Depressed FX volatility allows for few surprises

Olivier Desbarres

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Global FX volatility has fallen further in the past month to its lowest level since September 2014 according to our estimate (see Figure 1).

Volatility in most major currencies has either fallen or only increased marginally in the past month and is now very low relative to the past 12 months. Sterling, the Brazilian Real and Turkish Lira have recorded the largest absolute and relative falls in volatility.

There are a few exceptions. Volatility in the Chilean, Colombian and Mexican Peso, Kiwi Dollar and Philippines Peso has increased materially in past month. Chilean Peso volatility is now near its 12-month high but volatility in the Mexican and Colombian Peso and Kiwi Dollar is still well within its medium-term range. Philippines Peso volatility remains low.

There has been limited contagion from the collapse in the Chilean Peso to other Latam and high-yielding emerging market currencies and few major macro-data surprises.

Moreover, the perceived uncertainty surrounding major central banks’ rate cycles has receded in recent weeks with markets now assuming that central banks in the US, Canada, UK, Australia and New Zealand are unlikely to cut rates near-term.

Sterling volatility has collapsed. The ruling Conservative Party remains about 15 points ahead of the Labour Party in opinion polls ahead of the 12th December general election. Markets seem reasonably confident that Prime Minister Johnson could secure a parliamentary majority and that a no-deal Brexit will be avoided.

But, as we argued in mid-July, the risk is that global FX volatility will rise in coming weeks, with the potential for a volatility spike in mid-December – a move markets may not be positioned for (see FX Vol gone AWOL, directionality has not, 19 July 2019).

First, there is scope for data-dependant central bank monetary policy to surprise, including in the United States. Moreover, the outlook for US-China trade negotiations remains at best opaque, with a number of possible scenarios on the table. This presents upside risks to USD/CNY and USD/Asia volatility in our view. Finally, if history has taught us one thing it is that British general elections are near impossible to predict with any accuracy.

 

Already low volatility has fallen in many currencies with a few notable exceptions in Latam

Volatility in major currency pairs has fallen to its lowest level since September 2014. Markets are ultimately pricing in very little risk of policy or macro data surprises.

We estimate that realised volatility in a turnover-weighted basket of 32 major currency pairs against the Dollar – measured by the 10-day standard deviation in the daily percentage change in the spot (closing) price – is currently 0.22, down from an already depressed 0.37 a month ago and well below its 10-year average of almost 0.50 (see Figure 1).

 

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Volatility in most major currencies (versus the Dollar) has either fallen or only increased marginally in the past month (see Figure 2). Sterling, the Brazilian Real and Turkish Lira have recorded the largest absolute and relative falls in volatility, according to our estimates. Volatility in the Swedish Krona has also fallen materially. As a result volatility in the vast majority of currency pairs is now very low relative to the past 12 months (see Figure 3).

 

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There are a few notable exceptions, specifically the Chilean, Colombian and Mexican Peso, New Zealand Dollar and Philippines Peso which have recorded material increases in volatility in the past month. Chilean Peso volatility is now near its 12-month high but volatility in the Mexican and Colombian Peso and New Zealand Dollar is still well within its medium-term range while Philippines Peso volatility remains low in both absolute and historical terms.

 

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Limited EM contagion and data surprises, mature rate-cutting cycles and Brexit “calm”

There are a number of inter-related factors behind this low and falling global FX volatility as well as sovereign-specific explanations for the level and direction of volatility in individual currency pairs.

 

Contagion from Chilean Peso collapse to other Latam and high-yielding currencies very limited

First, as we have highlighted throughout the year, there has been limited contagion across emerging market (EM) currencies. The Chilean Peso Nominal Effective Exchange Rate (NEER) has collapsed 10.5% in the past six weeks according to our estimates – largely due to domestic political factors and widespread social unrest – but this has only marginally fed through to other Latam and high-yielding EM currencies. The Mexican Peso, Brazilian Real and Argentine Peso have depreciated only 0.4%, 1.5% and 2.4%, respectively, over the period while the Colombian Peso has appreciated about 0.7%. In the same way weakness in the Turkish Lira and Argentine Peso in April only partially feed through to other EM currencies (see FX Vol gone AWOL, directionality has not, 19 July 2019, and Three Themes: Low FX vol, EM contagion and global growth, 5 April 2019).

This limited contagion can be partly attributed to central banks’ tight FX management, including the greater use of Dollar swaps and intervention in the FX market to smooth out currency moves. In particular Non-Japan Asia (NJA) central banks have been willing (and able) to buy or sell FX reserves in order to influence their currencies’ paths and shore up their inflation-targeting credentials. NJA currencies have indeed proved resilient and volatility in Dollar/NJA crosses remains very low, including in the high-yielding Indonesia Rupiah and Indian Rupee (see Figures 2 & 3).

It is telling that USD/IDR (closing price) has traded in a narrower range in the past month (0.9%) than the seemingly stagnant EUR/USD (1.5%) – see Figure 4. This would have been unthinkable only a few years ago.

 

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Second, the perceived uncertainty surrounding major central banks’ rate cutting (and in a very limited number of cases hiking) cycles, which arguably contributed to currency volatility in May-October, has receded in recent weeks in our view.

Many of the G10 central banks, as well as number of emerging market central banks – which have repeatedly cut their policy rates since late-April (see Figure 5) – have indicated that they are now comfortable with their current policy rates. Specifically, the Federal Reserve, Reserve Bank of Australia (RBA) and Reserve Bank of New Zealand (RBNZ) – which have each in the past six months cut rates 75bp – have all recently indicated that current policy rates are appropriate and further cuts unwarranted at this juncture, even if the risk remains tilted towards further easing.

Similarly, the European Central Bank – which cut its policy rate 10bp in September – has given few signs that further rate cuts are on the table, with Christine Lagarde having taken over from ECB President Mario Draghi only three weeks ago. In the UK, two out of the nine Bank of England (BoE) Monetary Policy Council members voted for a 25bp rate cut at the 7th November meeting. However, the consensus forecast is that the BoE is likely to keep rates unchanged until after the 12th December general elections and there is greater clarity as to whether and when parliament will approve the Brexit deal. Finally, Bank of Canada (BoC) Governor Poloz in a speech on 21st November seemingly played down the odds of the BoC, which has kept its policy rate unchanged at 1.75% since October 2018, cutting rates in the foreseeable future.

As a result markets are currently pricing in very little in terms of rate cuts by year-end for the Federal Reserve, RBA, RBNZ, BoC or BoE.

 

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It is no coincidence, in our view, that the New Zealand Dollar and Mexican Peso are amongst the few currencies which have recorded materially higher volatility in recent weeks.

The RBNZ surprised markets by keeping its policy rate unchanged at 1.00% at its meeting on 13th November. The New Zealand Dollar Nominal Effective Exchange Rate (NEER) promptly rallied over 1% to a 3-week high before giving back some of its gains (see Figure 6) and NZD/USD volatility spiked (see Figure 7). Analysts had forecast a 25bp rate cut and markets priced in a 65% probability of a cut, thinking that the RBNZ – which has a history of surprising markets – would deliver one last “insurance” cut in its easing cycle.

 

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Mexico’s central bank cut its policy rate 25bp to 7.50% on 14th November but the five members of the Board as well as the 26 analysts polled by Reuters were divided between a 25bp and 50bp cut and Peso volatility has since edged higher (see Figure 8).

 

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Macro-data surprises have been far and few between

Third, there have been few major macro-data surprises in recent weeks and the Citigroup Economic Surprise Index has moved to around zero (from slightly positive territory). Specifically recent CPI-inflation figures in the US, Eurozone, UK, Australia and New Zealand were all broadly in line with expectations, as were preliminary Q3 GDP data in the Eurozone and UK.

 

Sterling volatility has collapsed with markets waiting for 12th December general election result

Finally, Sterling volatility – which continues to be largely dictated by fluid Brexit-related and political developments, has fallen sharply in the past month with GBP/USD stuck around 1.29 (see Figure 9).

Sterling showed very little reaction to the first televised debate on 19th November between Prime Minister and Conservative Party leader Boris Johnson and the leader of the opposition Labour Party, Jeremy Corbyn or to the release on 21st November of a Labour Party manifesto which envisages significant tax hikes to pay for greater social spending and infrastructure investment. Much has been written about who performed best on the night and which party manifesto stands up best to scrutiny but, in an era of almost continuous political coverage, British voters and markets have likely learnt little new about the respective party leaders’ policies or personalities.

 

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Ultimately, we attribute Sterling’s recent stability in large part to the Conservative Party remaining well ahead of the Labour Party in the polls (see Figure 13) and a consensus view that it could gain seats at the 12th December general election and secure a parliamentary majority. This would in turn increase the odds of the House of Commons voting in favour of Johnson’s Brexit deal and by extension reduce the odds of the UK leaving the EU without a deal on 31st January. Sterling was one of the most volatile major currencies in October (see Figures 2 & 9) after newly-appointed Prime Minister Johnson failed to get his revised, EU-approved Brexit deal through parliament and the House of Commons voted on 29th October in favour of early elections.

 

Risk tilted towards higher global FX volatility, particularly around mid-December

We argued in mid-July that the threshold for global FX volatility to materially rise was potentially quite high but also that markets were maybe growing complacent and not prepared or positioned for any spike higher (see FX Vol gone AWOL, directionality has not, 19 July 2019). FX volatility subsequently spiked materially higher in the following month (see Figure 1). Once again we would argue that the risk for global currency volatility is clearly tilted to the upside in coming weeks and months, with the potential for materially higher volatility in mid-December.

 

Scope for central bank monetary policy surprises

For starters, a number of major central banks have made clear that their policy rates’ future paths remain highly conditional on domestic and global macro data and developments in US-China trade negotiations. Material data surprises could therefore easily translate to central banks changing tact, markets repricing rate cut expectations and ultimately greater currency moves.

Markets are currently only pricing in negligible Federal Reserve rate cuts by year-end and 34bp of rate cuts in 2020 and the Conference Board as of 13th November forecast that US GDP growth would remain broadly unchanged in Q4. However, the Atlanta Fed GDPNow tracker as of 19th November estimated that the seasonally-adjusted annualised rate of US GDP growth had slowed sharply so far in Q4 to 0.4% qoq – a four-year low – from 1.9% in Q3 and 2.0% in Q2 (see Figure 10). While the Federal Reserve could argue that its 75bp of rate cuts in July-October will feed through to US economic growth (and inflation) with a lag, it is perhaps premature for markets to fully discount the Federal Reserve cutting its policy rate at its 11th December policy meeting or in early Q1 2020, in our view.

 

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Beyond the Federal Reserve, the RBNZ has already twice this year surprised markets – first by cutting rates 50bp (rather than 25bp) at its 7th August meeting and then by leaving its policy rate unchanged at its 13th November meeting (see Figures 6 & 7). Its next meeting is admittedly not until 12th February 2020 but its neutral rhetoric could change materially between now and then. The Reserve Bank of India also surprised markets with a larger-than-expected 35bp rate cut in August while the Bank of Thailand delivered an unexpected 25bp rate cut.

 

US-China trade negotiations likely to condition Renminbi and USD/CNY volatility

Moreover, the outlook for US-China trade negotiations remains at best opaque, with a number of possible scenarios on the table. There has been no material announcement from either the United States or China regarding trade negotiations in the past fortnight but reports out on 20th November conclude that the two sides may not sign a Phase One trade deal until next year. US President Trump is reportedly still not satisfied with Chinese concessions, including on core intellectual property and technology transfers, in exchange for the US cancelling its planned tariff hikes on 15th December on $156bn of imports from China and removing the 15% tariff it imposed on 1st September on about $125bn of imports from China.

 

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Should the US and China fail to agree to a deal in the next three weeks, USD/CNY spot could rise within the +/- 2% trading band around the USD/CNY fix, as it did in August and again in late September (see Figure 11), and USD/CNY volatility – which has remained subdued – could conceivably edge higher (see Figure 12). This would in turn likely feed through to higher volatility in USD/Asia crosses, in particular USD/KRW in our view. In this scenario, the US would have to decide whether to stick to or delay its plan of introducing tariffs on Chinese imports on 15th December – another likely source of uncertainty and volatility for USD/CNY.

 

Only certainty is that precise outcome of British general elections remains highly uncertain

Finally, if history has taught us one thing it is that British general elections are near impossible to predict. The first-past-the-post electoral system, uneven distribution across seats of candidates – including over 200 independent candidates (some recently expelled Conservative Party MPs), party-alliances and tactical voting by the British electorate make it neigh impossible to accurately translate UK-wide polls into actual seat numbers. The 8th June 2017 general elections are a point in hand.

Three weeks before the 2017 election the ruling Conservative Party held a 15 percentage point lead over the opposition Labour Party in opinion polls and while this lead had shrunk to about 5-7pp on 6th June 2017 the vast majority of polling agencies were still predicting that the Conservative Party would win a significant majority of the 650 seats. In the end, the Conservative Party and Labour Party won 42.4% and 40%, respectively, of the national vote – a far closer-than-expected result. The Conservative Party won 317 seats (48.8% of total) but this loss of 13 seats left the party about 10 seats short of a parliamentary majority. This in turn proved to be a major handicap to then Prime Minister May’s ambitions of getting her Brexit deal approved by the House of Commons. The Labour Party won 262 seats (40% of total) – a gain of 30 seats.

 

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With the 12th December general elections only three weeks away, the Conservatives are once again leading Labour by about 15 percentage points (see Figure 13). Moreover, unlike 2017, Labour has failed to close the gap with the Conservatives – if anything it has widened slightly in the past fortnight – which has seemingly helped underpin market confidence that the Conservative Party will regain its parliamentary and confidence in Sterling. We attribute only modest credence to this confidence.