Forex volatility has fallen as the dollar finally weakens

LONDON, Nov 22 (Reuters) – If you are looking for a beep to mark the end of the interest rate cycle, then there is a loud decline in currency market volatility.

Deutsche Bank’s CVIX (.DBCVIX) – the foreign exchange market’s version of Wall Street’s “fear index” of stock volatility and a weighted average of implied “volatility” in nine major pairs – has essentially imploded.

The CVIX, subdued since the middle of the year, recorded another significant decline this month, reaching its lowest level since mid-February 2022 – just before the Russian invasion of Ukraine and the US Federal Reserve’s first vigorous campaign to raise interest rates by more than five percentage points in this March.

The index, where the prevailing weight of the three-month implied volume in euro/dollar and dollar/yen exchange rates accounts for more than 50%, is now exactly half what it was in September last year and about 1.5 points lower its historical average.

At first glance, the easing of volatility marks the end of the recent turbulent reign of “King Dollar” as the Fed ceases tightening and speculation will now subside.

By driving up short-term dollar interest rates and U.S. bond yields over the last 20 months, the Fed essentially sucked cash out of the broader investment world and drove up dollar exchange rates everywhere. Now that it looks finished, things are finally going downhill again – the water pipe levels haven’t been reached since August.

In what ING strategists Chris Turner and Francesco Pesole describe as the dollar’s “long goodbye,” 2024 is likely to see a prolonged, biased bear market for the dollar, which in itself will dampen volatility as risk markets rise on hopes of a Easing by central banks revives.

“Talking about ‘reflationary’ policy right now seems criminal – but the Fed has a dual mandate, and if inflation comes under control by 2024, it can cut interest rates to mitigate the impact on workers,” wrote the ING team and added commodity currencies within the G10 were a favorite for 2024.

Because implied volatility is directional, the Dollar Index and CVIX tend to correlate well and both peaked at the same time in the same month of September last year.

This trend is largely due to the disruptive aspect of dollar strength, which increases economic, trade and financial stress around the world through inflation in commodity import prices as well as pressure on dollar-denominated debt in many emerging markets.

This sensitivity, in turn, creates tensions and often leads to more extreme monetary policies or even open market interventions to take countermeasures – making a sharp rise in the dollar along the way even louder.

The flip side is more serene for the same opposite reasons.

Currency volatility returns to pre-Fed rate hike levelsReuters graphicsReuters Graphics Reuters Graphics

‘NORTHWEST PASSAGE’

Nowhere is this more evident than in Japan, where the Fed’s tightening met the Bank of Japan’s continued loose monetary and yield cap policies, sending the yen to its lowest level in 33 years and prompting at least one period of intervention while the government and the BOJ tried to withdraw the interest line below the yen as the dollar broke the 150 yen mark.

But if the Fed’s peak interest rates align with the BOJ’s – and both trend in opposite directions at least over the next year – then the dollar/yen will finally recover in earnest, and so will the dollar/yen’s two-point premium over the euro/ Dollar dissolves.

For the euro and sterling, the damage from the dollar’s rise was mitigated by the parallel tightening of monetary policy at the European Central Bank and the Bank of England. And a Fed reversal will most likely lead to the downside or even forestall it.

While the three-month interest rate differentials between the U.S. and Japan are the largest they have been since 2000 and are still at those highs, the corresponding interest rate differentials between the U.S., Germany, and the U.S. and U.K. have never exceeded the 2018 highs and are both back declining.

And while a Fed rate cut by June is already priced into futures, this also applies to a BOE rate cut – and an easing of ECB interest rates is already anchored in the money markets in April.

Then there is not much scope for relative currency transactions and volatility is further contained.

And of course, these moves have a habit of influencing each other, not least in that a decline in implied vol feeds leads to trades in currencies with higher interest rates – not just within the G10 but also in emerging markets and beyond the Fed vacuum is reversing cleaners of the last two years.

As the ING team points out, the yen would also typically suffer in this regime, as it typically acts as the cheapest funding currency. But a likely change in BoJ policy stands in the way.

The waiting game could certainly lead to a certain standstill again. UBS Global Wealth Management’s Solita Marcelli thinks this week’s decline may be “exaggerated” as the Fed’s thinking becomes clearer – although selling dollar rallies in the meantime probably makes sense.

But the sharp rise in U.S. Treasury yields over the course of October – as a “term premium” for Treasuries re-emerged amid worries about stagnant fiscal policy and rising debt levels – may have kept the dollar higher than volatility levels otherwise over the past two years suggested months.

With yields falling again and the term premium slipping back into negative territory after just two months, the dollar’s weakness could catch up.

The alternative assumption is that the dollar is not ready yet and may not disappear until the spring.

Morgan Stanley expects the DXY index could rise as much as 8% from here to around 111 before finally falling back later in 2024. The argument is that the near-term direction remains unclear, with interest rate differentials likely to continue to favor the dollar in the first half of the year, while growth and geopolitical risks support a defensive stance on dollar cash.

“Much like the Northwest Passage in winter, the path to a weaker dollar this winter is narrow, cloudy and fraught with risks,” Matthew Hornbach and his team told clients this weekend.

And yet, if you start from Vol, the clear water is already in sight.

Morgan Stanley produces charts of US growth and relative real interest ratesING chart on G10 forex valuations and carry

The opinions expressed here are those of the author, a columnist for Reuters

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Mike Dolan is Reuters Editor-in-Chief of Finance and Markets and has worked at Reuters for 26 years as an editor, correspondent and columnist – specializing in global economics, policymaking and financial markets in the G7 and emerging markets. Mike currently lives in London, but has also worked in Washington DC and Sarajevo, covering news events from dozens of cities around the world. A graduate of Trinity College Dublin in economics and politics, Mike previously worked for Bloomberg and Euromoney and received Reuters awards for his work during the 2007/2008 financial crisis and on frontier markets in 2010. He was a regular Reuters columnist in the International New York Times between 2010 and in 2015 and currently writes twice-weekly columns for Reuters on macro markets and investing.