From 2008 to COVID-19, currency market volatility trended down. Volatility was elevated in 2015-2017 after its 2014 record low (measured by CVIX), but this fit within the trend, as December 2019 levels tested the previous record. This trend can be attributed to:
- convergence in the drivers of currency value like growth and inflation
- aligned monetary policy
- globalization and decreasing value arbitrage
- algorithmic value trading.
Figure 1: CVIX Index
Source: Record Currency Management, Bloomberg.
The pandemic brought several international risks to the surface:
- US dollar dependency
- Europe’s fiscal/monetary discord
- Energy market disruptions
- Social stratification and unrest
Looking forward, we expect a period of heightened currency risk for a number of reasons, including:
- US dollar centrality
The international and national policy responses to COVID-19 have aimed to smooth over the worst real economy and financial market outcomes. This monetary and fiscal stimulus has entailed a rapid expansion in world debt — especially US dollar debt, at home and abroad. Although the dollar’s special status has been geopolitically contested for decades, the crisis consolidated, even expanded, its position for the near term. This means that we will continue to see the dollar in high demand during future liquidity crises. As such, the dollar’s role in the global economy has become even more disproportionate to the USA’s relative economic and political power, exacerbating geopolitical tensions around the greenback and contributing to systemic instability.
- Balance of payments / real economy vulnerabilities
The expansion in debt levels and the policy-induced delay of real economy outcomes indicates the potential for latent vulnerabilities in national economies, which could be expressed in currency value. This is especially true in a world of compressed interest rates across both developed and emerging markets. When interest rates no longer equilibrate international supply and demand for funds in line with current account needs, but are used exclusively to maximize domestic monetary stimulus, global imbalances will exhibit themselves in exchange rates more strongly.
The separation and shortening of supply chains was a trend already in place well before the COVID-19 pandemic, and one that we expect to see accelerate going forward. This trend can be understood in light of US-Chinese competition, but it can also be seen from the perspective of domestic politics and social classes marginalized by globalization. Deglobalization contributes to currency risk through its impact on prices, economic growth and productivity, credit flows, and public policy.
- Price instability
Both inflationary and deflationary pressures will be at work in coming months and years. Higher savings rates, possibly lower wages, ‘socially distanced’ demand, and low energy costs spell downward pressure on prices. Deglobalization, bankruptcies, fiscal stimulus, and higher debt levels indicate higher inflation. Inflation metrics are by their nature reductive, masking meaningful differences between sectors. We expect these differences (between goods and services, for instance) to widen in the future, with commensurate effects on nations’ terms of trade and currency exchange rates.
- Experimental policy
In the name of emergency logic, almost every country in the world was pulled into some sort of policy experiment, many of them blending both fiscal and monetary measures rarely used before. Currency value is an implicit focal point of these policies because, much like the policies, it triangulates:
- Real economy output
- Money supply and velocity
- International supply and demand
For this reason, we see experimental policy and currency stability to be at odds. Traditional drivers of currency value like economic growth and productivity could give way to other factors. Equity and other asset markets have emerged as important short-term drivers, while we expect the structural transformations wrought by significant policy changes to present as a long-term driver of value.
- Euro: a two-way risk
This moment is a trial by fire for the European Monetary Union. Although existential threats are peering in, this crisis also opens the opportunity for Europe to consolidate its governance apparatus in a way that strengthens the bloc and the currency. Already, the Euro is trading in line with the likelihood of measures representing fiscal consolidation. The Frugal Four are caught in a bind between the cost of intra-European support and the risk of a faltering Union.
- FX market structure
In the era of Basel III, the FX market evolved from a structure in which market-making banks were central, warehousing FX inventory (liquidity) and short-term risk for a broad range of counterparties. When regulations limited their ability to warehouse FX risk, they were displaced by a complex of electronic networks which could source liquidity from a broad range of participants, blurring the line between market maker and participant. This new pattern was notable for offering ever-slimming spreads in FX transactions, owing to the integrated nature of the networks. Yet, at the same time, price impact measures revealed a relatively illiquid market. Absent market makers with the capital and expertise to warehouse risk in rough markets, even a slight bump in the road—but especially a big one—could prove extremely disruptive to prices. Going forward, banks’ risk-taking capacities may be further limited, especially in services such as FX. A less liquid market is a more volatile one.