An FX Volatility Explosion May Be Lurking Around the Corner
(Bloomberg) -- There is a complacency haunting foreign-exchange markets.
Measures of how much traders expect currencies to gyrate over the coming months have plunged amid apparent assurances from central banks that they aren’t going to create major waves with further policy normalization anytime soon. But some observers, including strategists at Canadian Imperial Bank of Commerce, Morgan Stanley and Scotiabank are raising warning flags about the lack of volatility.
While the Federal Reserve has made clear that global risks warrant holding interest-rates steady, a rebound in growth in the second half of 2019 could well put increases back on the radar. Likewise, some warn against writing off entirely the prospect of additional normalization steps from the European Central Bank. Yet the situation being priced by the market is about as calm as it’s been in years. A JPMorgan Chase & Co. gauge of global currency swings on Thursday fell to around 6.2 percent, its lowest close since 2014 and down from more than 9.3 percent in January.
“As we start to move into the middle and second half of the year, markets will need to reassess their assumptions,” Jeremy Stretch, head of Group-of-10 currency strategy at CIBC in London, said on Bloomberg radio. “That may well bring forth a degree of volatility back into the market as investors are forced to reprice interest-rate cycles from the very benign scenarios they’ve been looking for.”
That lack of commotion has been evident not just in currencies, but has also been notable across asset classes. The Cboe Volatility Index -- a gauge of Wall Street stock-market movement more commonly known as the VIX -- has tumbled by around two-thirds from the level it was at in late December. And in the U.S. government bond market, Bank of America Corp.’s MOVE Index last month touched a record low.
Andrew Sheets, a strategist at Morgan Stanley, has warned that the current low turbulence environment can’t persist across asset classes, while John Normand, JPMorgan’s head of cross-asset fundamental strategy, called volatility “the least-loved market.”
“These multi-quarter undershoots are common during Fed pauses and typically require a rates rethink or geopolitical shock to revive,” Normand wrote in a note on Friday.
Implied volatility in the world’s most-traded currency pair has plunged this year, with the 12-month measure in euro-dollar falling to its lowest level since July 2014 last week. The exchange rate has closed in a $1.1250-$1.1450 range 75 percent of the time in 2019, according to UBS Group AG.
“As is often the case, range trading can mask an underlying build-up of pressures that get released eventually,” said Themos Fiotakis, head of currency and rates strategy at UBS. He predicts the euro will climb to $1.20 by the end the year.
The shift in stance by major central banks in the past few months does give a better backdrop for risk assets, according to Scotiabank strategists Shaun Osborne and Eric Theoret. But with liquidity low and complacency potentially edging higher, “a blow up in volatility is perhaps lurking around the corner,” they wrote in a note Monday.
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