The Strange Death of Forex Volatility
What is happening to the forex market and how can we profit?
In a week that saw the Fed confirm a stronger case for rate cuts and Iran shoot down a US drone, we saw SPX fully erase the ‘Sell in May’ weakness with new all-time highs.
Also notably Oil (+10%) posted its best week since 2016, Gold touches $1,400 a level not seen for five years, and US 10-year yields briefly fell below 2%, a level not seen since before the Trump election. For Gold to touch a new multi-year high at the same time equities make a new all-time high is surely unprecedented.
Indeed the FOMC allowed us to exit index longs and attempt shorts at the end of a at least a short-term trend sequence. It also gave us an opportunity close some USD shorts (USDCAD, EURUSD) and attempt some USD longs (EURUSD) even though we are still running long GPBUSD and NZDUSD into next week. But why the divergence in approach? Is this more range trading. Surely this can’t be a trend like USDJPY. After all it is typically the lead interest rate and risk currency. This cynicism about the sustainability of currency move begs the question what is happening to the forex market as volatility continues to collapse to almost historically low levels.
This week’s newsletter explores the reason for this stagnation using our unique but now traditional FITS approach. Today we focus on the fundamental and intermarket causes of the volatility collapse as they explain why and therefore when conceptually we can expect a return to forex volatility. Next week we look at the technical and sentiment reasons as they will help us take advantage of the next exciting cycle in the foreign exchange market.
The Forex market is trapped between two sets of counterbalancing fundamental forces and the dominant themes such as inflationary growth surrounded by too much uncertainty. If you read our daily and weekly commentaries, it is all detail.
The Dollar is trapped between supply from falling yields due to slowing US inflationary growth caused, in part, by the Trade war and demand from the consequent lower yield driven hopeful risk appetite.
EURUSD suffers from EU economic stagnation punctuated by various political risks (notably Italy) but the ‘catch up’ softening in the US economy is holding it in check.
Sterling remains confronted but also confounded by political and therefore economic uncertainty from Brexit and Tory leadership issues and therefore unable to recover in line with relative economic stability.
The Japanese Yen is trying to catch up with the interest movements it started to ignore in the last quarter of 2018 due to concerns over its sales tax hike. But is now also still held back by its risk appetite status.
Similarly, the Canadian Dollar needed an end to the sharp Oil decline to wake up to falling US rates and a more resilient Canadian economy, and the Australian Dollar remains a blend between the aftermath of the surprise Coalition election victory last Month that has reinforced expectations of quantitative easing and a revival in Gold.
But that doesn’t answer the question as it doesn’t explain why the average movements caused by these factors have fallen so much.
There is a conceptual reason for the range trading. One word describes well the macroeconomic environment for currencies: uncertainty. It is difficult for investors to invest with confidence where there is so much political uncertainty. It is tough to generate a return where most global yields are falling. There is little incentive to move money. We have spoken before about ‘stasis’ an uneasy range bound equilibrium. Markets and particularly currencies hate uncertainty triggering players to sell assets or currencies associated with that risk and seek safer higher returns elsewhere.
Yet the macroeconomic outlook is always a little uncertain and that hasn’t prevented trending markets before. After all the prospect of Trumpflationary growth caused the USD to rally strongly in the last quarter of 2016. The simple fact this was counterproductive to the Trump agenda of Making America(n Manufacturing) Great agenda prompted a Trump inspired USD decline in 2017. The failure of this policy to remove the trade deficit and its associated dangers was the pretext to the current trade war that ironically and typically caused the USD to rally through 2018. Yes, ironically one of the greatest causes of stock market volatility, Donald Trump, is partly responsible for the collapse in forex volatility.
Changing policies and different effects leads to confusion uncertainty and militates against trend or lead to unjustifiable/unsustainable trends. Where there is uncertainty about uncertainty as we have now about the duration and consequent impact of the Trade War, the result is often a range. The decision many longer-term participants make is not to decide or rather commit until the outlook is clearer. This leads ironically to either a stasis where markets, such, range until a resolution or to the pursuit of trends sometimes with little justification simply because they are trending.
One of the more famous examples of a stasis range is the Greek Euro in 2014 which only collapsed once the Greek debt crisis appear resolved. Alternatively, investors and traders often seek a return in such uncertainty by pursuing trends that would appear to have little justification. The current uptrend in indices is a prime example. Where else can you find a return? The result is that many are front running a resolution to the Trade War setting up an aggressive ‘buy the rumour, buy the fact, oops sell’ scenario.
However, the effect a resolution would have on currencies is curious. On the one hand the consequent ramp in US yields would ramp the Dollar but only to fade as the long-term consequences of both protectionism on the economy and yields on equities would send both stocks and the Dollar back down hard. In other words, what appears to be a range in price is actually an expansion where two-way volatility in forex develops into trend. In our opinion, a downtrend.
Fundamentally, volatility will return to the forex market when uncertainty about uncertainty ends and that will be when the Trade war appears close to resolution. And the best guide for that will be the Bond markets and probably when the bond-stock relationship returns to a negative correlation.
In theory (or the longer term) forex is driven by interest rate differentials where a currency will strengthen vis-a-vis others if its bonds are producing higher yields due to confidently expected inflationary growth (as opposed to risk aversion). However, where there is uncertainty (about uncertainty) in a falling yield environment it leaves investors or traders scratching their heads as they seek a higher safer return. The impact on forex volatility is threefold. Firstly, investors are unlikely to stay committed for as long. Secondly the percentage and duration of relative bond movements fall curtailing any potential trend. Thirdly greater uncertainty creates periods of divergence between currencies and their interest rate differentials. One of the reasons for this is that, again, traders are pursuing trends because they appear to be trends rather than any real fundamental justification.
Currencies cannot sustain such divergence in the medium term. The EURUSD top in early 2018 followed the differential bottom 140 days earlier. The EURUSD bottom in May was set 145 days after the differential bottomed.
EURUSD Differential Divergence
Other USD currency pairs are showing similar potential to follow the decline in US yields.
USDJPY Differential Divergence
GBPUSD Differential Divergence
USDCAD Differential Divergence
USDCHF Differential Divergence
However, curiously this divergence is not so prominent in either AUDUSD or NZDUSD
What causes currencies to return to their differentials is less consistent or clear. However, fundamental news (that is better reflected in the bond markets) is often the cause of a realignment. Again, we need the fundamental trigger, and probably a resolution or anticipated resolution to the trade war.
The current forex market and collapse in volatility may seem unusual but it is not. Forex, like any other market, is cyclical. There are also plenty of historical precedents (fractals) that should help us manage our way through a slow low volatility USD turn.
Next week we highlight some of the exciting longer-term fractals that are guiding us and explain why traders are repeating the same pattern: Sentiment.
Here’s to making the very best.
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