For macro hedge fund traders, the prospect of a tap on the shoulder from the boss has loomed all year.
Short rates vol strategies have blown up in spectacular fashion: at the start of the Iran war in March; around the time of US Federal Reserve chair Kevin Warsh’s comments in August; and after the surprise hawkish rates outlook from the European central bank in September.
For many traders, the most recent implosion triggered an instruction to move on. Some estimate that upwards of 70, and perhaps more than a hundred, portfolio managers have been let go in recent weeks.
Soured foreign exchange bets are now adding to the misery.
Take the Brazilian real. The second round of the country’s presidential election was meant to be an easy win for Flavio Bolsonaro based on the results of the previous round. Polymarket gave Bolsonaro a 75% chance of victory. Traders saw this as positive for the currency.
Looking ahead, the macro calendar could further unsettle markets
FX options dealers reckon 95% of trades were positioned for a stronger real, mostly through limited loss structures such as put spreads, digitals and risk reversals.
But the shock re-election of Luiz Inácio Lula da Silva sent US dollar/Brazilian real spot surging 12% in the opposite direction – from around 4.95 to almost 5.60 when the domestic market opened on Monday, October 26.
Even hedge funds that had traded call spreads – for instance, buying a call option with a 5.20 strike and selling a 5.25 call – saw spot trade through these levels by a significant amount.
One trader at a large US bank likened the move to 2016, when the election of Donald Trump saw the Mexican peso plunge 12% overnight and trading spike to 63 times normal levels.
In USD/BRL, dealers report that when the market opened, most activity involved stop-outs and unwinds from hedge funds that had bet on the wrong candidate, adjusting short-term positions for USD/BRL higher.
CME Group’s Brazilian real futures hit a new daily volume record of 500,000 contracts with a notional value of $9.20, around two-and-a-half times the previous record set on September 28. CME says $2.5 billion was traded even before Brazilian markets opened at 9:20am eastern time.
According to the Depository Trust & Clearing Corporation’s Swaps Data Repository, more than $8.5 billion in vanilla USD/BRL FX options traded on October 26, with a further $13 billion added the following day.
Some believe the market absorbed the shock well. But if dealers were caught short USD/BRL or short gamma – that is, if they were over-hedged with sold options – the gap in spot at market open would have proved painful for them too.
Further shocks
Looking ahead, the macro calendar could further unsettle markets. The Bank of Japan will release its outlook report on October 30, while the mid-term US elections are around the corner and then the last Federal Open Market Committee meeting on December 8 could set the scene for its rate-setting policy going into 2027.
Barclays researchers said this week that FX volatility will likely increase because of dollar appreciation, increased interest rate volatility and cross-country dispersion.
A higher FX volatility regime may spell trouble for the carry trade – a strategy that, while more or less everything else has failed, has been a mainstay for macro funds.
Carry trades involve borrowing in lower-interest-rate currencies to buy those that offer higher rates, on the assumption that spot moves during the life of the trade will not erase gains made on the investment. These strategies are popular during a low-volatility environment.
According to Barclays, carry-to-volatility ratios dropped since the end of August for carry currencies such as Brazilian real, Colombian peso and Mexican peso. That’s to say, the trades are paying less for the risk investors are taking.
The Bloomberg FX emerging market carry index, which measures the cumulative total return of carry positions in eight emerging market currencies funded by short US dollar, has fallen from a high of 300.2 in early September to 289.6 as of October 29. Meanwhile, the US dollar index has risen from 98.6 to 102.8 over the same period. If it strengthens further, the unwind of these carry trades could be painful.
“In the current environment, we do not see value in chasing global carry trades, as EM FX spot values are likely to reprice,” the Barclays researchers state.
For traders, the question many will ask is: “Can it get any worse?” With that potential tap on the shoulder looming, the options for safe and reliable performance seem only to get narrower.