As interest rates in developed market economies converge around zero, it is tempting to conclude that FX volatility will decline right along with them.  After all, changes in interest rate differentials, or carry, are an important driver of FX rates.  This week, we explore why this conclusion is not only premature but why monetary policy trends will likely increase, rather than decrease, currency market volatility.

The idea that we are at the end of FX because we have the same (interest) rates…it is wrong to see this as an equilibrium where everything is relatively calm.

Steven Englander, Global Head of G10 FX Research at Standard Chartered Bank, August 6th 2020 (Validus Company Meeting)

Do not be surprised if a new era of globalized zero interest rate policy leads to currency instability.

‘Why zero interest rates might lead to currency volatility’, The Economist, July 2nd 2020

To avoid economic volatility, currency movements must be larger. That reality creates ‘currency wars’, pegged exchange rate break-ups, and increased currency risk for investors.

Ray Dalio, Co-Chief Investment Officer and Co-Chairman, Bridgewater Associates, 2016

We have been fragilizing the economy…by suppressing randomness and volatility.

Nassim Nicholas Taleb, Antifragile, 2014

Last week, we had the pleasure of hosting one of the FX market’s most respected analysts, Steven Englander from Standard Chartered bank, at our weekly (virtual) company meeting.  We were particularly keen to hear from Steven following the publication of his research note (‘If policy rates are zero, what drives FX?’), which was also referenced in the Economist article quoted above. 

At the core of Steven’s argument is the insight that as the number of dimensions available to respond to economic shocks is reduced, the remaining dimensions will have to respond even more.  In other words, as the ability of interest rate adjustments to absorb economic or market stress declines, there will be even greater pressure on the FX market to react to these events.  Steven used the analogy of a balloon, where squeezing one end just displaces pressure to the other end, to illustrate how market pressure will always need an outlet, and that  FX volatility will likely increase as exchange rates become an increasingly important ‘pressure valve’ for economic shocks.

Steven’s reasoning brought to my mind the Ray Dalio / Bridgewater Associates framework for analysing monetary policy options.  Dalio states that the ‘first choice’ monetary policy tool of central bankers (‘MP1’) is interest rates.  Once interest rates lose their potency (typically a result of reaching the zero (or slightly negative)  lower bound), quantitative easing (‘MP2’) is deployed.    Once quantitative policy begins to exhibit diminishing returns (where Dalio argues we are now), then direct fiscal policy intervention (‘MP3’) is required.  Typically, this involves direct monetary injections into the economy, including so-called ‘helicopter money’.    

Dalio predicted the emergence of MP3 four years ago, and was clear about the consequences for currency volatility: ‘we should expect currency volatility to be greater than normal because…when interest rates can’t be lowered and relative interest rates can’t be changed, currency movements must be larger.’ 

Both Steven Englander and Ray Dalio’s arguments for increased FX volatility are based, at least to some extent, on the reality that currency sits at the centre of our financial system.  After all, financial markets are ultimately measured and transacted in dollars, euros and rupees (amongst others!).  FX represents the ‘atomic level’ of our current financial system – and as such, is the final frontier of monetary policy – the ultimate pressure valve for economic stress.  

These arguments are convincing.  As interest rates around the world converge near zero, and as fiscal policy starts to do more heavy-lifting to help fix COVID-impaired economies, FX volatility will likely increase.  Furthermore, there is one unique feature which distinguishes FX markets from other financial markets, such as fixed income or equities.  Due to its ‘atomic’ nature, FX is a relative game – currencies are measured in terms of how they perform in relation to one another.   In other words, while countries can work together to bring down interest rates (lower interest rates in the US do not necessitate higher rates in Europe, for example), currency volatility will have winners and losers. 

Expanding on Dalio’s framework, this could mean that we enter into a fourth phase of monetary policy (‘MP4’?) – a phase where activist currency intervention becomes the primary monetary lever available to policy-makers.  This could exacerbate FX volatility by a factor of two or three in the years ahead.    As N.N. Taleb implies above, suppressing financial market volatility is ultimately an exercise in futility.   It weakens the economy over the long term, which in turn creates even more financial and economic pressure.  Currency may end up being the battleground on which the next phase of the financial crisis is fought.

Author: Kevin Lester