Is a US recession going to awaken currency volatility from its slumber?

Much of last week’s media coverage centred around the potential for an imminent global slowdown/US recession. The excitement was largely triggered by the less hawkish Fed on Wednesday – it appears bad news is no longer good for equity markets. To be fair, whilst sentiment is becoming more cautious, it is not quite the panic seen at the end of 2018.

So what exactly did the Fed say? Essentially, they pivoted their monetary policy to take a more dovish posture, signalling that they are unlikely to raise rates at all this year, compared to the two 2019 hikes foreseen for most of last year. Furthermore, they also confirmed they will reduce the pace of their balance sheet reduction. This came as no real surprise, and US stocks initially rallied before selling off once the market digested what the Fed actually said. In recent years, bad data would have sent risk higher as it has traditionally helped shape monetary policy, the Fed has now pledged “patience”, meaning they will monitor data for longer. Given the trade and political disruptive uncertainties, it could be seen as quite a smart move.

On Thursday, European PMIs disappointed by coming in weaker than expected (notably with a large decline in German manufacturing orders, led by exports) – this further soured risk sentiment and by Friday, – both global stocks as well as crude oil closing down 2% whilst VIX (a measure of the 30-day implied volatility of the S&P 500) spiked higher. More significantly (and with many considering to be the leading cause) in the bond space, Germany’s 10 year bond returned a negative yield whilst the spread between the 3-month and 10-year US bond yields turned negative. As a reminder, an inverted yield curve – usually measured by the 10-2 year spread has been a harbinger for upcoming recessions. So much so that an inverted yield curve has predicted the past seven recessions.

Whilst the chorus for a global recession/slow down may be synchronising, this is not a foregone conclusion; there are plenty of arguments as to why this could be another false alarm. Primary amongst these:

Also, it is noteworthy that recessions usually begin 6 to 18 months after an inversion, and stock markets can continue to rally well after the yield curve starts flashing red. The 2s-10s curve, as it is known, inverted in July 2006, yet the US market continued to rally for nearly 15 months before topping out in October 2007. The S&P500 index returned 25% during that period.

Despite all the furore in the broader macro markets, FX markets, relatively speaking, still remain quite subdued – appearing to be languishing both in absolute spot return as well as volatility terms. This has been true for a while and for risk managers, with currency volatility levels still at low levels historically speaking, it would be prudent for one to hedge against any rebound in correlations or prolonged systemic shocks.

During the 2006-07 period, currency volatility showed a similar pattern, falling gradually at first before spiking as the first rate cut approached. With money markets now pricing in over 70% chance that the Fed will cut rates by 25bps by December, is history about to repeat itself?

by James Sebastian


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