The bank suggests the dollar is pushing up against technical barriers in a number of currencies and might be ready to break them.
“There are signs that currencies are set to break out of recent ranges, having the potential to trigger an increase in volatility,” it states in a research report.
The increase has arguably started. While it is customary to expect a summer lull in trading and volatility in July and August, this season might buck the trend by being the time when volatility returns.
“We are already seeing policy evolving and currency pairs breaking out of their ranges,” says Ian Stannard, head of European FX strategy at Morgan Stanley. EURUSD has already breached the limit of its recent range in the 1.3500 area.
Others, such as EURJPY and EURGBP, are trending downwards, while Morgan Stanley notes the dollar is close to the edge of its ranges against the Australian and Canadian dollars, Swiss franc and sterling.
“We may not have to wait until after the summer for volatility to rise,” adds Stannard.
Perhaps the most interesting pair is USDJPY, which has been unable to break below the 101.10 level. “USDJPY is still trading in its narrow and long-established range, but if it does break out, that pair has perhaps the greatest potential to increase volatility,” says Stannard.
Fund managers note that the world’s two dominant central banks – the US Federal Reserve and the European Central Bank (ECB) – are at extremes with their fiscal and monetary medicine.
The Fed, having blitzed its economy with repeated rounds of quantitative easing (QE) and low rates, is approaching the start of a tightening cycle as it looks to wean financial markets from years of support. By contrast, the ECB is looking to kick-start growth with more liquidity, or even QE.
“Europe is two years behind the US in its growth and recession cycle,” says Louis Gargour, chief investment officer at LNG Capital. “They are in very different places, with rates likely to go down in Europe as they rise in the US. The US is looking to rein in QE as Europe may conduct a round of its own.”
These opposing actions could cancel each other out or combine to create new circumstances.
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Morgan Stanley is sanguine about the return of volatility, despite the unchartered economic waters. “When you see a sharp spike in volatility, that is usually associated with a crisis,” says Stannard. “In this scenario we are talking about volatility rising for more positive reasons, so I would expect it to be more gradual. It is likely to be a slow grind higher.”
Gargour predicts: “Emerging markets currencies have done well this year and have probably already reacted as much as they are going to in response to US tapering plans.”
Further volatility is therefore likely to be driven by any deviation from market expectations. “What brings volatility is if the economy accelerates more than expected and alters current expectations,” says John Hardy, head of FX strategy at Saxo Bank.
Conversely, if tapering causes a sudden economic slowdown and the Fed declines to offer further QE stimulus, preferring to manage the situation with fiscal measures, the market would be left feeling that QE had been a false god or a confidence trick, says Hardy. This would likely exacerbate market jitters.
If the divergence of central-bank actions doesn’t shake the markets out of their lethargy, an exogenous shock might be required to do the job.
Big news from China or disruption in the derivatives markets are an ever-present risk and would increase activity in the FX markets. The possibility of a German recession is not priced into the markets and is a higher risk than presently appreciated, says Hardy.
For now, volatility remains subdued, which is likely to remain the case throughout August, with markets usually quiet during the summer months. If there are to be dramatic moves, the chances are they will come in September or into Q4, once the holiday period is over.
Some managers think even that is optimistic.
“The evidence in current price action is not there yet,” says Chris Brandon, principal at Rhicon Currency Management. “[However,] the risk reward of being short volatility at these levels seems quite poor, and in fact argues the other way.
“Timing is crucial, however, and we need to see some more evidence that volatility will pick up on a sustained basis.”
A break of longer-term technical levels, a bout of risk aversion or an increase in short-term interest-rate volatility increases would be the most likely drivers, adds Brandon.
If and when volatility does pick up, Gargour says “those markets that depend on cheap financing may suffer, but others should fare better. If we see a pick-up in inflation and the US dollar strengthening, that will benefit export-driven economies.”