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Below is summary of January’s FX Market Voice publication from Ron Leven, Proposition Manager, FX Pre-Trade Strategist at Thomson Reuters. He discusses volatility in the January issue of The Market Voice. To access the full publication click here (PDF).
A Happier New Year for Volatility
BEGINNING OF THE END OR END OF THE BEGINNING?
Implied volatility surged for currencies in 2014 and is also higher for stocks and fixed income. There is a long-term relationship for volatility in these three markets with fixed income market (10-year U.S. Treasury note) providing a base for currency volatility while equity (SPX) volatility serves as a cap. But it is not clear whether the turn of the year represents the beginning of the end of historic low volatility or the end of the beginning of an upturn in vol. There were exceptional events in 2014 that contributed to the surge in volatility. Just a partial list would include: October’s plunge in stock prices; the Russian invasion of Ukraine; the oil price collapse and renewed concerns about the euro and today’s abandonment of the Swiss National Bank’s Euro floor for the Swiss franc.
While these events contributed to higher volatility, we believe there are fundamental reasons for the rise. Quantitative easing (QE) and the tendency for zero rates across the G10 were both broadly bearish for volatility. QE is bearish bond volatility as it traps rates between zero and a declining central bank-imposed ceiling. The connection of QE with equity volatility is more subtle but still substantial. The Fed’s commitment to QE implied they were trying to avoid a major decline in stock prices – the “Bernanke” put – a price stabilizer. Foreign exchange volatility also specifically suffered from the convergence of interest rates. Narrow rate spreads deterred investors from moving capital across borders in search of higher yield, diminishing currency volatility.
The market consensus is for a gradual U.S. economic recovery allowing the Fed to start raising rates around the middle of the year. While the market is pricing for a more restrictive Fed, rates abroad are still falling and divergent rates is a scenario for higher foreign exchange vol. The end of QE also means, by definition, that the Fed is no longer resisting higher long-term rates which should create more room for volatility in the bond market. Equity market volatility should also firm as evidenced by the October sell-off in response to a more hawkish stance by the Fed.
The priced-in scenario suggests the volatility pickup should persist in the first half of this year. Deviations from this scenario should actually lead to yet higher volatility, at least temporarily. Stronger U.S. growth and a more aggressive Fed would accentuate the volatility-positive trends. But even if U.S. growth disappoints and the Fed fails to hike, this too should temporarily push up volatility as the market re-prices. But in the long run, weaker U.S. growth and a Fed on hold would point to an eventual resumption of volatility doldrums.
Ron Leven is the head of FX Pre-Trade and Economic Strategy at Thomson Reuters. Ron joined Thomson Reuters in January 2014 with over 25 years of FX investment strategy experience on both the buy- and sell-side firms, most recently as head of FX derivatives strategy at Morgan Stanley. Ron earned a PhD in Economics from Rice University and is a Columbia University Adjunct Professor teaching courses on emerging market investments.