BNY Mellon: The Aerial View: Patterns of Realized Volatility in USD/JPY

18 okt 2018

By Simon Derrick, Chief Currency Strategist, BNY Mellon

As noted recently, the way USD/JPY trades has been well established for over two decades, with the relatively high cost of owning JPY discouraging investors from being long of the currency unless they have absolutely had to be.

The net impact of this is that risk aversion-related moves lower in the USD against the JPY have had a tendency to be vicious, with October 6/7/8 of 1998 remaining the best examples of how bad it can get.

This raises the more general question of how closely realized volatility in USD/JPY has tracked to realized volatility in the S&P 500 since the Nixon Shock in 1971 and what it might indicate.

Looking at a running correlation over 130 trading days between 21-day realized volatility (measured on a close-close basis) in USD/JPY and the equivalent in the S&P 500 reveals there were 742 days since 1971 when it ran at 80% or higher.

Interestingly only 193 of these days came prior to 2006. However, this makes sense when it is remembered how active Tokyo was in the foreign exchange markets prior to 2004.

Since 2004 there have been eight periods of high correlation between realized volatility in USD/JPY and the S&P 500.

The first of these emerged in October 2006 and lasted until the end of January 2007. About a month later the second period emerged and lasted through until June of that year. Late September 2007 saw the start of the third period, lasting until mid-January 2008. What is interesting about this grouping is that it coincides pretty exactly with the latter stages of the post-March 2003 bull market in equities.

It’s hardly surprising that the next grouping comes between the start of October 2008 and June 2009 as the global equity bear market reached its peak before beginning its (now nine-year-old) recovery.

The next burst of high correlation comes in July and August 2014 and coincides with the start of the heightened volatility in global markets following the introduction that summer of a negative deposit rate by the ECB.

Similarly, high correlations emerged in September 2015 and then in January/February 2016 as the CNY devaluation scare emerged and then developed to a peak.

Perhaps the most interesting point that emerges from looking at these periods of high correlation is that while there is no question a number have coincided with periods of highly negative sentiment (most obviously late 2008/early 2009), the most sustained period (in aggregate) of high correlation came between October 2006 and the start of 2008 as the post-2003 bull market in equities rallied to its very peak.

In other words, high correlation seems to coincide with extremes of market sentiment in either direction.

With this in mind, it’s worth noting that the latest period of high correlation between realized volatility in USD/JPY and the S&P 500 emerged in mid-April of this year - although it has faded slightly in recent weeks.