DOW JONES NEWSWIRE FOREX VIEW: Markets Eye Prolonged Volatility Slump November 1, 2006 By Isabelle Lindenmayer NEW YORK (Dow Jones)--While the word volatility has been known to carry a negative connotation, for traders and investors with a short-term view, volatility pays the bills. Which is why the recent drop in volatility to all-time lows in many of the major currencies has disappointed investors who had hoped market swings would pick up after a summer of narrow range-trading. "Low volatility has frustrated currency portfolio managers in recent months and has led to difficulties extracting," profit, analysts at Merrill Lynch said in a recent note to clients. Indeed, one-month euro-dollar volatilities have hit record lows while one-month dollar-yen volatilities have fallen to near 10-year lows. Similarly, 3-month implied volatilities in dollar-yen hit 6.82% in early October, the lowest level in ten years. For traders and short-term investors, volatility is key to garnering returns in the $1.9 trillion-a-day currency markets, as price swings allow them to make quick profits on positions. In first months of the year, currencies saw some sharp movements, but over the summer, trading stuck to tight ranges, and though ranges have widened a bit as the end of the year approaches, volatility has declined as liquidity remains ample and investors chase yields. Volatility Dwindles Volatility's slow grind lower has been awhile in the making, reflecting some longer-term market trends, which include the availability of more information to all market participants, computer-generated - so-called blackbox - trading programs, and a more transparent Federal Reserve. "When information is much more evenly and widely spread, and the knowledge of past behavior is much more widely known, everyone has a more balanced view of what is or is not likely to happen," Joseph Trevisani, chief market analyst at electronic currency trading platform FX Solutions said. "Those factors are what are driving the overall drop in volatility over the past fifteen years." Lower volatility has in turn come hand-in-hand with unusually tight range-trading for the five major currencies. Whereas Tuesday's disappointing Chicago PMI data and consumer confidence report caused a roughly 50 basis point drop in the dollar for example, according to Trevisani the market would have seen a 250 basis point drop just a few years ago. The Fed's relatively new chairman, Ben Bernanke, has also played a role in smoothing markets, analysts say, thanks largely to his actions to improve the transparency of the central bank's decision-making process. "His approach has drained some of the speculative opportunities from the market," Trevisani said. Blackbox trading programs - computerized systems which automatically execute trades based on an algorithm, or mathematical formula - have also leveled the currency trading field, analysts say. A black box trader generally develops a proprietary model through historical analysis of trading patterns and applies the model to a computer program that generates buys and sells in the market. The quantitative approach takes emotion out of the trading equation and operates on a 24-hour basis. In addition, reaction time following data releases can often be diminished when using the blackbox system. "You're seeing many more arbitrage programs in the foreign exchange market," Trevisani said referring to such automatic programs which simultaneously purchase a currency in one market for immediate resale in another market to profit from a price discrepancy. "That will inevitably smooth out the market place," he added. Finally, in a market obsessed with statistics - largely because the Fed has made such an effort to emphasize its data-dependent approach - investors are analyzing every first, second and third tier data release. But "because there are so many more statistics, each statistic is not going to get as much speculative interest," as was given to fewer data releases in the past, Trevisani said. A Turn To Yield An environment of low volatility together with ample liquidity has inevitably caused investors to chase yield, investing in high-yielding currencies such as the Australian and New Zealand dollars and sterling. Yet such strategies are not without significant risk. Low volatility has led traders to increase the size of their dealing positions, analysts say, a dangerous proposition if volatility returns to the market. "This environment may weaken the incentives for disciplined management of currency risks," Marc Chandler, global head of foreign exchange at Brown Brothers Harriman noted. But "the cost of chasing currency moves may prove more expensive than maintaining the discipline in the first place." Indeed, among the bets that went wrong for hedge fund Vega Asset Management - which was hit by wrong-way bets in currency and government bond markets - was one that the yen would appreciate against the euro, when in reality, the euro rallied sharply against the yen. Volatility's Lethargy To Stay There is currently little evidence that the recent period of dampened volatility is near its end. "Volatilities remain low and we don't see any clear sign that things will pick up just yet," Steve Barrow, chief currency strategist at Bear Sterns in London said. "Liquidity remains ample which we think is driving down returns - including volatilities - and, with the Fed likely to hold rates this year, rather than hike in December, as we had expected, liquidity looks set to stay ample." Indeed, the risk of a rate cut by the Fed, which would lift liquidity more, would depress volatility even further, Barrow noted."