BofA sees selective currency volatility plays ahead of Fed hikes

Investing.com -- Bank of America said investors should focus on specific currency pairs rather than buying broad foreign exchange volatility if the Federal Reserve resumes raising interest rates.

The bank's analysis of past Fed hiking cycles shows that implied volatility tends to rise selectively in certain currency pairs during the 21 business days before a rate hike and five business days after. Realized volatility during these periods has been more mixed across the G10 currency universe.

BofA said the market often prices in the risk of Fed rate hikes more consistently than actual volatility materializes across all major currencies. This pattern suggests that selective positioning in specific currency pairs may be more effective than broad exposure to G10 foreign exchange volatility.

The bank identified three conditions for choosing volatility trades around potential Fed hikes: implied volatility should not have moved too far already, the currency pair should have historically shown realized volatility sensitivity around hiking events, and the connection between interest rates and the exchange rate should be clear.

Japanese yen crosses remain candidates for long volatility positions due to their sensitivity to funding conditions and interest rates, BofA said. The bank added that implementation should be based on the gap between implied and realized volatility rather than a general preference for yen-cross volatility.

British pound pairs also appear attractive, according to the bank. Both implied and realized volatility have risen in past hiking events across major pound crosses, supporting a long volatility position in sterling ahead of the next Federal Open Market Committee meeting.

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