Deutsche Bank’s currency volatility index, which measures expectations of currency fluctuations, has fallen in recent weeks from a three-month low to its highest level since March, due to fluctuations in the US dollar, the euro and Japanese yen as well as a wide range of other currencies.
The divergent outlook of central banks, which are moving at different speeds to normalize monetary policy after numerous interest rate cuts and adopted extraordinary measures last year to protect their economies from the damage caused by the COVID pandemic- 19, are at the origin of these fluctuations. Expectations of higher rates tend to make a currency more attractive to investors seeking yield.
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The increased fluctuations in the forex markets can provide investors with the fluctuations they need to make money by trading currencies against each other. Too much volatility, on the other hand, could force investors to reduce their risk and create problems for international companies that have to convert their profits back to their national currency.
While volatility is still low from historic levels, some investors believe gyrations should not abate anytime soon. The volatility of the bond markets, also strongly influenced by rate expectations, has been on the rise for weeks.
Many are also taking steps to protect their portfolios from excessive market fluctuations, pushing hedging activity in many currency pairs to its highest level in months.
“We have a policy divergence, a divergence in inflation rates… a divergence in the rate of economic growth,” said Lisa Shallet, chief investment officer at Morgan Stanley Wealth Management. “Overall divergence will be the name of the game in 2022 and investors are starting to smell it.”
Much of the recent volatility has stemmed from an accelerating rally in the US dollar, which is benefiting from bets that the Federal Reserve will have to unwind its government bond purchase program and possibly raise rates at a faster rate than other central banks.
The US currency is up 9.1% against the euro this year, keeping pace with its biggest annual gain in six years. It also gained 11.6% against the Japanese yen and 7.0% against the Australian dollar.
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Richard Benson, co-chief investment officer at Millennium Global Investments in London, bets the dollar will continue to appreciate against the euro, expecting the Fed to tighten monetary policy next year faster than the European Central Bank in the face of booming US growth and inflation. .
“The underlying fundamental view is that the Fed will raise interest rates over the next 12 months, and the ECB will not,” he said.
On Wednesday, federal funds futures, which reflect investors’ expectations for monetary policy, had taken into account a 100% chance that the Fed would raise rates by next June. Eurozone rate futures, on the other hand, fully integrated a 10 basis point hike by December 2022.
Other factors driving the currency movements include concerns over COVID-19, weighing down the euro and other European currencies as the region faces another wave of the pandemic while strengthening the Swiss franc, a popular destination in uncertain times.
Concerns about a potential war with Ukraine have stumbled the Russian ruble in recent weeks, while the Turkish lira plunged 25% this month after President Tayyip Erdogan pressured the country’s central bank to that it is pivoting towards an aggressive easing cycle, potentially triggering a crisis in its own right. in the countryside.
With volatility on the rise, some investors are taking steps to protect their portfolios against further currency fluctuations.
Implied volatility, used by banks to price three-month options on the euro against the dollar, stood at its highest level since March on Wednesday, indicating greater demand for hedges against rising gyrations of the currency pair. Demand for certain options that would protect against fluctuations in the dollar-yen currency pair is at its highest level in a year.
Bernhard Eschweiler, economic adviser at QCAM Currency Asset Management, bets that the dollar will continue to rise, but also recommended that investors use derivatives that could offset fluctuations in currency markets. Worsening inflation, COVID-19 surges and intensifying energy scarcity are among the factors that could give markets a shake, he said.
“There is no shortage of potential shocks,” he said.
Exchange rate volatility tends to increase as the Fed approaches the rate hike, said Bipan Rai, head of foreign exchange strategy for North America at CIBC Capital Markets.
“If you’re an asset manager with exposure to major currencies that might diverge because of what the Fed will do after you, then you’ll want to have some protection in place,” he said.
(Reporting by Saqib Iqbal Ahmed and Gertrude Chavez-Dreyfuss; editing by Ira Iosebashvili and Edward Tobin)
By Saqib Iqbal Ahmed and Gertrude Chavez-Dreyfuss