Q4 Outlook: A Multitude of Factors Which Will Leave FX Volatility Unabated

While the ECB might hold its fire for now, the Fed is looking at first signs of declining inflation, which

As the foreign exchange industry has become accustomed to low monthly trading volume figures due to dismal FX volatility ever since Q4 of last year, we might finally be witnessing a sustained change in this trend. After the announcement of Abenomics and the following 6 months of record high figures, it almost feels unreal that the G7 foreign exchange markets are so active again.

With the sharp spike higher in G7 FX volatility, some industry players are already wondering whether this is a temporary occurrence or a more persistent trend.

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It has been a little bit more than a month since we witnessed the sharp U-turn in foreign exchange traders’ mood. While it was mainly triggered by the President of the ECB, Mario Draghi, announcing that the European Central Bank (ECB) is the latest to hop on the bandwagon of central banks actively engaged in asset purchases, there have been many other signals for currency traders that its time for major risk reappraisals.

After we saw favorable market conditions return to the fray, the main point worrying industry insiders these days is whether this environment is here to stay, or if it’s just a short term blip. Are we experiencing a solid rebound across the board in G7 FX volatility, or just a minor rebound followed by more dismal months reducing the appetite of forex traders towards actively engaging in trading activities?

In the opinion of Forex Magnates, we are seeing a series of factors which support the former notion and we will put our reasoning on the table in the following paragraphs.

Factor I: The European Central Bank Is Far from Done with Easing

Mario Draghi, President of the ECB
Mario Draghi, President of the ECB

While the European economy is entering its third recession in 6 years, there is little doubt that the ECB is here to stay with its easing effort. Mr. Draghi has stated in his last press conference that there is no “grand bargain” about him buying time for European governments to engage in structural reforms.

With Mr. Stieglitz reiterating his point that austerity has failed to produce the desired effect on the European economies and with limited fiscal room to go, there is little doubt that the next step on the agenda of the ECB is outright quantitative easing, including purchasing of government bonds.

Mr. Draghi reiterated his warning towards governments in a speech last week saying, “I am uncertain there will be very good times ahead if we do not reform now. While stabilization policies that raise output toward potential are necessary, they are not enough. We need to urgently raise that potential. And that means reform.”

The central bank remains committed to buy time for EU governments which lack competitive conditions to boost businesses and job creation, however, there is still little sign of efforts by the governments to go ahead and show willingness to take political responsibility for the tough acts required.

Factor II: The Federal Reserve’s Rate Hikes Are Not a Done Deal

Fed LogoJust as we have been tuning in to the new Fed, the Fed which is gearing towards commitment to raise interest rates next year, some worrying signs are reappearing despite one positive jobs report. For the first time the U.S. central bank has not ignored seemingly worrying conditions in the rest of the world, and has included its concerns in the latest set of minutes published last Wednesday.

The Federal Reserve already seems worried about the recent rally of the US dollar, which to put it bluntly, is far from unsettling, keeping in mind the dire straits the European and Japanese economies are in.

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The Federal Reserve’s Open Market Committee (FOMC) stated, “The foreign exchange value of the dollar had appreciated, particularly against the euro, the yen, and the pound sterling. Some participants expressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the U.S. external sector.”

“Slower economic growth in China or Japan or unanticipated events in the Middle East or Ukraine might pose a similar risk. At the same time, a couple of participants pointed out that the appreciation of the dollar might also tend to slow the gradual increase in inflation toward the FOMC’s 2 percent goal,” the text went on.

As recent moves in the short-term section of the U.S. Government bonds market indicates, the expectations for an early rate hike have been shattered. External growth factors have made their way into the Federal Reserve’s thinking, leading to elevated risks to the U.S. recovery from a tailspin in the EU for example.

Factor III: Fed’s Balance Sheet Reduction Challenges

Janet Yellen, Chairman of the Federal Reserve
Janet Yellen, Chairman of the Federal Reserve

Renowned Federal Reserve critic, Peter Schiff from Euro-Pacific Capital, explained in a recent research note, “In her September press conference, Yellen made the stunning assertion that the Fed’s balance sheet, which in recent years has swelled to a gargantuan $4.5 trillion, will likely be reduced in size to “normal levels” by the end of this decade.”

“While most accept this statement at face value, Yellen must know the absolute inability of the Fed to deliver on this promise,” he added. And the IMF agrees with Mr. Schiff. This week the IMF issued a stark warning that raising interest rates too much and too quickly could result in wobbling bond, stock and currency markets, as volatility across asset classes has been at all-time lows.

At the same time, the IMF also acknowledged the risks of rates staying low for a protracted period of time. Nobody seems to know which way to go, sounds like a good deal for volatility again.

Other Factors: Hong Kong Protesters, ISIS, Ebola and Ukraine

A recent drop in commodity prices has lead many economists to believe that the global growth environment is quite far from solid. As the FED reasserted this notion in its minutes, we have to add a set of seemingly non-critical factors, which could become quite erratic at some point.

With protests against the Hong Kong government at risk of being actively reignited following the cancellation of talks with pro-democracy protesters, global geopolitical tensions are rising on yet another front.

Keeping in mind the latest Islamic state actions and escalation of tensions in Turkey, the Middle East is likely to be on the radar of global markets again. Falling oil prices are telling as to how disconnected the commodity market has been from fundamentals, and the rising pandemic risks from Ebola have the potential to spook risk takers across the globe.

Last but not least, the Ukrainian crisis remains unresolved and there is all the potential for it to continue affecting risk sentiment across the board. With the Russian ruble hitting new all-time lows almost daily, the Bank of Russia might be looking at some unconventional measures to influence the market. And boy do speculators like to put such measures to the test!

The fourth quarter of this year looks very promising in terms of elevated FX volatility persisting across currency markets and driving increasing volumes. Long gone are the dull days from the first half of this year which wreaked havoc for some companies in the industry, forcing them to consolidate their operations and look to M&A in order to remain in business.

Our regular readers are sure to find more about the topic in our upcoming Q3 Quarterly Industry Report.

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