This article was written by Kevin Rodgers, former managing director of Deutsche Bank and author of “Why Aren’t They Shouting?: A Banker’s Tale of Change, Computers and Perpetual Crisis”.
In the last few months of my career in FX in 2014, there were serious discussions at my employer about whether the volatility had been permanently squeezed from FX.
At first sight it seemed a plausible – and worrying – possibility. Central banks, through close-to-zero rates, direct intervention and QE seemed to have tamed the markets. Measures of FX volatility like Deutsche’s CVIX index were at historic lows. Given that the profitability of an FX business is closely linked to the degree of volatility (when it is volatile more business is transacted at higher spreads as corporations look to hedge and funds look to profit), this thinking had profound implications for the future health of the market.
In some senses, we needn’t have worried. The market’s perception of central banks’ ability to control the financial world was dealt a shattering blow in January 2015 as the SNB gave up on its three-and-a-half year attempt to cap the rise of the Swiss franc.
In the 18 months since then, first via Brexit and, today, via the election of Donald Trump (contrary to all prior predictions and polls), fresh doses of uncertainty and adrenaline have been injected into the supine body of the market. Rather like the character Mia in Pulp Fiction, volatility has jumped to its feet while shocked observers whisper, “that was f*****g trippy”.
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It is still too early to say what the impact of these two shocks will be in the medium to long term, although I think it is clearly the case that the untrammelled upward progress of globalisation and market integration seems to have passed its high point, at least for some years. The backlash is plain to all. This raises a lot of questions. What will become of trade? What will become of NATO? How will the Middle East play out? All unknown.
What this means though, is that market volatility will surely climb. And this won’t simply be the result of geopolitical uncertainty. The market’s ability to process new information in a orderly way has been impaired.
First, because the FX markets have become somewhat more fragile. This is the result of a decades-long process of concentration of market making and the reduction (through regulation) of banks’ ability and willingness to commit risk capital to it. The recent cable flash crash is indicative of that trend – I expect more examples of this as the years progress.
Second, one great stabilising force is now missing from the markets: the force of carry. In the past, FX rates reflected the forces of valuation (the familiar ‘Big Mac Index’ idea of PPP) and momentum (it’s going higher, so buy it). But dominating these two was the interest rate differential between currencies. With this gone (ZIRP all over the G20), FX is rudderless. The recent travails of the macro hedge fund community is symptomatic of this new, skittish environment.
All in all, there is more uncertainty coming to a more fragile and less firmly anchored market. The next few years could be extremely interesting; so have fun and stay solvent.