FX Market Volatility Won’t Stay Low For Long and Here’s Why

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As we are approaching the end of the economic cycle, we should expect that things won’t stay as they are forever.

There are already multiple signs of weakness in the markets and several risk factors that threat the current situation.

Among them, the slowing down in economic growth, central banks that are loosing their monetary policy once again (that alone, basically confirm that the economy isn’t doing that well), uncertainties about international trade, a frightfully high level of debt and the inverting yield curve.

Volatility and the dollar

Right now volatility on the markets is relatively low, although it may sound as a good thing, it only one part of the story because it could be the result of ignoring problems.

When markets operators realize that it is really the end of the cycle, the market prices that change in expectations in a very short time.

In fact, volatility doesn’t go up gradually over time, but it skyrockets.

When talking about currencies, we can see that JPMorgan Global FX Volatility Index has fallen to levels not seen since 2014 while the U.S. Dollar Index gradually declined over the last months.

This first index tracks the level of aggregate volatility in G7 and emerging market economies and helps to measure aggregate risk premiums in currency markets.

The second index gives us a measure of the relative strength of the dollar compared to a basket of foreign currencies.

If past trends tell us something about what could happen, by taking into account the U.S. Dollar Index and the JPMorgan Global FX Volatility Index there are good reasons to think that volatility won’t stay low for long.

The true might be the opposite and low volatility could be the forerunner of a big move in the dollar.

Take a look at this chart:

Source: Bloomberg


In the last couple of decades there have been only three times in which the JPMorgan Global FX Volatility Index fell below a value around 7.

Every single time, the dollar strengthened 10% or more soon after.

Nothing is sure, of course, but the results of this pattern in the past are pretty clear. Everything can happen but we should not be surprised to see a big upward move for the dollar.

Uncertainties

We could argue that this calm won’t last anyway because of rising uncertainties on many areas. Just to name one, if the FED remains dovish and other central banks like the ECB, prepare to do so, while economic data show rising weaknesses, volatility will necessary go higher.

The same could be said if the economy does well and a general expectation for new interest rates hikes starts to form among investors.

Another important source of uncertainty that could really be a trigger for volatility are global trade tensions and in general geopolitics.

Levels of debt, that are very very high compared to the last time that we had a crisis, are a risk factor that is crucial for the fragility of the entire system, not only financial markets. As central banks changed their mind on interest rates hikes we gained some more time, but sooner or later debt is a burden that will have its negative effects on the economy. This time it could really be a serious issue as we might be at the end of the long-term debt cycle (something that sounds old fashioned and no one likes to talk about but is real and sooner or later we have to cope with).

Conclusion

There is not a clear and defined direction yet. Probably there isn’t enough euphoria for those risks to manifest into a shift in the dollar during the next weeks, but over a few months we might be able to see that things start moving. Remember that when things start to melt down, volatility spikes immediately and by a large amount as speculators and investors rebalance their positions, causing huge swings in asset prices.


This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.

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