Why FX Volatility Has Been Falling, And What To Do About It
There’s no doubt about it – volatility in the foreign exchange markets has been falling recently. The Deutsche Bank historical volatility index of the major G7 currencies, while not quite back to the lows of 2014, is certainly getting there.
The slowdown is evident across the board in all currencies, including the commodity currencies, the Scandinavian and the EUR crosses. Even GBP, amid one of the greatest political upheavals in any country in decades, is seeing lower volatility than just a few years ago.
It's making life particularly difficult for retail traders. EUR/USD, the most widely traded pair, has a narrower trading range than any time since the common currency was launched. It reminds me of what one trader said to me during a lull in activity many years ago: “I could be replaced by a voicemail.”
While lower volatility makes it hard for traders to make money, in fact it’s something to be celebrated. It results in part from the success of policymakers around the world.
Current account imbalances are becoming, well, less imbalanced. The dispersion of current accounts among countries (the standard deviation of a cross-section of current account balances as a percent of GDP) is falling. That means less reason for money to flow from one part of the world to another. Currencies often act as the “balancing item” between countries. Changes in currency values are the way that these imbalances get rectified. With fewer imbalances, there are fewer opportunities to profit from eventual policy changes in one country or another.
The same goes for emerging markets:
Similarly, policy makers have succeeded in bringing inflation down around the world. Years ago there was a very wide dispersion of inflation rates; now they are all converging. Furthermore, they’re converging mostly below 2%, the rate that the majority of major central banks have chosen as their target.
On top of which, inflation expectations are also falling. With the exception of Britain – where a weaker pound is expected to feed through to higher prices – not only are inflation expectations falling, but again they’re below the 2% target range.
However, not everyone sees that as an unqualified success. It may be too much of a good thing for central banks. Below-target inflation and inflation expectations worry central banks, because they see their inflation mandates as symmetrical. They’re supposed to be just as worried now about inflation being too low as they used to be about inflation being too high.
Below-target inflation is causing them to cut their interest rates. This too is dampening volatility, for two reasons. First off, there’s less opportunity to profit from central bank moves. No one is hiking rates, so while there may be reasons to leave a currency, there’s less reason to buy a currency. Secondly, countries can only cut so far. Switzerland, with its -0.75% policy rate, has the lowest interest rates in recorded history. As interest rates get lower and lower, once again the divergence among countries falls, meaning there’s less reason to move money from one country to another.
In this low inflation, low-interest-rate environment, carry trades – a major strategy for FX investors – haven’t proved very profitable. That’s because with a narrower spread between different interest rates, there’s less money to be made borrowing in a low-interest-rate currency and lending in a high-interest-rate currency.
So what can we do? What can we as traders do to make money in this environment?
The first thing I would say is that while volatility has fallen, some currency pairs are still more volatile than others. We can focus on those.
AUD/JPY is the quintessential “risk-on” pair. Market participants tend to buy AUD when the global economy – in particular, the Chinese economy – turns up, because of the country’s reliance on economically sensitive commodities and trade with China. On the other hand, Japanese investors tend to adjust their hedge ratios according to their view on risk, causing JPY to move in the opposite direction of AUD. Note that this pair has the highest historical volatility as well as the highest current volatility.
GBP has seen the smallest fall in volatility, for reasons that shouldn’t be hard to discern. (Note the Z-score, which measures how many standard deviations a number is away from its average.) Traders should look at GBP/USD and EUR/GBP for some action. The problem there though is that the major source of the volatility is politics, not economics, and politics is subject to human whims causing random events.
The Scandis have relatively high volatilities, but they also have relatively wide spreads, making them less-than-ideal for the average retail trader.
That leaves us with NZD/USD, EUR/JPY and AUD/USD. These would seem to offer the best opportunities for short-term traders looking for movement. USD/JPY has close to the same volatility recently, and both tight spreads and good liquidity throughout the trading day.
Given the nature of the most volatile pairs – the “risk-on” AUD/JPY and the Brexit barometer GBP pairs – it’s crucial for traders to watch the news. Just watching technical points isn’t good enough in a market where support and resistance can be wiped out by an announcement.
It’s also worth watching the economic calendar. Traders looking to pick up some movement during the day should be well aware of what economic indicators are coming out or who is going to speak. Any deviations from expectations in these events can be an opportunity to “harvest” some volatility.
It may be heretical for me, an FX strategist, to say this but in the current environment, traders may also want to look at precious metals. Gold and silver are not only more volatile than currencies, they’ve also been seeing a notable increase in volatility recently.
That’s probably because as global interest rates go negative, the “opportunity cost” of holding gold – the yield that an investor could’ve gotten by buying interest-bearing bonds instead of an asset with a storage cost – diminishes and may even turn around into an “opportunity benefit” if the yield on bonds goes far enough negative. At some point, gold and silver become an attractive store of wealth relative to bonds.
Oil also gives traders the opportunity to pick up some volatility while diversifying their trading portfolio. Not only is oil more volatile than currencies, but it also is affected by many events that don’t impact currencies, such as unusually cold weather or a war in some far-off place. I included copper in this graph just to see if the high volatility of oil was general for all commodities or specific to oil. Answer: it’s oil.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.