Just where has the FX volatility gone?

It seems that the days of 200 pip movements in popular pairs like EUR/USD & USD/JPY are over for now (and their attendant margin calls when caught on the wrong side!!) with typical recent daily ranges of 40-80 pips at best. The forex market is uncharacteristically quiet and peaceful with traders enjoying rare peaceful sleeps!

So, just what is happening in the forex markets and what is driving this new volatility reduction?

It is said that forex is a zero-sum game with there being a loser for every winner (in fact, there being very, very few winners who, in part through manipulation and capital mass, and also privileged information flow, take the spoils from the very many retail traders) but with the volatility diminution at the moment, it could be argued it is a negative game. It is the absence of responsiveness to the recent risk events like Ukraine that is perplexing. A prime example of this is the EUR/USD pair. While the FED promised to scale back on its monetary easing program, investors could be forgiven for thinking this a bullish event for the dollar. Truth is that the dollar has in fact been losing ground against the euro and also the other major pairs – the pound and then Yen. Against the Euro, it is back at levels not seen since 2011.

Traders are finding it tougher than ever to identify any kind of pattern or discernible trend out of the currency market at the moment.

One could argue that this is really all based upon the collective similarities of the 3 major central banks. While it is true that the FED is scaling back its monetary easing program, when analysed all together, the major central banks of course have similar interest rates and policies, as the developed world continues in its fight to get growth back on a self-sustaining track in the face of still very large sovereign and private debt burdens – natural brakes on economic growth. Interest rates are under 1% in the UK, Europe, the US, Japan and in many other countries and so interest rate differentials that can drive movement are smaller than ever.

The real action in recent months has been seen in emerging markets with currencies like ike the SA Rand in particular seeing large moves. The overall change in policy from the US from super, super loose towards neutral (albeit at a slow pace), has had a direct impact on the value of these countries with the hot money making a quick exit.

Still, some argue that the problem is not only due to global central bank’s policies, but instead due to a structural change that may actually lead to a long-term loss in volatility. They argue that the market microstructure is changing with many of the traders being forced out of the market forever. For example, currency traders from the major banks often use their order flow from clients to position their own trades (in effect a form of “front running”). But, as of recently, there have been regulatory probes into alleged collusion among traders at these big banks and which has put many of them out of the market. At the same time, the proliferation of electronic trading means that these banks have a decreasing part of the order flow picture (a good thing in our opinion) and so it is becoming ever more riskier for them to place trades as they are losing the informative part that previously gave them the edge.

It may very well be the case there are some fundamental changes taking place in the market but one thing is for sure, as long as some central banks continue with their game plan to raise interest rates towards a more normalised level, divergences will emerge among various pairs with the Yen cross v the Dollar and Euro likely to be at the epicentre. We expect a resumption in volatility as we move in the 2Q 2014.