Given FX market movements across the world, it was little surprise that the latest survey from the Bank of England’s foreign exchange joint standing committee, published at the end of July, reported increased turnover across swaps, outright and non-deliverable forwards. All three reached record highs, the survey found.
The rising cost of funding in dollars and more recently in euros has ramifications for the rest of the world and explains the record demand for instruments that provide hedging in FX and rates markets.
As long as stagflation fears persist, we would expect FX volatility to remain high
George Saravelos, Deutsche Bank
Bank of America expects this trend to extend to the end of the year amid the perfect storm of a global economic slowdown, hawkish monetary policy, an equity sell-off, geopolitical uncertainty, inflation and an energy crisis in Europe.
There is precious little certainty to be had anywhere else this year, with elections in Latin America clouding the policy picture in that region, according to Oliver Brennan, FX volatility strategist at BNP Paribas Markets 360. Brazil goes to the polls on October 2, while municipal and regional elections will be held in Peru on the same day.
“In addition, uncertainty about the economic growth outlook in Asia remains high while Covid-19 policy remains restrictive,” says Brennan.
These developments have left investors trying to grasp how far central banks can raise interest rates to bring inflation under control without trashing their economies.
“This driver of volatility probably won’t end this year,” says Kenneth Broux, head of corporate research, FX and rates at Societe Generale. “In August, we saw an upward repricing of US and euro terminal rates, which caused a small shake-out in equities and credit and lifted the dollar to new cycle highs against a range of currencies – including the yen.”
China’s stop-start Covid strategy also has considerable implications for supply chains.
“This readjustment can be accompanied by large FDI-portfolio investment and hedging of FX flows, which can only benefit the use of hedging instruments,” says Broux.
The focus will return to emerging markets currencies next year following a decade of divestment
Daniel Tenengauzer, BNY Mellon Markets
From a macro perspective, Deutsche Bank says the single most important driver of FX volatility over the medium term is the US and global growth cycle.
“When growth slows down, FX volatility historically tends to rise, and vice versa,” says George Saravelos, the bank’s head of global FX research. “As long as stagflation fears persist, we would expect FX volatility to remain high.”
What does this mean for specific currencies, particularly outside Europe and North America? Societe Generale expects USD/JPY and AUD/USD to be among the main G10 movers, while in emerging markets it anticipates volatility in CNY, BRL, TRY, ZAR and central and eastern European currencies.
Daniel Tenengauzer, head of markets strategy at BNY Mellon Markets, reckons overall market volumes will rebound if China reopens fully while pressing on with easing policies after the National Congress meeting in October and into the Chinese New Year.
“Portfolio flows rotating out of the US and into ex-US assets would also boost trading,” he says. “We believe the focus will return to emerging markets currencies next year following a decade of divestment. Currencies likely to be affected include MXN, BRL, ZAR, IDR and INR, and we also anticipate interest in eurozone convergence trades, which should push EUR crosses higher.”
BofA’s most recent report on FX volatility identified EUR/GBP and USD/CHF as especially vulnerable, where the options market has yet to fully price in various risk factors after the summer hiatus.
We see the risks of a recession in major economies and the energy crisis in Europe as catalysts for volatility to rise into the year end
Thanos Vamvakidis, Bank of America
“In our view, the major central banks are likely to choose to curb inflation and not market volatility,” says Thanos Vamvakidis, global head G10 FX strategy at BofA. “For this reason, we see the risks of a recession in major economies and the energy crisis in Europe as catalysts for volatility to rise into the year end.”
Meera Chandan, FX strategist at JP Morgan, notes that conditions have worsened outside the US and expects EUR/USD to test 0.95, with a hiking ECB motivated by inflation and heading into a recession unlikely to be a source of support for the currency.
“Ongoing weaknesses in China related to housing, exports growth and the zero-Covid policy will continue to push CNY weaker as well, although anticipated moves are lower, with USD/CNY target at 7.05,” she says. “We expect yen movement to be larger on the back of policy divergence and worsening terms of trade with a target of 147 – and a test of 150 can’t be ruled out.”
Brennan acknowledges that USD/JPY has been the most important mover among the major currency pairs this year, but suggests that sources of uncertainty are changing as the market narrative moves on from monetary policy tightening in the US towards European economic and political risks.
“The response of new UK prime minister Liz Truss to her large in-tray of issues could also introduce a new source of volatility over the next few months,” he concludes. “While neither EUR nor GBP will necessarily provide the largest directional move, they are likely to be significant sources of volatility for the rest of the year.”
