It is not just major developed currencies that have had life sucked out of them; just about all currencies have ground to a standstill. 

Watching dry paint has been more exciting than watching currencies, and not just this year. Euro/dollar saw its second smallest trading range last year since the euro came into being in 1999. But it is not just major developed currencies that have had the life sucked out of them; just about all currencies have ground to a standstill. The by-product of this is plunging FX volatility, something that usually works to the benefit of ‘risker’ currencies, such as those in emerging markets and to the detriment of the dollar. But that’s not happening right now; at least not against the dollar. Why?

Implied volatility has tumbled so far this year and was already on the way down before the year started. Across G10 currencies one-year implied volatility is now around 7.5%. That’s the lowest in two years and far removed from the 12% peak that we saw around the end of 2022. A 4.5 percentage point fall in implied volatility in just over a year is a lot but it is still smaller than the 6 percentage point fall that we’ve seen in 1-year implied volatility in EM currencies over the same sort of period. Implied volatility in EM is now down to around 8% in the 1-year maturity, and it has not been lower than this since before the pandemic in early 2020.

Usually, falling volatility aids riskier currencies. Why is this? Mr. Steve Barrow, Head of the Standard Bank G10 Strategy, argued that falling volatility hints at a smaller risk of sharp and significant currency movement in the future and, most often, dramatic movement in riskier EM currencies occurs when they fall, not when they rise. This is an important consideration when it comes to the carry trade as low volatility suggests a lower chance that the interest rate pick-up from holding a higher-yielding currency will be offset by a currency plunge. But in spite of this significant decline in implied volatility over the past year, or so, “riskier” currencies in the DM and EM space have not made gains against the dollar.

For instance, the US dollar’s broad effective exchange rate is slightly higher today than it was a year ago. The obvious reason for the US dollar’s stability in the face of this fall in volatility would seem to be the rise in US rates. As a result, even if low and falling volatility is beneficial for dollar-funded carry trades, the fact that the funding rate (the US interest rate) has gone up so much rather nullifies the help from falling volatility. But even here, we need to bear in mind that US rates stopped rising last summer, meaning that funding rates, such as 3-month SOFR rates, have been stable at around 5.3% since late July. Nonetheless, the high US funding rate is probably still a factor given that carry trade performance has been better where other low-rate funding currencies such as the yen and Swiss franc have been used.

All this raises the issue of how currencies might respond once the Fed starts to cut rates, which the market predicts will happen from June. As long as this happens in the context of a relatively benign macro and geopolitical backdrop, which allows FX volatility to stay low, or even fall further, we should see the US dollar slip back. Of course, movements in rate differentials will be important, especially if the Fed cuts rates later and/or slower than EM or DM central banks, but we would not put too much stress on this.

As long as US rates come down and volatility stays low, Mr. Steve Barrow expects riskier currencies to rise. The difficulty could occur if the macro/geopolitical backdrop is malign. This may force the Fed to cut much faster, but any benefit to riskier currencies would likely be negated by a surge in volatility; especially as the extent of the spike in volatility could be all greater given the very low levels to which it has fallen recently.

“Our base case is that the benign scenario is the most likely, not the malign one, and hence we see the US dollar giving some ground over the longer-term. However, we should not forget that the malign scenario cannot be discounted and could be particularly harmful for risk currencies given the levels to which volatility has fallen recently”, said Mr. Steve Barrow.