2023 has seen FX volatility trend downwards near pre-Ukraine war levels, largely shrugging off certain risk events such as SVB banking crisis, US debt ceiling resolution process and ongoing Ukraine-Russia conflict developments (both G3 and G9 three month rolling volatility p.a. reached pre-war levels and pandemic lows).
Investors are now questioning if low FX volatility can persist, returning us to the previous era where very easy monetary policy, convergence of inflation expectations and ample market liquidity saw volatility largely compressed. This serves as useful junction to take stock of recent factors?explaining?recent volatility phenomenon including:
- Conducive global risk environment:?Markets have been largely risk-on this year - VIX*, a measure of market risk sentiment, has neared pre-pandemic lows. This has also been consistent with stronger equity performance and marginal USD weakness vs G10 YTD. Despite aforementioned risk flare-ups, the overall quelling of geopolitical tail risks and recovery from COVID fall-out have likely added to such an environment.
- US economic outperformance, confidence and banking resilience:?Risk has continued to remain constructive amidst economic momentum, supported by a tighter labour market, strong consumer spending and resilient housing sector which has remained insulated from aggressive tightening – all narrowing the well of recessionary risks. The SVB crisis episode has also provided a litmus test of how well the Fed (and other economies) can weather regional banking risks and financial instability, which have significantly moderated and help anchor volatility.?
- Central banks near end of their tightening cycle:?Rate differentials have been a key factor driving currency moves recently. With central banks focusing on communicating a data driven rate path, subsequent expectations of cycle pause into H2 23 has also had its bearing in driving softer FX volatility across the board.
- Declining energy prices:??Energy prices have been more range-bound recently, after unseasonably warmer winter months, bolstered energy security in Europe and diversification of gas supply away from Russia have helped relieved extensive pressures. Considered a key factor for certain commodity-linked currencies such as Canadian dollar and Norwegian krone, these recent commodity dynamics have also helped to limit currency moves.
- Technical factors:?Seasonally summer months tend to be slower for banks (who have achieved positive PnL between June 22 – June 23 due to the increased volumes and volatility after initial Russia/Ukraine conflict). High levels of competition for market share between banks has generally seen spreads extremely tight also likely compressing vol. In terms of equity volatility specifically, a wave of engineered share buybacks this year has also helped supress volatility across the board.
* S&P500 30-day implied volatility. In general, VIX values >30 are considered to signal heightened volatility from increased uncertainty, risk and investor fear. <20 generally corresponds to more stable, less stressful periods in the markets.
Going into H2, investors are now questioning the sustainability of the recent low volatility regime. Current technical indicators (e.g. ATM volatility term) do not currently see material expectations of FX volatility into year end, though beyond the 6 month horizon provide some early indication of higher implied volatility for higher beta currencies such as GBP/EUR/SEK/AUD – likely a reflection of rate cutting cycles. Meanwhile we lay out some scenarios that would be consistent with a reversal in volatility dynamics below:
- Lingering inflation risk and monetary transmission lags:?Despite aggressive hiking cycle, core inflation momentum remains elevated, a bi-product of elevated labour market tightness and wage price pressures. Mistiming risk of monetary transmission mechanisms as well as unexpected U-turns in the rate path as central bank try to manage inflation expectations can lead to erratic market re-pricing and follow through to currencies. Already we have encountered some signs of this with e.g. surprise rate hikes from the BoC and RBA this past month, who have expressed frustration with sticky price pressures and US June CPI headline/core prints coming in very soft.
- Geopolitical tensions and rising risks of polycrisis:?(1) US and China remain at odds over Beijing’s sovereignty claims over Taiwan, export controls of over strategic raw materials and counter-sanctions laws that complicate American business operations. Risk flare-ups along any of these verticals could have spill overs into markets and FX.?(2) Ukrainian counteroffensive, supported by the West which if progresses successfully could push Russia to utilizing nuclear weapons would be considered the ultimate downside risk event.
- China recovery is losing steam: Disappointing manufacturing and services data, persistent weakness in property sector, along with structural youth unemployment continues to weigh on economic recovery. If economy continues to slump without effective fiscal/monetary policy support to boost overall sentiment, this could have a bearing for both global risk appetite and for countries with economic exposure to China.
