A year ago FX markets were heading for the doldrums. It was the end of July that saw measures of FX volatility record multi-year lows, with the 1-month simple average true range (ATR) on EURUSD also bottoming out at that time (at 43 pips). Already I’m reading talk of more subdued volumes and lower ranges over the summer period, but I don’t think that’s going to come to fruition.
For starters, it’s been the increased volatility in bond yields that has been driving FX in the past few weeks. The move from nearly zero on the 10 year yields in Germany towards the 1% level over 6 weeks has been a game changer for EURUSD. In the wider picture, it’s also been a key element in the moves we’ve seen on USDJPY, with the yen underperforming as US yields have moved higher at a much faster pace than seen in Japan. We’ve seen a 40bp move in the 10 year yields spread in favour of the US over the past two months, which is nothing to be sniffed at.
But I tend to look a lot more at shorter-dated yields spreads, usually 2 years. These are far more dependent on what markets expect to happen to official interest rates going forward and these tend to be a lot more influential on the currency. What we were seeing earlier in the year were expectations of the Fed tightening rates this year (and possibly as early as June) combined with growing expectations (proven correct subsequently) of a move to full-blown QE in the Eurozone. Such a divergence in underlying monetary policy expectations is more often than not a strong driver of the currency between the two economies.
So my volatility outlook splits into two distinct parts. Over the summer period, I see bond yield volatility remaining at these more elevated levels. Let’s face it, things had moved to fairly extreme levels and the recent run of better data gives some fundamental backing to the correction we’ve seen, particularly in Europe. This will keep FX volatility around current levels. But beyond that, I don’t see the Fed moving rates higher this year. What ultimately matters in driving sustained volatility and wider trends in FX is actual changes and divergence in official (central bank) interest rates. Until we see these (beyond the moves we’ve seen in Australia and Canada on the majors), then yield differentials can only do so much for currencies. So the second half of the year is likely to be one of still elevated volatility compared to what we saw a year ago, but with the major (US, UK, Eurozone and Japan) central banks still keeping policy on hold, a return to the sustained dollar strength that characterised the latter half of 2014 is unlikely to be seen. As such, true moves to more volatility will have to wait until 2016.