World Cup effect on forex: volatility jumping and liquidity

Seventeen hours have passed since the World Cup kicked off. Across the financial system, liquidity levels are falling, risky assets are on the defensive, bond prices are rising, implied volatility levels are jumping…and the Brazilian real is up sharply.

With many traders concentrating on television screens rather than computer screens, currency markets are seeing lower-than-normal volumes. If past tournaments are any indication, this effect will become stronger as the finals approach, meaning that relatively minor events will assume greater-than-normal significance.

The pound is flirting with a five year high in the aftermath of the Bank of England press conference yesterday, where Mark Carney said that an interest rate hike “could happen sooner than markets currently expect”. Coming after the International Monetary Fund warned that housing prices in many developed countries are rising too rapidly and that markets could collapse, investors took the Canadian’s words quite seriously.

Both of the Antipodean currencies are up nicely, moving ever closer to par with the US dollar, despite deteriorating fundamentals. Carry traders are borrowing from central banks in the United States, Europe, Japan and China, and are using the proceeds to invest in high-yielding instruments across the globe. To us, this is a dangerous echo of the situation a few years ago – and will likely end in tears. But for now, hedgers need to be aware that current trends could go a long way before the steamroller arrives…

Front month West Texas tea is trading near the $108 handle, capping a solid week of gains as violence in Iraq escalates. With Sunni rebels threatening to march on the government in Baghdad, pulling Iran and the United States into the conflict, supply concerns are putting momentum behind the market – and with hundreds of billions in low-cost money sitting on the sidelines, this is the sort of opportunity that many speculators are looking for.

Although the Canadian dollar has lost much of its correlation with crude over the last year, this represents a clear and present tail risk. A spike in risk premia could take the currency much higher through the summer months, in an echo of the pattern that has occurred countless times over the past two decades. The historical record clearly shows that this sort of situation can wreak devastation on fundamental forecasts – and on corporate balance sheets.

In short, try to stay frosty in the summer heat, and have an excellent weekend!