there was very
[00:35:00] little options ownership and what that would correspond to is well if not many options are owned
[00:35:06] there's not many natural gamma edges. If a one many natural gamma edges we realise Volk is going
[00:35:11] to be higher than it was before if we realise Volk's higher implides have to be higher as well.
[00:35:16] So there was this reflexive reaction we went to a level of spot that was under owned that there
[00:35:23] is an imbalance and then we had this high of all lowest spot, higher uncertainty in Dolly
[00:35:29] and all drift and largely all precipitated largely by extended long carry positioning.
[00:35:38] It's always interesting to try to understand the supply demand dynamics in
[00:35:42] valve for an asset class in the equity derives market there's all kinds of people acting at
[00:35:50] different points in the strike curve and certainly the maturity curve down to one day there's
[00:35:55] mutual funds and punters and hedge funds and there's overwriters and so forth. And so they all come
[00:36:01] together and at some point there's a trade to be had. I think it's very interesting to hear your
[00:36:06] commentary that at least some part of perhaps the unexpectedly strong increase in vol as Yann
[00:36:15] Rallyed is some function of the non-emergence of expected supply. I think you pointed to corporates.
[00:36:22] Tell us a little bit more about that just the ecosystem of supply and demand. I assume there's
[00:36:28] a lot of hedge funds demanding optionality and various forms maybe it's through sometimes through
[00:36:34] spreads as well but the big picture of how these prices come to be in volland in terms of buyers
[00:36:41] on one side and sellers on another tell us a little bit more about that. That's an asset class.
[00:36:46] FX is huge. It's the number seven trillion dollars that's transacted a day. That's an asset
[00:36:51] class FX speculation is tiny, mini-skill, think of Paris and the imbalance in FX fold, the
[00:36:59] supply and demand pitch there well largely is driven by transactional FX players it's driven by
[00:37:07] importers and exporters. It's somewhat driven by financial institutions as well. Structures
[00:37:13] supply probably similar reasons that you see in equity space. FX fold is typically a mean
[00:37:19] reverting asset class so the imbalance is and the seasonality and the supply to my pressure we see
[00:37:24] is reasonably small. We certainly don't have things like a Santa Rally. We don't have a positive
[00:37:30] trend in FX fold that trend is zero and distributed around zero but we still see significant
[00:37:37] seasonality at the start of the calendar year in January. At the start of the fiscal year in Japan
[00:37:42] in April we capture regular supply of fall so this is from corporate and from stretch its supply
[00:37:50] which are on the stretchers side at least this is a yield enhancement product of any form
[00:37:56] if it has come to exposure then there's some element of selling good option around it,
[00:38:01] some element of harvesting premium in it. That may diminish in the future when yields are high
[00:38:07] particular if yields keep on rising into burn but for now it's been consistent for the last 10 years
[00:38:11] and it contributes to this full supply picture and then if you're an exporter from Europe
[00:38:16] and you're expecting income in dollars then you may have different rules about how you
[00:38:22] hedge your dollar income some of those rules may be simply by the forward in the amount of
[00:38:28] income we expect some of the models maybe more sophisticated in terms of slightly more structured
[00:38:33] products to have forward participation and some of those rules may turn into vol selling strategies.
[00:38:40] In aggregate what we find is there's natural supply of fall from the transactional sector
[00:38:48] and that outweighs natural demand from the speculative sector in the first half of the year
[00:38:54] but it doesn't tend to outweigh demand in the second half of the year so the way I think about that
[00:39:00] as well is time based not price based and the start of the calendar year and the start of the
[00:39:05] fiscal year or times in which price in sensitive investors or price in sensitive participants
[00:39:13] would typically increase their hedge ratios and then throughout the rest of the year
[00:39:19] if we think about hedge funds they have no acts to be massive buys on the first of January
[00:39:25] or the first of July they'll be volbised persistently throughout the year especially when there's
[00:39:30] an opportunity. That is super interesting I had not really understood there to be
[00:39:35] some version of seasonality with respect to supply and demand for optionality that's really interesting.
[00:39:43] I wanted to get you to take we've alluded to it but it's hard to get away from the fall out
[00:39:48] in some of the cross-ass accorler I mean if we assume that a big part of this was the yann rallying
[00:39:55] these consecutive 10% moves in the NECA have just really got me thinking and scratching my head about
[00:40:03] what does it tell us you certainly alluded plenty to the degree of speculation that's
[00:40:10] financed over time but two 10% moves in a row it's got to tell us something and the VIX got
[00:40:18] incredibly and I would say disappointingly dislocated the morning of August 5th throughout the day
[00:40:26] bit offers basically made the product untradable and the reason the VIX is untradable is because
[00:40:32] the S&P options market broke relative to what you'd expect and I get it it's a 4%
[00:40:38] move in the S&P that's a big move there's global tumult but it just was a lot worse than it
[00:40:46] really ought to have been even adjusted for some big moves around the world. What does it tell us
[00:40:52] and then just on a going forward basis we talked a little bit about your interaction with
[00:40:58] your economics teams that studying central banks of course you're studying at B.O.J.N.
[00:41:03] industry of in itself but what does it tell us about the potential going forward with respect to
[00:41:09] disruption? Yes it's really interesting when we have these kind of setups or crises
[00:41:16] beyond the event itself and the fallout of the event it's really interesting to study what
[00:41:21] happened it's like a fingerprint of the market. It's really interesting to study what happened to
[00:41:26] understand where the fragility was while positioning was like what the market behavior is like
[00:41:33] and there's a lot of takeaways it's where the science comes in never let good crises go
[00:41:37] to waste never let a failed experiment go to waste and what happened then because it looked a lot like
[00:41:43] there was herding behavior in these successful trades so for the first six months of this year
[00:41:50] and for previous years the right trade in Dolly and has been to be long, been to be long spots
[00:41:57] and shortfall in some limited loss form the right trade in Dolly China this year has been to be
[00:42:03] long spot and shortfall. The right trade in Swiss has been to use that as a funder and we could
[00:42:08] go on the right trade in mex and the right trade in basulance one and some of these trades have
[00:42:12] on well now but if we're thinking about whether right trade was early in the year then it was very
[00:42:17] much long carry trade so it looks like there was a lot of herding in these right trades
[00:42:24] why was that herding we didn't used to get that back when I started we were allergic to
[00:42:30] copying trades or allergic to jumping on the momentum bandwagon the whole point was to
[00:42:36] generate uncorrelated turns and generate alpha you're not going to generate alpha if you're doing
[00:42:40] this thing that everybody else is doing and well maybe if we think in terms of a bigger picture
[00:42:45] the rise of multi-manager shops which have tight stop loss limits and penal pressure
[00:42:51] we don't really have the opportunity or the time of the flexibility to think what happens in six
[00:42:58] months or one year or two years you don't have the staying power for that anymore it's there
[00:43:03] do you need to make P&L either quickly or consistently which is a short hand for saying you need to
[00:43:10] be long carry short options you don't want to be spending premium for three months
[00:43:16] in the case of an event which happens in three months on one day because you need to demonstrate
[00:43:21] P&L games initially and I think we saw some similar behavior following rushes and
[00:43:27] vaginal if you're creating in 22 there was another example of fragility that because at the time
[00:43:32] FX4 was even lower than it was in July and there was the usual supply demand and there was
[00:43:39] the usual hedge on fly or an corporate flow but also speculicif short gamma strategies were
[00:43:45] popular at the time simply because they'd been working and if they'd been working for three months
[00:43:50] then you may as well add to your short gamma increased the position it's like momentum positioning
[00:43:55] involves and so you'd increase your positioning every time they work but then an exogenous risk hits
[00:44:02] and all of these strategies get stopped out and probably most importantly they don't come straight
[00:44:07] back they stay out for a long time so it's almost like we had the same dynamic going on into
[00:44:13] August where the only trades being attitude with successful trades the only successful trades with
[00:44:18] the carry trades the best carry trades were in yen and tnh so there was a concentration and a
[00:44:24] hurting so by the time we actually had the unwind pressure a lot of the spec market was all the same
[00:44:31] way and so we get this big down in market behavior options markets are insurance markets and I
[00:44:37] sometimes think about the actual insurance markets like property insurance and they have this
[00:44:43] answer to the hard market there's an event an insurance event that causes capital to be lost because
[00:44:50] there's a payout on some catastrophe and then the market takes a while to repriced self because
[00:44:56] the capital is just really not there it just takes a bit of time so it's like you get the event
[00:45:02] and the vix of the property market goes to 40 and it gets stuck there for a while as the capital
[00:45:08] rebuilds itself I've seen that in the actual equity derivatives market as well certainly post
[00:45:14] the covid crash of March of 2020 there was such a loss of capital in equity,
[00:45:20] valkary strategies that it took fully two years for the valkarist premium to settle back to
[00:45:27] something that's more normal what's the fallout just in terms of the carry trades that were working
[00:45:34] spectacularly and then the ball gotten hit in FX what are the implications going forward in terms
[00:45:40] of things like valkarist premium or the capacity to bear risk in these strategies how do you see
[00:45:47] racing materializing going forward? The way I think about this is a FX fall surfaces that anchor
[00:45:53] somewhat that anchor by realised and volvus premium it can only get so high until as you said earlier
[00:45:59] somebody decides they have enough compensation to sell the option but they also reflects supply demand
[00:46:05] and dolly ends a good example here implied fall is likely to stay elevated until
[00:46:11] supply demand gets to an equilibrium and what that means is in terms of our analytics we see our
[00:46:18] strike map saying that there's a reasonably balanced options profile around the prevailing spot
[00:46:24] at the moment the options profile is still quite mismatched they're still not much owned to the downside
[00:46:31] and still more owned to the top side so in terms of the pressure points there may still be some
[00:46:37] pressure there may still be high realised for all of them may still be supported tolly endfall
[00:46:41] and you mentioned earlier VIX snatched back very quickly which could either be a reflection of
[00:46:47] a very quick on-wind and cleaning out of positions or it could be a reflection of the unwind
[00:46:54] with far from completed and instead position started being added and actually we're seeing
[00:46:59] something similar in dollar china at the moment where the positioning and the initial setup
[00:47:04] was similar to dolly end and actually the moving dollar china voltage huge realised volume dollar
[00:47:11] china was two points something a few weeks ago and it's a baffiery now okay
[00:47:16] you're a bit specialist and the idea of realised for being two is completely alien but
[00:47:21] it more than doubled in a couple of weeks on a few one percent moves and a very big move there
[00:47:27] but actually if we take a look at what the false mine has done between last week and today
[00:47:34] it looks like the supply demand in dollar china is for top side options again
[00:47:40] it looks like the demand is to react to a long dollar CNH trade now either that means the market
[00:47:48] is fully covered and the unwind is over or it means there could be more paint to come
[00:47:56] as hard to say what the answer is in that case but it's notable that there appear to have been
[00:48:01] a rapid recovery in investor behaviour in that pair compared to say in dolly end where there's
[00:48:07] a lot of time to go or a lot of wood to chop before it looks like the market is balanced
[00:48:12] well last question I want you to reflect on a little bit and I think we've gotten to it
[00:48:16] to some degree but I think what's so interesting is for the last couple years the market narrative
[00:48:23] has been that aggressive fed tightening can create spillover into other asset classes other countries
[00:48:31] it can be destabilizing fed tightening and to some degree there were elements where it was
[00:48:38] and now it's almost as if the opposite maybe true where if I don't know US disinflation continues
[00:48:46] or the growth slow down continues to present itself and then God forbid Japan does more than
[00:48:53] we've expected from a monetary tightening standpoint but is that the canary in the coal mine
[00:48:58] with respect to risk and I guess my question is we got a window here into some fragility here
[00:49:06] is there potential with respect to this re-emerging as a protracted risk event should we see again
[00:49:14] the fed ease more than we expect and other central banks maybe namely Japan do more on the
[00:49:21] opposite front I think we mentioned this at the very beginning so it's important to remain evidence
[00:49:27] and if somebody comes in and says well the fed is tithing too quickly and it will break markets
[00:49:32] the fed is easing too quickly and it will break markets my antenna immediately picks up and thinks
[00:49:37] well the fed isn't breaking markets so what do we actually mean here but you're absolutely right
[00:49:41] the dolly and move is a window into dolly and fragility I think what's really interesting in dolly
[00:49:45] and is the cross asset correlation that took place we look at correlations in slightly different ways
[00:49:52] involved because it's an asset class with a lot of noise that's lost to custody volatility
[00:49:57] involved so we want to make sure that we capture the moves rather than just the noise and to do that
[00:50:02] we just look at correlations in the up direction so if S&P Volgaes up what does dolly and Volgaes do
[00:50:08] if S&P Volgaes up what does dolly and Volgaes up what does dolly and Volgaes up so on and what we found was
[00:50:13] the fingerprint of the cell-off was necare in S&P Volgaes not the U.S. rates for
[00:50:18] so from that respect it looks like it was largely a position on mind driven move
[00:50:25] so could it re-emerge if the fed keeps easing well if the fed keeps easing what happens to U.S.
[00:50:32] rates for what happens to S&P what happens to S&P and what happens to people and therefore what
[00:50:36] happens to dolly yet unfortunately there are two different ways the fed can use one is the
[00:50:41] recessionary easing 2007 style one is the soft landing kind of easing or the mid-cycle so
[00:50:48] I'm kind of eating like 1995 the former is clearly dollar positive,
[00:50:54] volt positive actually spot for correlation strength and as when in those outcomes
[00:50:58] and the dollar goes up and risk cells are in that case it would be dolly and negative and
[00:51:02] volt positive the latter is actually dollar bearish, risk positive and volt bearish so we can't
[00:51:10] escape from reflexivity now the reflexivity is between what the economic data is telling us about
[00:51:17] the nature of the slowdown whether it's soft or hard or accessory and therefore what kind of
[00:51:26] cutting cycle we'll see in retrospect when the market was pricing an intermediate cuts this time
[00:51:32] last week that looked like it was a response to a rapid tightening in financial conditions which
[00:51:39] were anticipated to continue and potentially destabilise markets in the end they didn't and some
[00:51:46] what we've been talking about it's been how the markets stabilize since that so well framed and
[00:51:51] I'd like to think about it is is the fed easing or tightening because they can or because they
[00:51:57] have to in your two scenarios the latter was more that we can we got this immaculate disinflation
[00:52:03] job complete and so we'll bring things down to a level that's more akin to equilibrium versus
[00:52:10] we're chasing it and we gotta do this fast that's got different implications for a lot of
[00:52:16] assets the shape of the yoke or certainly ball and so forth so I'm very very interesting so
[00:52:22] much to think about Oliver this has been a great conversation I really enjoyed it and again
[00:52:27] it's proven extremely timely in a way that I don't think we expected but certainly listeners
[00:52:32] to the alphics change are going to appreciate the insights from an expert on FXVOL so thanks again
[00:52:39] for taking the time it's been a pleasure that's having me you've been listening to the alphics
[00:52:45] if you've enjoyed the show please do tell a friend and before we leave I wanted to invite you
[00:52:50] to drop us some feedback as we aim to utilize these conversations to contribute to the investment
[00:52:55] communities understanding of risk your input is valuable and provides direction on where we should
[00:53:01] focus please email us at feedback at alphicschangepodcast.com thanks again and catch you next time