FOREIGN-EXCHANGE the markets were once a hotbed of lively speculative activity. But today traders looking for an adrenaline rush should look to assets like cryptocurrencies instead. Barring a brief surge at the start of the pandemic – and isolated events in the Turkish lira – currency markets have calmed down. Macro-trading funds no longer scare central bankers and finance ministries with speculative attacks. The latest sudden end of a major monetary peg – that of the Swiss franc in 2015 – was the result of the central bank taking investors by surprise, rather than the other way around.
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Inflation and low interest rates over the past decade have helped to stifle exchange rate fluctuations. of Deutsche Bank CVIX The index, an indicator of forex volatility, has been above its current level more than 90% of the time over the past 20 years. On the other hand, the VIX, which measures the expected volatility for S&P 500 stock index, and is often used as a measure of general market sentiment, has so far spent October at roughly its long-term average. But as consumer prices and interest rates rise, currency volatility may well generate a comeback, with potentially unwanted consequences for some investors.
The strangeness of the recovery from the pandemic makes it particularly difficult to predict the course of policy. However, certain differences seem likely to be reaffirmed. Countries are recovering at different speeds and central banks display varying levels of discomfort with inflation. U.S. policy is particularly important, given the dollar’s central role: 88% of over-the-counter foreign exchange transactions in 2019 involved the greenback, according to the Bank for International Settlements. The chances of the Federal Reserve turning more quickly to political tightening are increasing. Break-even points (the spread between the yields on inflation-protected Treasury bonds and conventional bonds of the same maturity) indicate annual inflation of around 3% over the next five years, the highest figure since minus 2003. By contrast, no one is anticipating interest rate hikes for decades in Japan, where year-over-year inflation, excluding food and energy, is negative.
Long periods of low volatility are naturally seen as a good thing by most investors. But they can have less desirable side effects. Hyman Minsky, an economist, suggested that periods of financial stability and sustained profits can change the behavior of market participants, pushing them to adopt riskier strategies that could in turn destabilize markets. The danger is that as the currency markets come back to life, the shortcomings of these types of strategies are exposed.
The boom in Asian economies in the 1990s, which led to huge unhedged dollar borrowing by governments and businesses, is a case study of how the perception of security, once overturned, can provoke violent market reactions. Faced with the sharp depreciation of the currency in 1997-98, this loan proved impossible to repay, causing defaults and bailouts. Governments in emerging markets today issue much more of their debt in their own currencies, and when they borrow in foreign currencies, do so at longer maturities. However, weak points remain. Non-bank dollar borrowing in developing countries has nearly doubled to over $ 4 trillion over the past decade, largely reflecting the issuance of bonds by corporations rather than governments .
Creditors are also vulnerable to currency risk. It is difficult to determine the extent to which asset owners hedge their exposures. But the figures available indicate that the decline in volatility tends to cause companies to reduce their coverage. Large Japanese insurers have tended to hedge more over the past two decades when volatility has increased, suggests a Fed study released last year. Insurers bought significantly more forward currency contracts and swaps during and immediately after the global financial crisis, when volatility peaked, and a declining share relative to their foreign assets thereafter. Net unhedged foreign assets in Australia have also grown over the past two decades, partly reflecting the increase in the number of non-bank borrowers who are unprotected.
An optimist might point to the market stress of the early days of the pandemic, when volatility increased without causing large explosions in the currency market. If the system was then able to overcome acute distress, why worry now? But calm was quickly restored last year because central banks were unusually coordinated in their easing. Now, on the other hand, they are preparing to go their separate ways. Currency markets may no longer be an oasis of calm.
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This article appeared in the Finance & economics section of the print edition under the title “Back with a vengeance”