The roughly $6.6 trillion-a-day, around-the-clock currency market may be in for a taste of the volatility that’s gripped bond markets over the past few weeks from the U.S. and Canada to the U.K. and Australia.
That’s the view of Jonas Goltermann, a senior markets economist at Capital Economics in London, who sees such a scenario unfolding in the next three to six months. He points out that currency traders have remained surprisingly calm in the face of mounting evidence that higher inflation is turning persistent and there is lingering uncertainty about how central banks will respond to it.
Bond markets have been grappling with two competing narratives that’s causing traders to move with less conviction. One is that higher inflation will ultimately lead to tighter monetary policy by central banks, and the other is the possibility of an economic slowdown that forces policy makers to be patient about raising interest rates.
In Treasurys, the largest and most liquid government-securities market in the world, most yields slipped after disappointing November consumer-sentiment data on Friday before turning mixed, just two days after the highest U.S. inflation reading in almost 31 years saw the 10-year yield
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post the biggest daily rise in a year. Escalating inflation, along with a growing belief among consumers that effective policies are not being developed to combat it, was identified as a factor behind the drop in the University of Michigan’s sentiment report.
“No one wants to take a particularly firm view and relative yields haven’t moved nearly as much,” which is leaving currencies listless because the two assets typically move together, Goltermann said via phone.
In addition, the inflation and economic growth shocks resulting from the pandemic are global in nature, leaving “a net effect on currencies that isn’t big” because no single country is necessarily doing better or worse than another.
The implied volatility of three-month, at-the-money options on G-10 currencies, versus the dollar, remains below average since 2010, according to data from Refinitiv and Capital Economics, a London-based research firm.
As the recovery from the pandemic continues, divergences between countries will widen amid varying progress in labor markets, according to the economist. From there, the probability of greater divergences in monetary policy would rise, followed by increasing differentials in yields and higher volatility in currency markets.
“We think that the recent surge in bond market volatility may be a sign of things to come in currency markets,” Goltermann said. “We think the divergence in the inflation outlook between the US and other major economies will widen in coming months, and that uncertainty around central bank reactions will remain high.”
This post was originally published on Market Watch
