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Bank of America: "The Sleeping Giant Has Awoken"

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In addition to the surge in equity volume in the first quarter as a result of sharp repricing higher in equity vol which helped US banks post record equity trading revenues, there was another sharp pick up in trading last quarter: FX trading volumes rose to a record high in the first three months of the year according to CLS data, as the rise in volatility from multi-year lows encouraged more buying and selling of currencies. Or, as Bank of America put it, "the sleeping giant has awoken."

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In a note from BofA's Vadim Iaralov, the FX strategist writes that after hibernating for most of last year, the FX market has awoken in 1Q18, and interbank FX volumes have picked up for the first time after hitting bottom in 4Q.

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Additionally, major currencies such as EUR, CNH, RUB have increased volume by more than 17%, 54%, 20% respectively vs 1Q17, despite rising geopolitical risk and fickle risk sentiment. The biggest gainers in EM were THB, CNH, and RUB, while EUR, NZD and AUD have picked up in G10 space.

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According to data from CLS, major settler of trades in the foreign exchange market, the average daily traded FX volumes submitted to it reached $1.87 trillion between January and March, surpassing a previous high of $1.67 trillion in the first quarter of 2013. Daily volumes in March reached $1.855 trillion, down 4.8% on February but up on a year earlier.  In addition to volatility, CLS attributed the rise in volumes to a trend of more buy-side firms like asset managers using its services.

As Reuters adds, average daily volumes of spot and derivatives currency trading touched $461 billion in March, slightly lower than the record month of February when volumes hit $463 billion. NEX Group, which owns another big FX trading platform, saw average daily foreign exchange spot trading volumes rise 7% to $92.7 billion in March from the previous year.

The rise in FX volumes will be welcomed by trading platforms and banks that have struggled with calm financial markets squeezing their profits in recent years. They have central banks to thank: “FX markets are in a wait-and-see mode,” Thu Lan, an FX analyst at Commerzbank in Frankfurt said. “Everyone is  waiting to see the first (monetary policy) normalization steps from central banks.”

Still, in an apparent paradox, the surge in FX volumes has not translated into either higher profit, easier trading or clearer currency trends.  In fact, as BofA notes, and as FX traders know too well, major currencies such as EUR have stayed in a tight range with falling volatility as volumes rose, while AUD broke out of its range on average volumes. In other words, "spot movement and trade volumes are increasingly diverging."

To decipher this puzzle, the bank conducted an analysis of spot movement based on its internal measurements and interbank volume data; it showed that flows have become more important than ever in a market lacking a clear fundamental theme. More surprisingly - and a nightmare for all momentum traders - order flow reversed direction every few days for EUR pairs as it stayed range-bound. At the same time, AUD broke out of its range under pressure of directional selling flows when equities fell.

Some more details from BofA:

Flows are becoming more important than before. We measure flow direction by aggregating monthly net order flow as the difference between buyer-initiated trades and seller-initial trades by value using a Tick History database of all trades on Reuters interbank platform since April 2006. We aim to disentangle buy and sell orders to capture the nature of supply and demand over time and test the intuition that a strong directional order flow drives currency movements.

We regress monthly spot log-returns on net order flow and find out that order flow has becoming increasingly important as a driver of spot movement. The adjust R2 has increased to a historical high in recent months for major currencies (USD goes with the flow).This trend is especially evident for ZAR, CAD, TRY and AUD (Chart 3).

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Spot movement and trade volumes are increasingly diverging. EUR stayed in a tight range with falling volatility despite rising volumes, while AUD broke out of its range on average volumes. In our view, the difference lies in the directionality and persistence of their flows.

To measure the directionality of the flow, we average the duration of the longest uptrend and downtrend. We define the main trend as the largest consecutive streak of flows in one direction in the last 90 days. Our analysis shows the AUD flows persisted for an average of 8.5 days above its long-term average of 5.5 (Chart 4), while EUR flows have persisted for only 4.7 days below its average of 6 days (Chart 5).

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In more recent developments, according to BofA's (partial) data there is broad evidence of USD selling vs EM that has yet to translate to corresponding currency movements. Using the historical regression for each currency and the partial order flow to date suggests the spot to play catch up for JPY and CNH. Meanwhile, USD was bought vs EUR, perhaps as evidence of repatriation and we expect EUR/USD to fall by up to 2%.

In the case of USD/RUB, there were actually more sellers than buyers especially on 10 April, which marked the high. While we do not expect RUB to unwind 7% as fundamentals have changed, it is a bearish signal to see net sellers come in at the new high (Chart 6).

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The surge in volumes - with or without associated spot moves - may note last: so far April has been a quiet month in FX, with currencies generally shrugging off rising geopolitical tensions, concerns about a possible U.S.-China trade war and the prospect a global economic growth boom is nearing its peak; in fact, in a redux of 2017, most currency pairs are once again stuck in narrow price ranges, as if central banks had to put down their "no volatility" fist.

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