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The US dollar’s unexpected surge over the past month is encouraging currency traders to pray for a return of lucrative but long-dormant price volatility on the main foreign exchanges, although early signs on that are strangely subdued.
Extra volatility — how much markets fluctuate up or down — opens up pricing gaps and anomalies that give traders more opportunities to make money, brokers more volume, and seeds greater demand for hedging services from multinational companies and cross-border investors.
But recent years have seen big currency swings evaporate as record-low interest rates converged toward zero and central bank money-printing weakened the cues exchange rates take from monetary policy trends and economic divergence.
That in turn has hammered profits at hedge funds and banks’ FX trading divisions, though some are asking whether the dollar’s blistering 5 per cent rally since mid-April will mark a turn for vol, as known in market parlance.
“FX is back to life. We will have to wait through a few more months of low volatility but the time will come and it is getting more attractive,” said Andreas Koenig, head of global FX at Amundi Asset Management.
So far there is little sign of this. Markets broadly look at two gauges of currency volatility — a daily swing in actual spot prices and an implied gauge derived from options markets on what traders expect volatility to be.
Three-month implied volatility in the euro has completely unwound its February surge and is heading back below 6, levels not seen since 2014, while actual currency market swings remain comparatively elevated.
Realised moves in the euro remain elevated with daily volatility creeping up to around 5.5 and nearly doubling from the start of the year, a function of the dollar’s rally that has taken currency markets by surprise.
And there lies the rub. Despite the dollar’s rise, which has drawn comparisons with earlier cycles of a surging dollar and increased volatility in early 2015 and late 2016, traders remain sceptical this move signals the return to more volatile markets.
“It doesn’t feel at this stage like the beginning of a larger structural move higher,” said Richard Bibbey, HSBC’s global head of FX cash trading, while adding that quiet currency markets were a “cyclical” rather than structural issue.
There are many in the market who say the recent dollar spike may be temporary, because it has been caused by speculators unwinding record bets against the greenback rather than a structural shift in the global economy.
What about volatility in other asset classes? US Treasury bond volatility is back towards record lows. In contrast, the S&P 500’s volatility in the first 90 trading days of 2018 was the highest start to a year since 2009, while price swings of crude oil and metals are far higher than for the dollar.
Even major events in the $5 trillion-a-day foreign exchange markets, still the world’s biggest, in the last three years including the Brexit referendum and the removal of the cap on the Swiss franc, have failed to inject meaningful volatility.
Broader FX volatility indicators also remain subdued — Deutsche Bank’s Currencies Volatility Index has ticked higher but remains near January’s record lows, thanks to the anaesthetising effect on markets from unconventional easing pursued by global central banks. JP Morgan said the world’s top three central banks pumped in a record $2 trillion last year as part of its policy support to markets. This year, injections are set to drop to a quarter of that amount, followed by net withdrawals from 2019.
“Implied currency market volatility has dropped as traders are comfortable collecting premiums from selling options in the knowledge that central banks will provide a backstop to markets,” said Neil Mellor, a senior strategist at BNY Mellon. “That may be changing.”
Rock-bottom volatility has seen revenues from trading currencies at the 12 biggest banks fall last year to a decade low of $7 billion, industry analytics firm Coalition says. At its peak in 2008, revenues were double those levels.
Bank forex trading desk heads say investor activity has retreated in recent weeks after a first-quarter bump. Cash currency trading volumes were down 30 per cent in April compared with January this year, one head of trading at a US bank in London said on the condition of anonymity.
In comparison, FX trading volumes surged in the first quarter, according to data from various sources, including Thomson Reuters and EBS. As volatility has subsided, so has the ability of large speculators to profit from betting on currency moves. Hedge funds trading currencies have made 1 per cent each year since 2013 — just a quarter of the average of overall hedge fund returns of 4.15 per cent, according to Hedge Fund Research. Even big investors who would have taken a punt on the yen or euro a decade ago now avoid direct currency investments, seeing them only as an asset class to hedge against, said Bob Michele, JP Morgan Asset Management’s fixed income chief investment officer.
“Because these are low-volatility markets you might sit on stuff a long period of time and the valuations never change. It’s effectively wasted capital,” Michele said. “We don’t see a lot of business coming into our FX group.”
What markets really need is a shake up in the consensus view of a long cycle of benign economic conditions consisting of synchronised growth, limited inflation risks and a slow tightening of monetary policy for volatility to return.
Others see a return of volatility as a matter of time as interest rate differentials between the US and the rest of the developed world widen further. “The question is: have currencies returned to focus on interest rates? I am not sure we are confident of that yet, but there is a very clear interest rate advantage in holding dollars,” said James Binny, global head of currency at State Street Global Advisors.
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