Is Low Volatility Here To Stay?

Forex Outlook: Is Low Volatility Is Here to Stay?

Over the past month, we have seen all of the major currency pairs trade in increasingly narrow ranges and not only is this evident in the day to day movements of currencies but their option volatilities are also trading well below long term averages. The current volatility of 1-month EUR/USD options is approximately 5.8%, compared to a 5-year average of 10%. The current volatility for GBP/USD is 4.93% versus a 5-year average of 9.15% and for USD/JPY current volatility is 6.34% compared to an average of 10.59%. Even with Tier-1 data such as last week's U.S. retail sales and Bank of England Quarterly Inflation reports, the weekly trading range of the 3 majors was between 100 to 170 pips. According to Dallas Fed President Fisher, who spoke earlier this morning, "there's almost no volatility in the markets" and there are a number of different explanations for this decline in volatility including crowded consensus trades, the lack of uncertainty in monetary policy, low yields that reduce return and an unexpected decline in U.S. rates that triggered a short squeeze in Treasuries, leading to a further contraction in risk appetite. The drop in volatility is having a significant impact on the profitability of many individual investors and currency funds. The question now is whether the low volatility environment is here to stay and unfortunately we fear that it is despite the abundance of event risks this week. The main reason is because none of this week's economic reports are expected to tell us what we don't already know. Seven Federal Reserve Presidents are scheduled to speak around the release of the FOMC minutes and all of them will be just as elusive as Fed Chair Yellen in providing very little guidance on when rates will rise. We already know that the central bank is poised to end QE in late 2014 but aside from confirming their schedule for tapering, no additional outlook for monetary policy will be provided. All of the U.K. economic reports scheduled for release this week will most likely validate the Bank of England's decision to provide zero guidance on tightening while the PMI numbers from the Eurozone should reinforce the European Central Bank's plans to ease. So while each of these event risks could trigger a reaction in currencies, the low volatility environment is here to stay for the time being and as a result we do not anticipate any big moves this week. USD/JPY could test its February lows at 100.75 but even if it breaks this level, the extension should be nominal.

EUR: Mersch Says Odds of June Easing Rose Significantly

With no major U.S. or Eurozone economic reports released this morning, euro ended the day only marginally higher against the U.S. dollar. The currency pair remains confined within a 1.3650-1.3735 trading range. Bundesbank President Weidmann's speech this morning received some attention because he said targeting a weaker euro could prompt a counter reaction and conflicts with price stability. This view isn't new - Mario Draghi has made it clear on numerous occasions that the central bank does not target any specific exchange rate but of course, a weaker euro in a low inflation environment could be more positive than negative for the economy. As indicated by ECB member Mersch Monday, " the probability of ECB action in June rose significantly" and we expect EUR/USD to remain weak ahead of the June announcement. By now there is a general consensus view that the central bank will introduce a series of measures including a reduction in the refi rate, a cut in the deposit rate, an end to SMP sterilization and new LTROs. Normally any one of these measures could send euro sharply lower but in an ultra low interest rate environment after a 3 cent sell-off in the EUR/USD, there's only so much impact these steps will have on rates and the currency. We still believe EUR/USD is vulnerable to further losses but its decline could be limited to another 100 pips before the June meeting with a possible move down to 1.35 after the central bank eases. On a technical basis 1.3500 is a key level not only from a psychological perspective but also because it is the 50% Fibonacci retracement of the 2011 to 2012 decline.

GBP: Will CPI Validate the BoE's Dovish Bias?

Of all the major currencies, the one that could see the greatest volatility this week is the British pound. Since the Bank of England released its Quarterly Inflation Report, sterling has been surprisingly resilient. If this week's economic reports validate the central bank's decision to keep their economic forecasts and monetary policy guidance unchanged, speculators could finally find a reason to liquidate their long sterling positions. The price action of GBP/USD indicates that the market is clearly more optimistic than the central bank and weaker data could bridge that gap. Maintaining stable inflation is one of the BoE's top priorities and this makes Tuesday's consumer and producer price reports extremely important. Economists are looking for CPI growth to increase slightly and if they are right, it would drive GBP/USD higher on the basis that it validates the market's expectations for a stronger reflation story. However if CPI surprises to the downside and the risks are high given the decline in shop prices reported by the British Retail Consortium, GBP/USD could drop back below 1.68 aiming towards 1.67.

AUD: No Surprises Expected from RBA Minutes

The Australian dollar traded slightly lower against the greenback ahead of the RBA minutes. We were not expecting much of a surprise from Monday night's release because the monetary policy statement was virtually unchanged from the previous meeting and was a nonevent for AUD/USD when it was released. At the time, nothing new was said by the central bank who maintained a neutral monetary policy stance and called the value of currency high by historical standards, a comment that investors interpreted to represent only mild concern about the level of the currency. There was very little consistency in the changes in Australia and China's economy between the last 2 meetings in that there was slightly more weakness than improvement in Australia but Chinese data signaled a potential bottom for Australia's largest trading partner. As a result, we do not expect the minutes to reveal a significant shift in the central bank's outlook. Canadian markets were closed for a holiday and the lack of economic data left the Canadian dollar slightly lower against the U.S. dollar (CAD/USD). New Zealand was the only one of the 3 commodity-producing countries to release data over the past 24 hours and the increase in service-sector activity along with rise in producer prices helped to support the currency (NZD/USD).

USD/JPY Hits 3-Month Lows

For the fourth consecutive trading day, the U.S. dollar weakened against the Japanese Yen. The latest decline took the pair to its lowest level in 3 months. The initial sell-off in the currency pair was triggered by the decline in Japanese equities and the jump in machine orders but the low was achieved at the start of the North American trading session when U.S. yields opened lower. By the end of the day, U.S. yields turned positive and that helped USD/JPY recover some but not all of its losses. Whether or not USD/JPY continues to decline for a test of its February lows depends on the direction of U.S. yields and it is still far too early to say whether U.S. rates have bottomed. Since the Bank of Japan is widely expected to keep monetary policy unchanged, the most important releases from Japan this week will be the trade balance and manufacturing PMI. We are also very interested in Monday night's department store sales reports because they provide initial clues on how consumers reacted to the tax increase.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.