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

A key options pricing indicator shows that as the situation in the Middle East continues to escalate, traders are bracing for further weakness in emerging-market currencies over the coming month.

An emerging-market currency index tracked by JPMorgan, its 1-month risk reversal indicator (a derivative used to gauge the cost of protection against downside currency moves relative to the payoff from upside moves) has surged sharply in recent days. The market is growing increasingly concerned that a prolonged conflict will keep pushing oil prices higher. The indicator is currently above the level of 1-year contracts—an inversion in which the cost of short-dated option protection exceeds that of longer-dated protection is extremely rare.

The depth of this inversion has widened the spread between 1-month and 1-year risk reversals (the difference between the short-term and long-term downside protection costs) to the highest level since the widespread selloff in global markets triggered by the 2020 COVID-19 pandemic.

Based on historical experience, such inversions often coincide with sharp market volatility shocks, including the 2008 financial crisis and the March 2020 pandemic turmoil. Part of the reason is that energy importers and other companies affected by trade uncertainty typically concentrate their hedging demand in short-dated products.

Nicholas Wall, global head of FX strategy at JPMorgan Asset Management, said: “As in 2008 and 2020, the market is pricing in a period of sharply elevated short-term risk, and markets may be feeling optimistic that this risk is only temporary.”

He added that in such market conditions, capital usually concentrates in 1- to 3-month tenors, because “investors are adding protection for the short-term bouts of intense volatility.”

Against this volatility backdrop, the situation is forcing investors to reassess their optimistic expectations for emerging markets. Early this year, the asset class was highly favored, but since March, stocks and bonds have been hit by selling; the MSCI Emerging Market Currency Index has fallen by about 1.5%, ending three straight months of gains. Implied volatilities (a measure of expected volatility) for multiple emerging currencies versus the U.S. dollar have jumped sharply.

Even though recent events have disrupted the long-standing calm in emerging currencies, long-dated options have not yet priced in expectations that macro volatility will continue to escalate, and the 1-year risk reversal remains far below the 2022 level.

That may be because investors have become accustomed to expecting spot prices to revert to their mean—that is, volatility will eventually fade over time.

Sagar Sambrani, a senior FX options trader at Nomura International in London, said: “From the standpoint of implied volatility and the skew curve, the market appears more optimistic about risk sentiment for the remaining part of this year.”

He believes that part of the extreme volatility this time stems from U.S. dollar short positions held by investors prior to the outbreak of the conflict. These shorts were mainly bets on currencies such as the South Korean won, the South African rand, and the Mexican peso, and they triggered larger-scale cover in markets where liquidity is relatively thin.

The current risk is that if oil prices continue to rise at around the $100 per barrel level, it will trigger a value-at-risk (VaR) shock to portfolios—that is, when markets experience sharp volatility, investors breach the VaR limit; even if they still like the underlying trading rationale, they are forced to cut positions.

Sambrani said: “Unlike in 2008 and 2020, there hasn’t yet been a situation where multiple asset classes suffer VaR shocks for multiple consecutive days. But as more and more countries get drawn into the escalation of the situation in the Middle East, the market is staying alert to the risk of contagion.”