Volatility has slumped in the G10 FX market.

If we look at implied volatility across G10 currencies right now, we see that it is around the lowest levels that we have seen in a year across the various maturities. In addition, if we look at risk reversals, we see that many G10 currencies are coming back to a more neutral position. For instance, one-month euro/dollar risk reversals were very heavily skewed in favour of euro puts a year ago but now they are close to balance; a level that was last in place before Russia’s attempted invasion of Ukraine.

In terms of spot rates, the euro has tried and failed to decisively break above 1.10 and this seems to have set it back into a trading range that looks to be between 1.05 and 1.10. Why has volatility slumped so much? After all, it is not as if there’s little news at the moment what with the Fed’s recent policy pause after a year of hikes, the banking tensions in the US and Switzerland and, most recently, the furore created by a potential debt default in the US.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy  thinks that there are two reasons. The first one is that high uncertainty over issues like banking stress and the debt ceiling creates volatility, but it is actually the opposite. It is certainty that creates volatility, not uncertainty. This is obvious when you think about it. For high uncertainty means that traders and investors are not sure what to do and, very often, end up doing nothing as they wait for the uncertainty to clear.

In contrast, when the uncertainty breaks and we move into a more certain environment, we often find that markets start to move and volatility rises in tandem. There is also a second factor which is that FX volatility is being dragged down by the fall in volatility in other assets. If we look at stock volatility, as indicated by the VIX index, or bond volatility as shown by the MOVE index we see that both have eased down quite a bit, particularly the volatility in treasuries after the surge in vols caused by the banking strains in March.

Volatility in FX markets moves quite closely with that of other assets. That’s not just because the same fundamentals that move other assets – like banking stress –also causes movement in currencies. It is also because the financing of asset positions typically involve funding through short-dated FX swap positions, and usually in terms of borrowing dollar.

When asset prices move dramatically, and especially when they fall, investors can become under or over-hedged and often use the spot market to adjust funding levels. This typically means buying dollars when asset prices fall, and selling when they rise. This is why the dollar tends to become very strong very quickly when a major plunge in asset prices occurs, as we saw during the initial phase of the pandemic, or the global financial crisis. But when asset prices are stable – as they have been recently – the need for spot adjustments to hedges becomes small and, as a result, the volatility in the FX market tends to come down as well.

If these two factors are behind the fall in FX volatility, what does it imply, if anything, about the future? It would seem to mean that a recovery in volatility won’t happen until some of these uncertainties clear, like the debt ceiling impasse, and only then will volatility rise if asset price volatility rebounds significantly.

Mr. Steve Barrow thinks that only half of this outcome will be achieved, for while some uncertainty in the market will be lifted in coming weeks, such as the debt-ceiling conundrum, general asset price volatility won’t move significantly. If it does, it is more likely to move in the direction of lower asset prices and so give the dollar a modicum of support. “This could mean that the 1.05 end of the expected 1.05-1.10 trading range for euro/dollar is more vulnerable than the 1.10 level but, even then, we are not anticipating such a volatility shock in asset prices that it really knocks the dollar out of what looks set to be a summer stupor”, said Mr. Steve Barrow.