FX options are sending a volatility warning signal ahead of Friday's Bank of Japan decision, with volatility protection costs reaching their highest levels this year.

As the much-anticipated BoJ policy announcement approaches, implied volatility in USD/JPY is drawing significant attention. The measure, which gauges expectations for future volatility, can offer clues about potential foreign exchange reactions to major event risks such as central bank policy decisions.

Ahead of Friday's BoJ announcement, implied volatility trends have diverged across major currency pairs. While overnight expiry implied volatility rose broadly before the US Federal Reserve's policy announcement on Wednesday, it has since retreated. USD/JPY is the exception, with overnight expiry implied volatility rising further, reflecting heightened anticipation and uncertainty surrounding the BoJ decision.

Excluding the broader surge in FX options implied volatility during JPY intervention episodes in late July and early September, overnight USD/JPY implied volatility is at its highest level since the Fed's January meeting and the highest for any BoJ meeting in the past year.

Overnight USD/JPY implied volatility currently stands at 21.0, implying a premium, or break-even, of 136 JPY pips in either direction for a vanilla straddle. That compares with implied volatility of around 16.0, or 100 JPY pips, ahead of the recent Fed decision, highlighting a much higher perceived risk for sharp JPY volatility following the BoJ announcement.

The BoJ is expected to raise interest rates to a 31-year high of 1.25% on Friday. However, analysts caution that the widely anticipated move may not provide sufficient support for the JPY unless Governor Kazuo Ueda adopts a hawkish tone on future rate increases.

Intervention remains a risk after USD/JPY edged up to 156.42 following the Fed decision. Japan has since reaffirmed its commitment to orderly JPY moves through close communication with the US, after being questioned about the Fed's hike, which helped USD/JPY recover more of its early September decline from 160.00 to 152.89.

Elevated USD/JPY implied volatility suggests markets are bracing for a significant reaction to news from the BoJ. While a rate hike is widely expected, the key factor for traders may be the tone of Ueda's guidance on the policy path ahead.
Overnight expiry FXO implied volatility

(Richard Pace is a Reuters market analyst. The views expressed are his own)