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Currency Market Analysis

Jan 21, 2020 | Currency Market Analysis

Global Themes

Calm before the storm?

• FX volatility hits an all time low
• Big fortnight for AUD and GBP ahead
• Global dairy prices eyed tonight

FX volatility hits an all time low

The JP Morgan FX Volatility Index hit an all time low yesterday. The series has been running for over three decades but yesterday marked a new nadir for FX movement. Low and stable global interest rates look to persist for longer, while immediate political risk has receded from the market this week. Currency calm is generally a good sign for market participants. It normally arises as a product of reduced global tensions, and low divergence in growth and inflation outlooks across the world.

Low currency volatility also marks the best time to take out currency insurance. Products that give importers and exporters optionality are cheaper. Think about it like home insurance: you wouldn’t want to be taking out bushfire protection in southern NSW right now. Better if you’d taken out a policy last winter. Similarly in FX markets premiums for Vanilla options (full protection, no obligation hedges) are very cheap right now due to the low level of implied volatility. And when something is cheap it often doesn’t stay that way. Or as Ulricht Leuchtmann, head of currency strategy at Commerzbank puts it succinctly “FX markets have to produce at least so much volatility that shifts in fundamentals can properly be reflected. My gut feeling is that we are at the lower end of what’s possible before the FX market loses its ability to reflect fundamentals”. We don’t yet know where that next big bout of volatility will spring from, but it makes sense to be prepared and hedge your risk accordingly, particularly when the cost of buying an option is so cheap.

Big fortnight for AUD and GBP ahead

Yesterday we highlighted the importance of our December quarter CPI print due this Friday for near term direction of the Kiwi, but there are two other currencies facing their own litmus tests over the next fortnight. Firstly the Aussie Dollar, where the recent bushfires have led bond markets to ratchet up the chances for a February rate cut by the Reserve Bank of Australia. Ahead of that we get key employment (Jan 23) and inflation (Jan 29) releases that are likely to shape this decision, and skew market probability from its current coin flip odds. On the longer term basis NZD/AUD looks overbought, and ANZ analysts agree. Provided upside is capped by 0.9720 they are targeting a return to 0.9400 in due course, presumably on a RBA hold, and more dovish RBNZ than might be otherwise expected when they meet on Feb 12.

On the other side of the world it's a similar story in the UK, where softer data has led to an approximately 60% chance of a rate cut at the Bank of England's January 30 meeting (source; Reuters). Thus far the Pound's reaction has been relatively muted, and suggests that the real risk might not be an "insurance cut" from the BoE, but a sign that further cuts might come on the back of it. With the political risk of Brexit soon to be removed any short term selling in Sterling might just be that, unless we get an overt sign that mutiple rate cuts are coming. After all if NZD/GBP can't rally much on the prospect of a BoE rate cut you'd have to think it is doomed to retrace some of its December gains in the near term.

Global dairy prices eyed tonight

Another bout of global dairy prices is due for release tonight. 6 out of the last 8 auctions have been positive and helped Kiwi sustain its late 2019 rally, but 2 of the last 3 have seen price contraction, so the numbers may be eyed with some degree of risk tonight. NZD/USD continues to linger just above key support in the high 0.65s.

Tonight the headline data comes form the UK in the form of unemployment data. The unemployment rate looks set to remain at a low and stable 3.8% in Britain, but any large swings to the claimant count can effect those BoE rate cut odds and buffet NZD/GBP accordingly.

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