BofA Recommends Selective Currency Volatility Trades Ahead of Potential Fed Hikes

Investors anticipating a resumption of Federal Reserve rate hikes should focus on selective currency pairs rather than buying broad foreign exchange volatility, according to a new analysis from Bank of America. The bank's research indicates that a targeted approach may be more effective than a general G10 volatility strategy in the period surrounding a potential rate increase.

Implied vs. Realized Volatility

BofA's analysis of past Fed hiking cycles reveals a divergence between market expectations and actual price movements. The bank found that implied volatility—the market's forecast of future price swings—tends to rise selectively in certain currency pairs during the 21 business days before a rate hike and the five business days after.

However, realized volatility, or the actual price movement that occurs, has been more mixed across the G10 currency universe during these same periods. According to BofA, this pattern suggests the market often prices in the risk of a Fed hike more consistently than significant volatility materializes across all major currencies.

Criteria for Volatility Plays

Based on its findings, the bank identified three key conditions for traders to consider when selecting currency pairs for volatility trades around potential Fed hikes:

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• Implied volatility should not have already moved to excessive levels.
• The currency pair should have a historical sensitivity, in terms of realized volatility, to Fed hiking events.
• The connection between interest rates and the exchange rate should be clear and well-defined.

Opportunities in Yen and Sterling

Bank of America highlighted two currency groups that currently appear attractive for long volatility positions. Japanese yen crosses were noted as strong candidates due to their sensitivity to funding conditions and interest rate differentials. The bank cautioned that trades should be based on the specific gap between implied and realized volatility, not a general bias.

Pairs involving the British pound also present a compelling case, according to the report. BofA stated that both implied and realized volatility have historically risen in major sterling crosses during past hiking events, supporting a long volatility stance ahead of the next Federal Open Market Committee (FOMC) meeting.