FX option volatility hits a post-COVID low as speculators build a record $51.4 billion dollar long

Year-end SOFR expectations have risen at least 95 basis points since January, from 3.05% to above 4.0% ^[4][3]. At the end of August the CME FedWatch tool put the odds of a hike by December at 89.5%, and the Fed delivered one in September ^[5]. Against the majors other than the Australian and New Zealand dollars and the yen, the dollar is still within 2% of where it began the year ^[9]. Its first-half range was 44% of the year-earlier range against the euro, and 44% against sterling ^[1][2].

Richard Stevens, writing on Seeking Alpha, puts the calm down to sticky inflation. Short-term rates are expected to rise or stay higher for longer in many countries, so the rate support that would normally lift the dollar is matched abroad ^[7]. "When rates seem to be rising everywhere, the impact on currency values can be unclear," he wrote ^[15]. Record equity highs and sustained foreign inflows into US markets should also have supported the dollar, he wrote ^[16]. The exception fits his case: three rate rises have helped the Australian dollar appreciate against the US dollar this year ^[8].

On that account, a G5 option volatility index at 5.33, its lowest since COVID ^[3], is a fair price for currencies whose central banks are moving together. I think it is too low for the positioning underneath. Speculators in CME currency futures were net long $51.4 billion of dollars at the end of July, a record, according to CFTC data Stevens cites ^[12]. They were also long the dollar against each G7 currency individually, the longest such run since 2019 ^[13]. Stevens wrote that "the positions data suggests that if there's going to be a movement, that movement could well be up" ^[14]. A record long is also a record stock of dollars that gets sold if the position stops paying. The same article reports that the dollar's trend over the past few weeks has been lower ^[9].

From here the dollar can stay pinned while rates rise in parallel, paying whoever sold options at 5.33 ^[3]; it can break upward if the speculators are right, as Stevens expects ^[14]; or it can break downward if they sell into the recent weakness ^[9]. Only the first outcome matches the market a post-COVID-low volatility reading describes. A treasurer who takes the first half's range as a forecast is choosing not to buy cover at the lowest implied volatility since COVID ^[3].

The case against me is Stevens' own explanation. If inflation keeps most central banks tightening together, rate differentials stay small and cheap options stay cheap for a reason ^[7]. The test is the second-half euro range. If it comes in at or below the first half's 6.8 cents, the options were priced correctly and buyers of protection lost their premium ^[1].