FX market to look for new catalysts

Currency volatility is very low.

Implied volatility in the G10 currencies space is around levels only seen twice before (in early 2020 and mid-2007). On both occasions, this slump in volatility was ended by shocks: Covid-19 and the global financial crisis. But is there anything looming on the horizon to break the impasse now?

Fed policy could be going to do it. For a start, Covid-19 and the global financial crisis were both unexpected shocks. Fed policy does not count as a shock, even if the Bank were to deviate slightly from the path that the market currently assumes. More likely the Fed will remain very predictable and transparent as it seeks to exit the very accommodative monetary policy setting without causing undue market or economic stress. Other central banks are not quite as pinned down as the Fed when it comes to making future policy moves as predictable as possible. The Bank of England, for instance, could easily cause a surprise. But the problem is that policy surprises here, or from any other non-Fed central bank are not going to be sufficient to break the FX market out of its lethargy.

The path of economic data, and particularly price data, could possibly offer up a route to higher volatility. For instance, persistently high inflation that starts to leave central banks such as the Fed behind the curve could cause some currency ructions. But even here, Mr. Steve Barrow, Head of Standard Bank G10 Strategy doubts that there’s much scope for huge currency volatility. For a start, inflationary strains are being felt almost everywhere given that the cause of the pressure is shared. Supply chain pressures and higher commodity prices represent a global threat of higher inflation and even if countries differ a bit in their susceptibility because of things like their commodity dependence or labour market position, there’s not enough discrepancy here to suggest to us that currencies will move too far. The bond market, of course, could be a different kettle of fish altogether but, for currencies, stability seems likely to persist even if central banks fall behind the inflation curve.

Political factors could create the shocks required to take currency volatility away from its comfort zone but, as we see things, it is unlikely right now. Yes, there are key elections in Germany and Japan soon and a change in government is certainly possible in the former, if not the latter. But these sorts of political upsets don’t usually cause volatility to soar. The last time we saw a volatility shock on an election was Trump’s win in 2016. That was because he was the underdog and because he had a radical agenda of tax cuts in the corporate sector that galvanised the stock market. Looking towards Germany and Japan we see no such shifts looming.

So, does all this mean that we are destined to see volatility slide some more – to hit even more record lows? Mr. Steve Barrow said that he is not so sure. For a start, as he has argued previously, central bank monetary largesse lowers volatility because it acts a bit like an anaesthetic. High liquidity drives returns down, as we see most clearly in the bond market. In the FX options market, the ‘return’ is the premium earned by the seller of the option and this is primarily a function of implied volatility. Hence, liquidity pressure for lower returns means pressure for lower volatility. But we know that central banks are slowly starting to turn; some are raising rates and some are scaling back bond purchases – with the Fed likely to begin fairly soon. Hence, the pressure for lower vols may abate from this source but it will probably still take quite a significant shock to really push vols back up significantly. “We can’t tell if such a shock is coming but we do feel that there are factors around that could stir things up, such as financial strains in China and the scope for policy mistakes as central banks try to deal with a problem most have not had to deal with for the best part of 30 years: inflation”, Mr. Steve Barrow stressed.