Forex markets likely to languish in the doldrums
If you believe the options market, the world’s major currencies are going nowhere fast in 2024. A world of rapidly rerouted trade, political standoffs, pivotal elections, sparky inflation and widening growth gaps among Group of Seven (G7) nations — it might reasonably be seen as an ideal incubator for volatility in major currencies.
And yet, even as central banks hit inflection points in their swingeing interest rate hiking campaigns of the past two years, implied volatility of the major exchange rates has imploded.
Judged by Deutsche Bank’s currency VIX index, or CVIX, implied volatility of the world’s most-traded currency pairs plunged again in February to its lowest level since just before Russia invaded Ukraine.
It is now less than half the levels seen at the peak of the energy shock that followed — a jolt that forced monetary policymakers everywhere to scramble to contain the inflationary spur of soaring oil and natural gas prices.
Other measures tally with that. CME Group’s G5 currency volatility index FXVL has subsided to its lowest level since 2021 and within a whisker of prepandemic levels.
Three-month options prices for the dominant exchange rates of euro/dollar, dollar/yen and sterling/dollar, which together account for three-quarters of CVIX weightings, are all back to where they were at least as far back as the first quarter of 2022.
If you look further out, oneyear measures are higher — but only just. These have cratered to about half the peaks of 2022 and nosedived in February too.
There is still some “skew” embedded in these prices, with euro and sterling puts — options to sell these against the dollar over the coming year — remaining pricier than equivalent calls. But even these premiums, or risk reversals, have shrunk dramatically and are as close to zero as they have been since early 2022.
At its simplest, this just reflects a lack of demand to hedge against or speculate on potentially sharp currency swings over the rest of the year at least, or at least not via options. You could argue this represents a screaming buy. But few players are biting. If it were just nonchalance, it would be peculiar. The year ahead includes potentially seismic elections in the US and UK and a likely return of Bank of Japan interest rates to positive territory for the first time in eight years.
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It is tempting, to think it may have something to do with “geoeconomics”. Might a growing home bias among investors obviate the need to worry about currency swings? Or maybe there is less urgency among corporate treasurers now frantically reshoring business and rerouting supply chains closer to home. Yet, low currency volatility may suggest the flipside. It should tempt punters to overseas carry trades that seek out higher-yielding currencies without fear of being sideswiped by violent exchange rates — or even draw funds from expensive Wall Street stocks to bettervalued European or Tokyo bourses without taking a foreign exchange hit.
They are all circular arguments, depending on your take. But there is a more familiar culprit in the dock.
The dollar is still historically overvalued in most people’s eyes. Its DXY index remains more than one standard deviation above 20-year averages. And it won’t give up the ghost until the Federal Reserve (Fed) starts easing rates, which is something US central bank policymakers have spent most of the year pushing back and back.
The most surprising aspect is that the other central banks seem intent on matching the Fed in lockstep.
Markets are now convinced the Fed, European Central Bank (ECB) and Bank of England will hold off on cutting rates at least until late July, and then all take the plunge together in less than two weeks of scheduled meetings.
The upshot is little or no fodder in interest rate differentials for currency markets to feed off.
George Saravelos, head of foreign exchange research at Deutsche, says it is less about timing the first cuts and more assessing “terminal rates” of ensuing easing cycles. And he shows that even then it is hard to see any wedge between the Fed and ECB right now.
Short-dated interest rate futures out to 2027, for example, put the full extent of the Fed and ECB rate cut cycles within just 10 basis points (bps) of each other — about 170bps and 160bps of easing, respectively, in total.
Using real and nominal fiveyear rate spreads to illustrate that, Saravelos questions the setup as unrealistic. Adding that a pickup in US election risk into November is also likely, he believes markets seem to be underestimating the potential for more dollar strength, if anything.
“For the dollar to rally more, two things need to happen,” he said. “A more significant reassessment of relative terminal rates between the US and the rest of the world — which we believe is warranted — and a greater pricing of US election risk premium, which remains close to zero.”
With clarity on all that unlikely until the middle of 2024 at least, it seems we’re in for months more in the foreign exchange doldrums.