The surge in euro/dollar volatility was indicative of the fact that the increase in volatility was centred on G10 currencies. 

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, certainly believes that FX trading conditions will be volatile meaning that the dip he saw in implied volatility levels towards the end of last year will probably reverse.

If we take one-year euro/dollar volatility, for instance, it rose from under 6% at the start of the year to a peak of over 11% before slipping back modestly towards the end of the year. The surge in euro/dollar volatility was indicative of the fact that the increase in volatility was centred on G10 currencies. One-year implied volatility in G10 currencies is about double the level it was a year ago, for a rise of around six percentage points, while emerging market volatility is up by only around one percentage point and currently sits close to the levels we see for G10 volatility.

Normally, emerging market volatility sits at much higher levels than G10 vol. If we go back to 2021, the gap was around four percentage points for the most part. The rand, for instance, saw quite stable volatility levels this year at around the 16% mark in terms of one-year implied volatility compared to the sharp movements in volatility that we have seen for the major currencies.

All this tells us that the surge in volatility last year was not due to tensions in EM markets but more a function of what was happening in major currencies. And this, in turn, suggests to us that the key trigger has been the reduction in central bank liquidity by the major central banks.

Given that this is set to continue and probably intensify in 2023, we should expect volatility to remain high in the major currencies. Why is central bank liquidity the key factor? Mr. Steve Barrow argued that central bank liquidity, meaning both interest rate levels and central bank balance sheets, have a big influence on returns in the market. Generally speaking, returns tend to be higher when liquidity is ample and vice versa. The most obvious way to see this is in the returns from the government bond market as rising policy rates and quantitative tightening produce falling returns as bond prices fall.

Last year, the Bloomberg total return index for global bonds fell some 16% as policy rates rose and bond prices fell. Stock returns tend to fall as well when liquidity is sparser and we saw the MSCI global index fall close to 20% last year. But what about FX?

In Mr. Steve Barrow’s view, the returns from holding options can be seen as a function of the premium paid. Option sellers – banks – seem likely to earn higher returns when the premiums they receive rise, which is due most often to higher volatility. The flipside is that the returns to holding options declines for the buyers the more that volatility increases. Looked at in this way we can see why sparser global liquidity, which lifts volatility, implies lower returns for option holders.

When we look at FX volatility in these terms, we can see that the biggest factor is the liquidity stance of central banks plus, it should be said, the general situation for liquidity outside of that which is directly influenced by the central banks. On both measures liquidity has been sliding and seems likely to continue through 2023. As well as further rate hikes by most central banks, the Fed is still set on trimming bond holdings by USD90bn per month, the BoE by nearly GBP7bn per month and the ECB will start a EUR15bn monthly contraction of its asset holdings from March.

“On the private side, too various liquidity measures, such as the provision of international dollar loans, is sliding and looks set to stay soft this year. In all, it is leading to a situation where a fundamental driver of option volatility – liquidity – is likely to keep implied volatility levels at least as high, if not higher through the first half of the year at a minimum. This, in turn is likely to mean that volatility in G10 currencies will remain closer to EM volatility levels than we have seen in the past”, said Mr. Steve Barrow.