You may already know this – but a favorite rogue economist of mine is Hyman Minsky. He’s one of the only Keynesian economists I find worthwhile.

And that’s because he came up with the Financial Instability Hypothesis (FIH) – formally known as the ‘Minsky Moment’.

So – what’s special about Minsky and his FIH?

It’s actually very simple – it’s the concept that low volatility breeds high volatility (and vice versa).

It works like this – when there’s long periods of calm, investors feel secure and safe (complacent). Thus they begin taking on more and more risk as the crowd becomes ‘risk tolerant’.

But eventually – this complacency and added risk taking by the crowd piles up. And eventually things sour. It could be due to an external event like 9/11 or a big bankruptcy or even the Fed hiking rates.

Or it could be because of an internal event – such as the market’s attitude towards the future changing or prices have just become too ‘bubbly’.

Whatever the cause – either external or internal – a ‘tipping point’ is reached.

The once risk hungry investors rush to liquidate and get out with what they can – sending markets spiraling down.

Now – suddenly – investors are consumed by fear and pessimism – meaning they’re ‘risk averse’ (i.e. avoid risk taking).

This ‘rubber-band snap’ of investors shifting from risk tolerance to risk aversion is the Minsky Moment. . .

(Eventually the cycle repeats in the opposite way i.e. the risk aversion causes prices to sink and investors will soon feel that the sky’s stopped falling. Then they’ll begin slowing adding more and more risk – feeling greater confidence. Repeating the cycle).

So – just remember – the key takeaway here about the FIH is: long periods of low volatility are the seeds for future high volatility (and vice versa).

Why does all this matter? Because the foreign exchange market – excluding the British Pound – has an implied volatility level (the estimated volatility) near its all-time low. . .

Meaning that there’s very low expected volatility in the currency markets because investors are complacent.

This trend’s reinforced because there are expectations that the European Central Bank (ECB) and Bank of Japan (BOJ) will continue easing – this gives investors the notion that the Euro and Yen will stay weaker relative to the USD.

(Not to mention the problems in Australia and Canada are putting pressure on their currencies as well).

Therefore – all this makes the U.S. dollar look like the best option as investors continue to bet against foreign currencies and buy the USD.

This means that investors are selling volatility insurance for pennies in return because they expect low volatility ahead. I view this as negatively asymmetric (high risk – low reward).

Or how Nassim Taleb would put it – they’re busy picking up loose change in front of a steam roller.

This is a good opportunity to take advantage of complacent and risk tolerant investors – just like Minsky hypothesized – and go long Forex volatility. . .

Keep in mind that levels of volatility this low (especially in currency markets) don’t tend to hold for long.

Just look at the chart above – the low volatility periods are followed by sharp spikes of high volatility.

Eventually the narrative will change (the market’s perception) and volatility will spike as investors re-price the new implied volatility.

For example – maybe there will be an external event – such as the Fed coming out and easing sooner and more aggressive than many expect. (Which will put pressure on the USD).

Or maybe an internal event – such as investors changing their volatility expectations on their own and demanding higher premiums.

Honestly – who knows?

The point is – instead of wasting time on guessing the potential internal or external events – we should remember Minsky’s FIH and seize the opportunity the market presents.

And currently – I believe long Forex volatility gives investors the positive asymmetry (low risk – high reward) I like.

So – to summarize – the excessive complacency and low volatility in the Forex market gives me the impression that there’ll be a burst of volatility.

And sooner than later.

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