Volatility is thin on the ground for most markets at the moment with the Vix trading close to 10 and stock indices close to record highs. For those looking for a change in trend or rising volatility it has been a frustrating time, however, looking beyond stock markets, there are signs of life coming back to other markets including the FX and bond markets. Below we look at three events that could trigger volatility in the FX market and beyond.
1. Dollar: divergence with bonds gives hope for rebound
The dollar is the weakest currency in the G10 so far this year, and although it has shown signs of life since bottoming out in September, its rally has been underwhelming so far. However, this lack of oomph has been at odds with US yields, which have rallied sharply in recent weeks: the 10-year yield is at its highest level since July, while the 2-year yield is at its highest level since 2008.
The driver for the rise in bond yields has been the Fed and the proposed tax cuts from Donald Trump. While these may turn out to be fairly weak foundations, the Fed could cease hiking rates if US economic data deteriorates and the Trump tax cuts still need to get passed by Congress before they can be enacted, yields are offering the USD enough support to continue to move higher. This is why we believe that the dollar could continue to rise in the coming weeks, even if it is a slow burner.
USD and the 2-year yield
2. GBP: positioning could protect the downside
The rally in the pound came to an abrupt halt last month, and last week the pound was the weakest performer in the G10. Interestingly, the market is still building up long positions in GBP, with long speculative positions at their highest level for 3 years. While positioning data can be a contrarian indicator, considering how far GBP has dropped since the June 2016 EU referendum, this data suggests that there could be a floor in GBP, which could limit another sub 1.30 decline like we saw last year.
Thus, even though last week saw a sharp sell-off in GBP/USD the sharp 1% rebound in GBP/USD shows that there is a decent amount of buying interest above this key level, hence Monday's rates. It found good support at 1.3027 last Friday, suggesting that there is a decent amount of buying interest above this key level, hence Monday’s sharp 1% rebound. This suggests that GBP/USD could be range bound between 1.30 and 1.36 for the foreseeable future.
As a caveat, we will need confirmation that GBP/USD can stay above 1.3110 - the 61.8% retracement of the August to September uptrend - before we would be comfortable with the view that GBP/USD won’t fall below 1.30 yet again.
CFTC GBP positioning data
3. Emerging markets: time to reassess the risks?
The sell-off in the Turkish lira is the main FX theme at the start of the new week. It fell more than 2% vs. the US dollar as rising tensions with the US spooked investors. This was the largest decline in the lira since 2016’s attempted coup. Emerging market FX has been one of the most reliable uptrends of this year, which is one reason why it is so vulnerable to geopolitical tensions: when risk levels rise it can spook investors. This is a problem not just for the Turkish lira, but also for other EM currencies including the South African rand, Brazilian real and Mexican peso. When a crisis hits high yielding, highly volatile EM currencies they can fall as a single block.
While USD/TRY has pulled back from earlier highs, it remains above Friday’s close, suggesting some nervousness. Overall in the EM space, the Turkish lira is still some 3% lower vs. the USD, with smaller losses for the ZAR, MXN and BRL at the start of this week.
Geopolitical risks are not the only factor troubling EM investors and risk levels have been ticking higher since the end of the summer. A stronger dollar and rising US bond yields may chip away at the attractiveness of EM assets, so what has started as an orderly exit out of the Turkish lira could turn into a stampede.
The risks are not only limited to the EM FX space, due to the popularity of the EM FX trade this year, if it continues to see losses then it may lead to losses in other markets, known as the contagion effect, as investors trim positions and try to reduce risk elsewhere. Thus, this morning’s decline in the euro may not be a one off.
Disclaimer: The information and opinions in this report are for general information use only and are not intended as an offer or solicitation with respect to the purchase or sale of any currency or CFD contract. All opinions and information contained in this report are subject to change without notice. This report has been prepared without regard to the specific investment objectives, financial situation and needs of any particular recipient. Any references to historical price movements or levels is informational based on our analysis and we do not represent or warrant that any such movements or levels are likely to reoccur in the future. While the information contained herein was obtained from sources believed to be reliable, the author does not guarantee its accuracy or completeness, nor does the author assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions.