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Volatility Returns to the Capital Markets

Volatility in the currency market has started to percolate over the past few weeks as specific decision the Federal Reserve has made the concept of two-way monetary policy flow has been interrupted.  Volatility was under control leading into the December Federal Reserve meeting, and helped by the Fed delivering on its first rate hike in 9-years.  The market then became comfortable with the idea that the Fed would target another 4-rate hikes over the course of 2016, but now then scenario does not seem likely which has generated volatility.

There are two types of volatility associated with the currency market, implied volatility as well as historical or actual volatility.  Implied volatility is the amount of volatility traders believe will be associated with a currency pair or index, and this number is used to help price options in the capital markets.  Historical volatility is the actually change in the price of an underlying instrument and how much that instrument fluctuates over a period of time.

Following the Fed’s December meeting, traders were convinced that the U.S. central bank would continue the process of increasing rates in an effort to normalize monetary policy.  Since the onset of the financial crisis the Fed has rates as unusually low levels, with the target Fed funds rate at zero. What most did not believe was that continued declines in economic output in Asia and Europe would generate fear that the capital market would tumble if the Fed continued to tighten.

Despite the devaluation of the Chinese Yuan in August of 2015, the Fed moved ahead with their tightening policy. Many believed that the Fed had a small window in which they need to pull the trigger and if they let the opportunity slide they would be left with little powder in their arsenal if the U.S. economy began to falter.

In just a few months it appears that the view of many of the Fed Presidents have changed.  This started with a change of the dot plot used by the Fed to target interest rates over the coming years.  Initially following the December FOMC meeting, the Fed dot plot had four 25 basis points tightening forecasted during 2016.  In their March meeting the Fed changed their tune and reduced the number of forecasted interest rate tightening down to two 25-basis points rate hikes.

The change in their forecast introduced volatility back into the currency markets.  Prior to this March dovish Fed prediction of future rates, the market where content to wait and see and markets were subdued.  After the Fed’s statements, the dollar started to decline which led to a rise in value of most of its counter currencies.  Volatility broke out especially for the yen which started to climb and has now generated some panic for the Bank of Japan.

Two-way flow in terms of what central bankers will do is what generates volatility.  The market seemed sure that the Fed was in tightening mode, while the Bank of Japan, European Central Bank and People’s Bank of China were in easing mode.  The dovish statements from the Fed turned their intents into a question which has generated volatility in the currency markets.

Going forward the markets will now be on high alert to read into comments from central bankers to see if they plan on altering the volatility in the forex market.  The Fed will likely be the linchpin, as traders begin to focus on the June meeting instead of the late April meeting which now appears to be off the table.

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