Nails bitten to the quick will soon be bitten to the knuckle. The next three months bring a U.S. presidential election, the endgame of tetchy trade talks between Britain and the European Union and more. With central bankers like Federal Reserve Chairman Jay Powell keeping bond markets on a tight leash, investors will express their angst through foreign exchange markets instead. It’s already starting to show.
Two big dates could generate large market swings: the U.S. vote on Nov. 3, and the end-year deadline to replace transitional EU-UK trade arrangements. Each brings its own extreme scenarios – say, President Donald Trump contesting the American election outcome, or Britain choosing an economically damaging no-deal option.
Another potential source of volatility is Powell’s new policy framework for the Fed, which targets average inflation rather than the level at any given moment. Investors are still figuring out what it means for policy and inflation. Meanwhile rebounding Covid-19 infections are casting new shadows that may require yet more fiscal and monetary easing.
Investors can usually express their nerves by buying and selling bonds. But they can’t do that as freely at the moment, because of the huge amount of fixed-income securities that Powell and his peers are buying to stimulate the economy. Equity markets offer another outlet, but company shares come in relatively small quantities. The more popular avenue will therefore be the vast and liquid foreign exchanges where global daily turnover is $6.6 trillion. That is reflected in the FX options market.
The gauge to watch is the gap between implied volatility, which shows how jumpy exchange rates are expected to be in the future, and historical volatility, which reflects the scale of actual past swings. The higher the former is above the latter, the rougher the anticipated ride. For example, Brexit crunch points have previously caused the gap between implied and historical sterling volatility to widen without affecting other currencies much.
Right now, however, implied-historical volatility gaps have grown across major exchange rates. While they are far from extremes seen in March when financial stress caused market mayhem, current readings are still well above a five-year average, particularly for sterling. This is not bad news for everyone: Investment banks’ trading desks tend to do well when markets gyrate. And the gap will eventually shrink – either because historical volatility will rise or because risks will dissipate and implied volatility will fall back. But the knowledge that all things pass will be slim consolation for money managers right now.