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Is FX volatility set for a recovery?

Volatility in the foreign exchange markets has been declining for the past few years. One of the major causes has been the consistent ultra-loose monetary policy engaged by the key central banks such as the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England.

Just looking at the average daily ranges of Euro/Dollar, Sterling/Dollar and Dollar/Yen, each has been in sharp decline since 2009. The average daily pip range for Euro/Dollar went from 170 pips in 2009 down to just 98 pips in 2013, a fall of 42% in just 5 years. Cable has been even greater with a fall from 224 pips in 2009 to 112 in 2013, a 50% decline. Dollar/Yen had been on the same path, losing 54% of its daily pip range by 2012 until the Bank of Japan started its huge Quantitative and Qualitative Easing (QQE) drive which significantly increased volatility for the yen in 2013.

If the figures for February and March are to be consistent through the year, the trends for 2014 are not looking great either. Both months show daily pip ranges that are between 20% and 30% lower than the equivalent months a year ago.

However, if there is a direct correlation between diverging monetary policies of the key central banks, then we could be in for an improvement as the year goes on. The Reserve Bank of New Zealand recently became the first of the major currency central banks to begin to tighten monetary policy and others are getting ready to follow suit. The Federal Reserve continues to taper asset purchases and the interest rate futures are pricing in the first rate hike to 0.5% in June 2015. Of the key central banks though, it could be the Bank of England that is the first mover. Short Sterling Interest Rates (which reflect the market’s view on interest rates) are pricing in a first rate hike as soon as December this year.

Contrast this with that of the ECB, which is struggling to deal with the threat of deflation and anaemic growth. The prospect of even looser monetary policy through “unconventional” measures such as cutting the deposit rate, further Long Term Refinancing Operations or even outright quantitative easing remains high. The market is not pricing in a first increase in interest rates until March 2016. The Bank of Japan also remains on a similar path as it appears set to continue its QQE programme for the rest of 2014.

Subsequently, if fx volatility is a function of central bank monetary policy then volatility on major pairs such as Euro/Dollar, Dollar/Yen, Euro/Sterling, and perhaps even Sterling/Dollar could be set to see increased volatility towards the end of 2014.

However, there is a counter argument. Perhaps the decline in fx volatility could be more of a structural issue than a cyclical issue. The environment of ever tighter regulation on foreign exchange continues to put the squeeze on investment banks, as a series of scandals have engulfed the industry, such as LIBOR fixing and trading collusion involving instant messaging services. With information flow limited due to the restricted use of instant messaging, volatility has been reduced. Add in the decline of the proprietary desk trading, foreign exchange volatility could be facing serious headwinds that the divergence in central bank monetary policy may not be able to recover.

Although there is an expectation that fx volatility will begin to recover into 2015, whether it can regain the levels hit in the late noughties, remains to be seen.

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Research Risk Warning

At Hantec Markets Ltd we provide an execution only service. Any opinions expressed by analyst Richard Perry should not be construed as investment advice or an investment recommendation. This report does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions.