Volatility Returns to the FX Markets

Is the Perfect Storm About to Hit the Currency Markets?

Currency markets rely heavily on volatility for driving trades. For several years, volatility levels in the forex markets have been abnormally low. This has been the net result of historically low interest rates across the board. The higher the volatility, the greater the overall trading volumes as measured over a larger range of values. During times of low volatility, there is generally greater price stability and tighter trading ranges with currency pairs. However, high volatility trading sessions are characterized by a broader range of values in the exchange rates. The currency markets have been racked by significant turbulence of late. The markets are now witnessing unusually high levels of trading, spurred by increased volatility.

The ECB Catalyst to FX Volatility

Just recently, Mario Draghi (president of the ECB) announced monetary policy measures designed to kickstart the 18-nation block Eurozone. Interest rates were cut 10 basis points in an effort to accelerate the velocity of money flow through the Eurozone. Various quantitative easing measures were also adopted, with analysts anticipating upwards of €700 billion being purchased. The goal of course is to drive the ECBs balance sheet towards its 2012 figure of €2.7 trillion. Present data suggests that the ECB balance sheet is hovering around €2 trillion. To this end, Draghi has embarked on an aggressive two-pronged approach to reduce interest rates further while purchasing privately owned securities.
When the US was facing the full effects of the recession, it enacted robust quantitative easing measures designed to kickstart the economy and prevent a massive economic catastrophe. The QE program adopted by the Fed had the effect of driving interest rates down, increasing the money supply in the economy and making the dollar more competitive vis-à-vis a basket of currencies. With QE spending cut by a further $10 billion and due to end in October, policy makers in the US are now more hawkish. With an economy clearly on the mend, it is expected that Fed Chair Janet Yellen will make an announcement to the effect that interest rates will rise within a certain period of time. There are opposing forces at work in the global economy: the Eurozone is only now enacting significant QE policies and reducing interest rates further, while the US is moving in the opposite direction.

How Monetary Policy Measures are Affecting Currencies

The most obvious change comes from the EUR/USD currency pair. This pair was trading around 1.38 to the dollar prior to the ECBs monetary accommodations, but soon fell sharply to below 1.29 to the greenback. The mechanics of this process are interesting. Since the Eurozone is now being flooded with more euros (through QE policies and lower interest rates) there is an oversupply of euros on the international markets. This makes euros less attractive to traders than dollars which are relatively scarcer. In the absence of any policy actions in the US, the dollar would automatically be more attractive than the euro. However, monetary policy is not static or stagnant in the US as there are very definite policy measures in place. As alluded to earlier, the US is rapidly tapering its QE program to the tune of $10 billion per month – leaving only $15 bill remaining. And by October 2014, the Fed is likely to put a stop to all asset repurchases. Recall that the Fed was purchasing $85 billion per month in bond-buying at the beginning of 2014. This is going to have a profound effect on the markets, the dollar and emerging market economies. The ECB is worried about persistently low inflation at 0.3% accompanied by high unemployment levels scattered throughout southern Eurozone countries. As its target rate, the ECB is looking at a 2% inflation rate.

The US Federal Reserve Bank
When the Fed pumps money into the economy, it has the effect of driving down interest rates since there is a glut of dollars on the markets. This means that it is less attractive for people to keep their money in banks and instead they invest their funds elsewhere, like real estate or the stock market. The theory points to a close correlation between stock market performance and the QE program. When more money is injected into the economy, the stock market prospers and vice versa. Banc De Binary analysts fear that stock market performance during Q3 2014 will be less robust, possibly even deflated if present trends are anything to go by.

The effect of these actions on currency exchange rates is equally important. If emerging markets are brought into the equation, it is clear that these are the least stable investment opportunities during financial crises or geopolitical uncertainty. When the Fed stops QE policies, interest rates in the US will rise thereby drawing more demand towards the dollar. Further, the dollar will appreciate relative to a basket of currencies – as evidenced by recent developments. This means that emerging market economies will have to pay more of their currency for every dollar-denominated purchase or asset holding, including gold. This drives up inflation in emerging markets and can create greater trade imbalances. Two currencies that have been particularly hard hit by the strengthening dollar include the South African Rand and the Turkish lira.

For the EUR/USD currency pair, this present combination of opposing policy measures is already having a profound effect on the EUR. Trading at lows not seen in over 14 months, the 18-nation Eurozone will have to pay more euros for every dollar denominated purchase. Traders are short on the euro and long on the dollar. In the UK, there are fresh pressures weighing on the GBP. Scotland is scheduled to vote yay or nay on independence on the 18 September. As it stands, the Scots are 51% in favour of independence (a recent poll found) and the UK is deeply concerned about this. Already the GBP dropped to a 9 month low against the USD and London is scrambling to grant greater autonomy to Scotland in the hopes they will not vote for independence after 300 years of union. The perfect storm may well be brewing in the currency markets!