By Jamie McGeever

ORLANDO (Reuters) – The dramatic recent rise in interest rates volatility and repricing by central banks of their near-term policy paths has left a few people behind. Currency-trading hedge fund is one such victim.

Investors were caught off guard by policymakers in Brazil, Canada and Britain with their surprise rates decisions and guidance. The most obvious spillover is in leveraged foreign currency trading where interest rate differentials are driving speculators’ currency bets.

Hedge fund industry data provider HFR saw its benchmark currency index fall 4.37% in October. It was a record low for the past four-and-a half-years, and it is now at the lowest point since 2008 when it began.

It is one of the few in red among the nearly 40 benchmark indexes that HFR has across many asset classes and strategies.

HFR President Ken Heinz explains that all FX strategies and trading styles lost money in October. This includes momentum, value and volatility. The flattening U.S. yield curve also tightened funding availability for FX carry strategy.

The large-scale aggregate losses that October saw are not surprising, considering the relative calm of most currencies. Spot exchange rates and implied volatility were barely affected by this.

Analysts Morgan Stanley (NYSE) Describes equity and currency markets as a duck swimming. They glide serenely through the water while paddling fast below it. You can see the extreme swings of short-term rates in frenetic churn.

Their findings show that the intensity of large cross-asset trades over the last few weeks has been the greatest since 2011, despite the volatility experienced at the beginning of the COVID-19 Pandemic in February/April 2020.

Hedge funds don’t crave volatility, but they do so to seize on arbitrage and price mismatches. They can ride the rise of volatility and that’s considered good volatility. However, if it crashes, then that’s bad volatility.

“Traders want relative value and disconnections. However, what we have observed in the rate space is that some of these relationships are unusually strange. This reduces risk appetite,” Andrew Sheets is Morgan Stanley’s chief cross asset strategist.

Some of these oddities include flattening and even inversion at the extreme-short ends of certain rate curves. This can confuse funds that are looking to profit from short-term anomalies as well as bettors on long-term trends.

POLICY DIVERGENCE

Investors are often more worried about the long-term outlook in normal times than they are about the short-term. The same applies for everything: inflation, central bank policy, growth, political risk.

This helps to explain the term premium and risk premium of bond markets and why yield curves should be sloped upward.

These aren’t normal times. The global pandemic is unpredictable and there are no guidelines for policymakers. Investors will also need to be aware of the lack of clarity.

Some of the best-known macro hedge fund managers in the world were reported to have suffered enormous losses due to the collapse of their funds. This was reportedly caused by the sudden repricing of rates expectations and a burst central bank “miscommunication”.

The Reserve Bank of Australia made an abrupt decision not to enter the bond market. It also decided to cap 3-year yields at 0.1%.

Many central banks of emerging markets stepped up the pace on tightening, most prominently Brazil’s. This led to unpredictable and mixed currency swings. In Turkey, the central bank slashed rates 200 basis points.

Most alarming of all is the uncertainty around the Federal Reserve’s direction and make-up. The re-nomination of Chair Jerome Powell is not certain. Three resignations have opened up places on the institution’s rate-setting commission.

The implied volatility in the U.S. Treasury markets last week rose to its highest level since March 2013, while other key indicators of U.S. Dollar vol against major currencies as well as the measurement volatility are still anchored at recent lows.

JP Morgan’s FX strategy group believes that interest rate volatility will continue to drive currency markets through the remainder of this year.

They wrote that markets have a much lower faith in the central bank’s forward guidance and a higher willingness to price data surprises, thus making them more inclined to challenge central bank patience.

(By Jamie McGeever; Editing by Jacqueline Wong)