Even with trade negotiations between the US and China becoming more heated, volatility in major developed market currencies has remained muted. As measured by FX options, implied volatility is at lows for the year and well below levels seen following Italy’s political crisis.
Why has FX volatility fallen to new lows? Investors buying USD on safe haven flows arising from trade tensions – While new tariffs of 25% have been announced, Citi’s base case is they are unlikely to be implemented due to push back from financial markets and there could be a chance for a deal with relatively minor concessions for both the US and China. On September 5th, the US Trade Representative (USTR) is scheduled to complete their recommendations for applying further tariffs.
Major central banks have moved to curb FX volatility – The ECB is likely to delay any rate hikes for a year – until 2019 summer. The BoJ’s recent moderate policy adjustment is unlikely to be repeated until the next consumption tax hike projected in October 2019. The PBoC has introduced new measures against currency speculation including a 20% reserve requirement on forward FX purchases by local banks.
An uncertain political backdrop in the US – Ahead of the Congressional midterm elections in early November, investors are not clear how the US political map will unfold within the Republicans and whether they will seek to oppose their own President regarding tariffs with China.
Currencies are likely to remain range bound through August as markets await more clarity on trade and political tensions in the US.
With that clarity, Citi analysts believe that investors could start to reduce exposure USD as a safe haven. As the USD rally loses momentum, investors may instead focus on commodity currencies, Japanese Yen and Swiss Franc.