To say that FX volatility is low is an under-statement. 3-month USD/JPY realized is at its lowest since 1977 and the EUR/USD equivalent is at its lowest since 1979. Here we make three observations cautioning that while a good part of the volatility drop could be cyclical (and hence temporary), there may be a market structure component as well.
First, the decline in currency volatility is unusual compared to other asset classes. Realized S&P 500 and 10yr UST vols are still above 2007 levels. Volatility in both is around 1% higher than the lows seen in the early 1990s. In contrast, currency vol is approaching the lowest levels in the history of free-floating exchange rates.
Second, macro cyclical conditions aren’t extreme enough to justify such low levels of currency vol. Data releases versus consensus forecasts are at the low end of surprises, but not extreme. FX market returns have been poor, but our dbCR benchmark return index doesn’t suggest a structural breakdown. Many say central bank policy is very predictable, but last summer’s “taper tantrum” and continued surprises from the ECB point the other way.
Third, and in contrast to the cyclical arguments above, there are structural arguments that could be unique. One is the ongoing narrowing in FX market spreads, which have collapsed by 20% to new record lows this year on the back of heightened competition and ongoing improvements in technology. Lower transaction costs may lead to lower volatility as markets reach equilibrium faster. Another is ongoing regulatory changes and scrutiny that are shifting market volume away from inter-bank voice trading towards electronic platforms. Volumes on EBS, a trading platform mostly used by the inter-dealer community, have collapsed 40% y/y to the lowest on record. A shift away from big-ticket voice dealing towards more granular electronic trade execution may mean flows leave a smaller footprint on the market. Other asset classes such as the US fixed income market are also shifting to electronic trading on the back of Dodd-Frank, but it is notable that the drop in inter-dealer volume isn’t as pronounced as that in FX. The shifts in the latter may be happening quicker, in the presence of more advanced technology platforms.
In conclusion, the depressed level of volatility across asset classes does point to a strong cyclical component. But given the particularly low levels of currency volatility, we would hesitate to dismiss the argument that at least part of the decline could be related to changes in FX market structure. This doesn’t suggest that volatility will stay depressed forever. But it does mean that it may be difficult to move back to the highs seen in earlier years in the absence of a global macro shock. It is also a warning shot on the impact that technology and regulation can have on other asset classes as competition and the market mature.
Read the full report: FX Daily