The currency volatility comeback

DOLLAR: The US dollar DXY index has surged 6% this year. As US economic ‘exceptionalism’ drives bond yield differentials and sucks capital into the US. Foreign holdings of US treasuries, for example, are up 9% the past year to $8 trillion. And been further supported by geopolitics driving safer haven demand. This has extended the Dollar’s 10% real equilibrium exchange rate overvaluation. And triggered a unwelcome pickup in FX and cross-asset volatility (see chart), as monetary policy divergence grows. With low-yielding SNB cutting, the BoJ ‘one and done’, and ECB ready for June. This also puts China’s PBoC in the crosshairs after relative CNY strength.

VOLATILITY: Currency volatility has rebounded from its lows. This is undermining a key driver of the carry trade and particularly hurting emerging market currencies. And is also catching up with fixed income volatility, and with S&P 500 volatility back near its long term average around 20. The ‘CVIX’ is a measure of 3-month implied volatility for the ten most liquid global currency pairs, weighted by their traded volume. It is concentrated on EUR, JPY, GBP, CHF, CAD, and AUD cross rates with the USD. Its levels have been rising but may have further to go. Levels remain 15% below the average since its 2012 inception and are 40% down from the 2020 high.

CHINA: The RMB has been a relative anchor, losing only 2% vs the stronger dollar this year. With many wondering why authorities don’t allow a stronger depreciation. To help the struggling economy, revert local deflation, and maintain competitiveness vs weaker Asian peers. The authorities are more focused on stability than competitiveness gains. And its ‘ease and squeeze’ fixing keeps traders on their toes. They will likely continue with only modest CNY weakness, backed by strict capital controls and the world’s largest FX reserves. And look to avoid a protectionist response from trading partners, or a repeat of 2015-16’s big $1 trillion reserve loss.