One of the biggest challenges in the foreign exchange markets in the recent period has been the relentless decline in volatility across the world’s leading currencies. However, as the global economy slowly emerges from crisis mode, some investors believe the first signs of renewed volatility might be appearing. The fall in currency volatility, which started in the mid-1980s with the Great Moderation of business cycle fluctuations, has gathered pace amid historically low interest rates, central bank balance-sheet expansions and a decline in hedging activity among global corporates.
One-year implied volatility on EUR/USD hovered at around 15% at the beginning of 2012, but fell to below 10% by the end of the year, a move reflected across most leading currency pairs. Whereas 30-day volatility on as basket of leading currencies spiked to around 30% in 2009, its long-term trend has been lower, and at the end of last year hovered at around 7%, according to Bloomberg data.
For investors, the decline in volatility has become somewhat of a self-fulfilling prophecy, deterring demand for FX options, which in turn has driven speculative activity ever lower. Amid slow growth, meanwhile, the motivation for exporters to hedge has diminished because of concern that order books will not be filled.
At the heart of the global decline in volatility has been the action of central banks, which in the western world have cut interest rates to historical lows, dampening international carry trade flows. In emerging markets, and particularly Asia, central banks have seen large increases in currency reserves, which have been used to suppress local currency volatility through trading on spot markets.
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| Source: IMF |
“If you have a situation where rates are the same around the world, there is nothing to attract capital from one market to another, and that is significantly reducing trading volumes,” said Andy Woolmer, a partner at currency manager P/E Global LLP. “We are going to need to see a return to interest rate differentials, and for that to happen what we need first is growth.”
Another issue for currency traders is that there has emerged a seeming consensus over estimates of fair value, particularly among G10 currency pairs. There have been numerous pieces of research during the past year putting the fair value of the euro against the dollar at around 1.30 to 1.35. The euro started 2012 at around 1.30 against the dollar and ended it at 1.32, a period of stability interrupted only by a brief dip at the height of concerns over the eurozone sovereign debt crisis in August.
“We need the real world to change to make money, which means changes in underlying economies, which will lead to higher volatility in the United States, Europe and Japan,” said Patrik Safvenblad, investment partner at London-based macro strategy fund Harmonic Capital. “It’s not clear yet that any of those economies are picking up but for us it’s probably all predicated on the dollar starting to move.”
The IMF, in its Global Economic Outlook published in October, did not see any swift return to the higher levels of economy activity that might lead to differentials in monetary tightening. Instead it highlighted the promise of the US Federal Reserve to retain its low-rate guidance until mid-2015, amid fragile economic and financial conditions, and pointed to moderating inflationary pressures around the globe.
However, those hoping for a rebound in volatility might in recent weeks have received some encouragement. The Japanese yen, which many investors believe is one of the world’s most overvalued currencies, fell to its lowest level against the dollar in more than two years in late December, and has declined 8% since mid-November.
The moves in the yen came before and after the election in December of new prime minister Shinzo Abe, who has vowed to boost inflation in the moribund Japanese economy, raising speculation that the Bank of Japan will look to weaken the currency in 2013.
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| Corominas, Record |
“The key question from a volatility point of view is whether we will we see a sharp move in the yen or just a steady depreciation," said Javier Corominas, head of economic research and FX strategy at currency manager Record. Meanwhile, after a subdued economic performance in 2012, growth is expected to pick up in Asia in 2013, according to the IMF, offering some potential upside for currency carry trades.
A slightly contrarian view is that the US might remain a potential source of volatility, if it fails to resolve its lingering fiscal issues.
“Demand is waning for longer-dated US bonds, suggesting there is still some concern that the US has not resolved its problems but rather kicked the can down the road,” said David Rodríguez, a quantitative strategist at DailyFX, the research arm of FXCM. “If we see a loss of faith in dollar-denominated assets, then there is definitely potential for a spike in volatility in the currency.”