A certain amount of reflection is normal and even necessary after a tumultuous period. Last year we witnessed large price movements in all the financial markets (fixed income, equity, commodity, and currency), which one might say were tumultuous, or if not tumultuous, then certainly difficult to predict and definitely not for the faint-hearted.
In the fixed income markets we saw U.S. Treasury 10-year yields begin the year near 4.00 percent, drop to 2.40 percent in October, and then move quickly back up to 3.50 percent by December. However, those swings pale in comparison to those of some sovereign debt yields, particularly those of the so-called peripheral euro zone countries — Portugal, Ireland, Italy, Greece and Spain (yes, the PIIGS). The country whose bonds had the wildest ride was Greece. Greek government 10-year bond yields began the year at 6.00 percent. In May alone they jumped to 12.5 percent and quickly dropped to 7.25 percent, then back up to 12 percent in September, down to 9 percent in October, and finally they finished the year at 12.5 percent. Whew!
In the equity markets we witnessed good-sized swings in the Dow Jones averages in the first eight months of the year. The DJIA moved back and forth though 10,000 several times before settling down to that slow, steady and significant rally we saw over the remainder of the year, reaching the year’s high of 11,625 during the last week in December.
Commodity prices soared throughout the year. Several commodities hit all-time highs, including copper, cotton, gold, sugar, coffee and a whole variety of so-called rare-earth metals. The rallies were fueled by a combination of natural demand (especially by China) and speculators/investors/traders en masse jumping on board the commodity price rally express train. Gold resumed its historical role as the anti-currency, meaning the influences and events that affected its price were not simple commodity supply/demand fundamentals, but the more complex global monetary issues.
Lastly, we saw effects on the currency markets, which attracted so much attention from the media and politicians. Here is the FX rate data for 2010 and comparisons against the 10-year period 2000-2009 for the three most actively traded global currencies:
OPEN: $1.4385, CLOSE: $1.3385 – a change of 6.8 percent; the average annual change for 2000-2009 was 9.90 percent
HIGH: $1.4580, LOW: $1.1877 – a range of 18.8 percent; the average annual range for 2000-2009 was 18.2 percent
However, in order to determine if the market for the euro last year was really tumultuous or not, we should look at measures of volatility. I typically analyze a currency’s Implied Volatility (that volatility implied by prices of tradable options), which represents the markets’ expectation of future rate moves over a specific time period. For the EUR:USD, the average Implied Volatility for the term of 12 months (12M) in 2010 was 13.3 percent. In other words, on average the market expected the euro to remain within plus or minus 13.3 percent of its then current price in a year’s time. The 13.3 percent figure was, in fact, exceedingly high compared to the average of 10.6 percent for the 2000-2009 annual periods. One can certainly understand why market expectations for big movements were so high given the huge swings that were seen during the course of the year. Peaks and troughs were 1.4580 to 1.1877 to 1.4250 to 1.2970 to 1.3500, and now down to 1.2900 this Monday morning. The market is increasingly nervous — 12-month implied volatility for EUR:USD currently stands at 14.30 percent!
OPEN: $1.6175, CLOSE: $1.5610 – a change of 3.6 percent; the average annual change for 2000-2009 was 10.2 percent
HIGH: $1.6175, LOW: $1.4230 – a range of 13.8 percent; the average annual range for 2000-2009 was 18.2 percent
Implied Volatility (12M): 13.2 percent compared to 10.5 percent for 2000-2009.
Here we can see, that although the change in the year’s opening to closing rates was relatively small, at 3.6 percent and the high/low range for the year a relatively narrow 13.8 percent, the GBP:USD rate during the year — as it was with the EUR:USD — was in fact very volatile. Even more importantly, the market expected such excessive volatility to continue, as indicated by the relatively high implied volatility prices. The 12-month implied volatility for GBP:USD currently stands at 12.40 percent.
OPEN: 93.00 , CLOSE: 81.10 – a change of 12.8 percent; the average annual change for 2000-2009 was 9.4 percent
HIGH: 95.00 , LOW: 80.22 – a range of 16.0 percent; the average annual range for 2000-2009 was 15.2 percent
Implied Volatility (12M): 13.4 percent compared to 10.6 percent for 2000-2009.
The Open–to-Close change of 12.8 percent in 2010 was huge from both a historical perspective and compared to the Open–to-Close changes in 2010 for both the EUR:USD and the GBP:USD. The 12-month implied volatility for USD:JPY currently stands at 13.0 percent.
The global financial markets in 2010 provided excitement and opportunity for investors and traders, a challenge for multinational corporations, a headache for central banks, fodder for the media and a platform for politicians. I see the markets’ ability to provide all this as part of a trend that has been in place since the turn of the century. The trend has been fueled collectively by increased globalization, the Internet, an expanding variety of market instruments/indices/services, massive amounts of government-provided liquidity, and changes in social mood both here and abroad (to be expanded upon in a later article). There is little doubt in my eyes that this trend will continue for years to come. In other words, more tumultuous times in the financial markets await us all.
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