Comparable to the 2008 financial crisis and the 2020 pandemic storm! This indicator indicates that emerging market currencies may face a short-term huge shock.

A key option pricing indicator shows that as tensions in the Middle East continue to escalate, traders are preparing for further weakness in emerging market currencies in the next month. The emerging market currency index tracked by JPMorgan has seen a significant increase in its 1-month risk reversal indicator (used to measure the cost of downside protection relative to upside returns in derivatives). The market is increasingly concerned that prolonged conflict will continue to push oil prices higher. Currently, the indicator is higher than the 1-year contract, a rare phenomenon where short-term option protection costs are higher than long-term. The extent of this inversion has led to the spread between 1-month and 1-year risk reversals (the difference in short-term and long-term downside protection costs) reaching the highest level since the global market sell-off triggered by the COVID-19 pandemic in 2020. Historically, such inversions often coincide with severe market disruptions, including the 2008 financial crisis and the March 2020 pandemic storm. Part of the reason is that energy importers and other companies affected by trade uncertainties usually focus their hedging needs on short-term instruments. Nicholas Wall, Global Head of FX Strategy at JPMorgan Asset Management, stated: "Like in 2008 and 2020, the market is pricing in intense short-term risks, and the market may optimistically believe that this risk is only temporary." He added that in such situations, funds usually focus on 1-3 month forward contracts because "investors are adding protection for short-term dramatic fluctuations." In this volatile background, investors are forced to reassess their optimistic expectations for emerging markets. This asset class was highly favored at the beginning of the year, but since March, both the stock and bond markets have experienced sell-offs, with the MSCI Emerging Markets Currency Index falling by about 1.5%, ending three consecutive months of gains. Implied volatility for various emerging market currencies against the US dollar has spiked significantly. Although recent events have shattered the long-term tranquility of emerging market currencies, long-term options have not yet reflected the expectation of sustained macroeconomic volatility, with the 1-year risk reversal still far below the 2022 levels. This may be because investors are used to anticipating the mean reversion of spot prices - that is, that extreme volatility will eventually fade with time. Sagar Sambrani, Senior FX Options Trader at Nomura International in London, stated: "Based on implied volatility and skew curves, the market seems more optimistic about the risk sentiment for the remaining of the year." He believes that this round of extreme volatility is partly due to the US dollar short positions held by investors before the outbreak of the conflict. These short positions are mainly betting against currencies like the Korean won, South African rand, Mexican peso, causing larger scale liquidations in markets with relatively low liquidity. The current risk lies in the continued rise in oil prices to near $100 per barrel, which will trigger a Value at Risk (VaR) shock in portfolios - where market volatility leads investors to exceed their risk value limits, even if they still have positive trading logic, they are forced to reduce positions. Sambrani stated: "Unlike in 2008 and 2020, we have not yet seen multiple asset classes facing consecutive days of VaR shocks. But as more countries become involved in escalated tensions in the Middle East, the market remains vigilant against contagion effects."