FX Volatility: Gone but not forgotten…

FX volatility has been remarkably compressed during the second half of 2017; however there are a number of signs that these placid conditions may be about to change…


Twas the night before Christmas

And all through the house

Not a creature was stirring

Not even a mouse…


A Visit from St. Nicholas

Clement Clarke Moore, 1837


As we head into the festive season, the markets are as quiet as the slumbering household in Clement Clark Moore’s classic poem.  Currencies, rates, commodities and equities are all trading at multi-year lows with respect to implied volatility – thankfully we have Bitcoin (with newly launched futures contracts now pricing in a rise to about $20,000 next month, up from about $1,000 at the start of the year!) to keep us on our toes! As we look forward into 2018, it is worth asking what factors could shake the the markets from their torpor and whether we are likely to see a shift in market dynamics in the near term?


Perhaps the most obvious answer to the first question is political risk.  Politics often drive markets, and there is undoubtedly a plethora of potential political risks which could surface at any time.  From Brexit to Trump, German political instability to upcoming Italian elections, it is easy to imagine any of these factors creating market turmoil in the months ahead.  However, there is an obvious flaw in this explanation; many of these events have been ‘live’ for months and have caused limited market volatility.  Despite a relatively messy German election outcome, EURUSD has traded in a narrow range (about 1.16 – 1.20) since September – following a rally of over 12 cents in the first half of the year.  Likewise, despite a frantic race to conclude Round One of the Brexit negotiations over recent weeks, GBPUSD has also traded in a subdued fashion, anchored in the low 1.30s.  In other words, heightened political risk has not cause a spike in market risk, at least not of late. 


A clue as to why this is so is found in the broad-based nature of the volatility drop, with pretty much all asset classes similarly effected (except, of course, in the cryptocurrency space).   The macro environment is currently exhibiting a ‘not too hot, not too cold’ combination of modest inflation, low interest rates and abundant liquidity – it is these benign market conditions which are dampening volatility across the board (see chart).  Incidentally, these market conditions are also responsible, in large part, for the rapid rise of cryptocurrencies (if not for the accompanying price volatility) as these digital assets represent a repository for the current excessive liquidity supply. 


Chart: US Bloomberg Financial Conditions Index (Black) vs EURUSD Implied Volatility (Blue):




As such, the catalyst for future market volatility will almost certainly result from a sharp tightening of financial conditions.  Broadly speaking, financial conditions are a function of debt and equity prices (both nominal and relative).  So, what could cause a rapid deterioration in financial market conditions?  There are three main warning signs to watch out for:


  1. Increasing inflation expectations – Inflation expectation declined in 2017, but they are currently showing signs of life once again. Inflation swaps showed five year US inflation expectations declining from 2.2% at the start of the tear to 1.8% during the summer; they are now back to 1.92%.  In the UK, a drop from 3.7% to 3.2% has reversed back to 3.4%, and a similar pattern is seen in Europe (inflation expectations dropped from 1.8% to 1.5%, but have since moved back to 1.7%).  If the market starts to feel inflation is back, it is almost certain that the low-volatility party will be over, and financial conditions will tighten in a hurry.


  1. Increasing short term rates – Anything that pushes up short-term rates could cause disruption in the markets. Some of these risks are well-telegraphed (e.g. there are three US interest rate hikes expected in 2018), but anything beyond this (e.g. an unexpected ECB tightening) will be a source of volatility. 


  1. Increasing credit spreads – This may the most important indicator to watch. Debt levels are rising in most developed economies, and in some developed economies (e.g. Canada) household credit now exceeds 100% of GDP.  If credit providers start to feel nervous and begin pulling out of the market (or raising interest rates), then it is highly likely that generalized financial market volatility will follow close behind. 


Across all three indicators above, the trajectory is pointing to higher volatility ahead; inflation expectations are heading higher, along with short term rates.  Credit spreads still look compressed, but there are clear reasons to expect this to change, and in fact there are signs that this is already happening, especially in certain sectors (high yield) and regions (China).  And there is also a possibility that some surprise factor comes crashing down, like Santa and his reindeer, to waken the markets from their slumber.  Bitcoin perhaps?


Author: Kevin Lester


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