From verbal to actual intervention

A barrage of official hand-wringing about the yen's weakness has put the spotlight back on the carry trade and investors are looking at how to position themselves should central banks intervene.

Implied volatilities on some currency options are at their highest in months, suggesting the threat of central banks turning their verbal intervention to actual intervention - however slim - is prompting investors to pay a higher price to protect themselves against sharp exchange rate swings.

The Bank for International Settlements said in its annual report last week that the yen's low value is "anomalous." Japanese, South Korean and Taiwanese officials expressed concern last Tuesday at the yen's weakness, adding to the Swiss National Bank's recent warnings that the franc was undervalued.

Speculation

This has intensified speculation that other central banks, such as the Swiss National Bank, may follow the path taken by the Reserve Bank of New Zealand (RBNZ), which intervened earlier this month to try and stem the seemingly inexorable rise in the New Zealand dollar's value.

"There is now more two-way risk and moves by central banks would see some unwinding of carry trades if they were seen as credible," said Marcus Hettinger, global foreign exchange strategist at Credit Suisse in Zurich.

"Implied volatility would increase somewhat but it's hard to see how they could turn the carry trade trend."

Currency traders are getting twitchy at the cranking up of official verbal intervention on the carry trade because it could herald the actual intervention that's been conspicuous by its absence from the market for some time.

On June 11, the day the RBNZ intervened, one-month New Zealand dollar volatility jumped by more than a percentage point to 10.6 per cent. While it has ebbed slightly since to about 9.7 per cent, volatility remains well above lows of 8.3 per cent seen at the start of June.

If the RBNZ acts again or another central bank like the SNB follows suit, traders will likely retrench positions and implied volatility could rise again.

Opportunities

Swiss franc implied volatility jumped last week as the unwinding of carry trades pushed the Swiss franc higher across the board. Implied volatility on one-month euro/Swiss options reached 3.5 per cent, its highest level for two months.

The yen's rally this week, meanwhile, has lifted implied volatility on yen options too. Any official intervention could open up opportunities for short-term traders but cause headaches for those looking to hedge currency risk.

"It would lead to greater volatility which could dent carry trades in the short run," said Kevin Grice, senior economist at American Express bank.