Lower current account imbalances, an increase in supply by the major central banks and a convergence in global interest rates have led to a constant decrease in the volatility of foreign exchange market. The G10 Foreign Exchange (FX) Volatility, which groups the top 10 global currencies in terms of trading, is currently at pre-2008 levels.
A country’s current account is a combination of its trade balance (imports and exports) plus net income and direct payments. As countries were forced to deleverage after the financial crisis, the dispersion of current accounts has decreased significantly. If we take the US and China as an example, the former reduced its demand for imports, causing the current account deficit (as a percentage of GDP) to decrease from five per cent in 2007 to 2.3 per cent in 2019.
On the other hand, as China experienced weaker export demand, it began promoting greater domestic consumption and investment amid a domestic credit boom. Moreover, it injected fiscal stimulus and allowed its real exchange rate to appreciate. Looking at the figures for China, its current account surplus fell from 10.1 per cent in 2007 to 1.4 per cent in 2019. This has led to a decrease in the exchange of currencies for trade settlement.
Since 2008, major central banks have been pumping money into their respective economies with the objective to entice businesses and consumers to spend. This was achieved by various rounds of Quantitative Easing (QE). During this process, central banks were purchasing mortgage-backed securities and treasuries from their respective member banks. To obtain such assets, central banks had to print notes, inflating their balance sheets and flooding the markets with money. This unprecedented increase in the supply of money has caused the FX majors to trade in very tight ranges, supporting lower volatility.
The accommodative policy adopted globally was another product of the global financial crisis. In a bid to reignite the world economy, central banks implemented loose monetary policies to encourage economic growth through investment and spending. This led to a convergence in interest rates, making carry trades strategies less profitable.
A carry trade is a strategy that involves borrowing a currency with low-interest rates and investing in a currency that provides a higher rate of return. The current interest rate has limited the attractiveness of such strategies, adding more headwind to FX volatility.
Given the current low-growth scenario, there seems to be little scope for the factors discussed above to alter significantly in 2020. In its last meeting, on January 23, Christine Lagarde confirmed that the European Central Bank’s interest rates will remain at their present or lower levels until the inflation outlook converges close to the two per cent target. Moreover, the Federal Reserve chairman, Jerome Powell, reiterated that the “current stance of monetary policy is likely to remain appropriate”.
Central banks are unlikely to reduce the size of their balance sheets as the ECB will continue to make net purchases at a monthly pace of €20 billion. Lagarde insisted that this programme is expected to run for as long as necessary to reinforce the accommodative impact of their policy rates.
On the other hand the Fed has purchased $60 billion worth of Treasury bills every month since October to mitigate the liquidity issue in the repo market, a market used by mutual funds and banks to execute transactions that amount to collateralised short-term loans.
The purchases have inflated the Fed’s balance sheet from $3.8 trillion in September 2019 to $4.1 trillion today. While the central bank’s balance sheet is expected to flatten-out over this year, downsizing looks unlikely at this stage.
The combination of these factors have been of great benefit for gold, which is currently trading at a seven-year high against the US dollar. As global interest rates plunged, the opportunity cost of holding gold diminished and could be seen as an ‘opportunity benefit’.
Gold prices have been highly correlated to the amount outstanding amount of negative yielding bonds. Negative yielding bonds give back less than what had been invested if held until maturity. Such bonds currently amount to more than $10 trillion.
Major economic shocks and divergence in monetary policies could reverse the current downward trend in FX volatility. Given that the economic cycle is in its latter stages a major global recession (although improbable at this stage) could drive the volume of currency transactions as investors seek ‘safe haven notes’.
The policies discussed above were intended to stabilise the economies after the ordeal of the 2008 financial crisis. Inflation is the missing ingredient in the major economies as both Europe and the US are experiencing a low inflationary environment. A spike in inflation in one of the major economies could force the respective central banks to adjust their monetary policies and keep inflation around their targets.
Glen Mifsud is a portfolio manager at BOV Asset Management Ltd.
The author and Bank of Valletta have obtained the information contained in this article from sources they believe to be reliable but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author and the bank offer no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this article.