FX Update: What is needed for volatility to return?

Today's Saxo Market Call podcast

FX Trading focus:

• JPY scrapes to new low as fear levels remain subdued
• US dollar awaits incoming data – what to watch for in today’s Consumer Confidence survey
• Is sterling showing signs of vulnerability.

Despite a lack of significant sovereign bond market volatility, the JPY has scraped to new lows for the cycle again today, although new USDJPY highs just ahead of 144.00 failed to stick, while EURJPY managed to clear 157.00 for the first time since 2008. We can argue all we want that the move is looking a bit stretched, given that key long yields elsewhere are not trading at new cycle highs and the 10-year JGB “cap” of 0.50% isn’t even under pressure in Japan, with 10-year JGB’s currently yielding only 37 basis points.

The past week has seen a solid downdraft in risk sentiment, as measured by global equities, at least. At the same time, “fear gauges” like the VIX suggest that equity traders are taking the mark-down very much in stride after the prior strong rally. In FX, implied volatilities have picked up ever so slightly, though the 1-month Deutsche Bank implied volatility measure sits near 7.0% today, the lowest since February of 2022, just before the Fed achieved lift-off with its hiking cycle. JPY volatility is a slightly different story, with USDJPY 3-month implied picking up from below 9% mid-month to just over 10% today. That 3-month tenor does capture the next two FOMC and BoJ meetings, it should be noted.

Given that markets are complacent on recession risks and that the forward central bank expectations curve is for perhaps just one more Fed hike followed by a series of cuts starting sometime next year as inflation is expected to weaken significantly, it is hard for the market to drum up volatility. A reheating of volatility would likely require either a) for bad news to materialize quickly in the form of incoming data, and for it to play as sufficiently bad to actual merit a bad news reaction function or b) for a reheating of the economy to become more evident and lift commodity prices and forward inflation concerns. Today does see the June Consumer Confidence survey. On watch there is whether the Present Situation comes unglued from its very elevated and stable levels of the last 7 months above 145. That part of the survey is correlated with the strength of the labor market and would likely need to drop considerably to suggest we are entering into a recession window. The expectations component meanwhile, is at the low end of the range of the last 10 years, but has stabilized in recent months as well, still solidly above the panic last summer on the spike in gasoline prices.

Sterling showing signs of vulnerability?
Sterling is looking a bit tired, particularly in light of the further advance in UK yields to new cycle highs (2-year Gilt posting 5.2% today, with BoE priced to peak above 6.00% this year). It’s a bad look for a currency that can’t find more support from a more hawkish central bank, likely because the UK inflation is seen as a structural issue that will hamper growth, tying the fiscal authorities’ hands behind their back if inflation is to be avoided. Fears of tight fiscal, in other words, risk offsetting the pricing of tighter monetary policy.  A smaller economy is the only viable path to less inflation when the supply side is the limiting factor. The 2-year German Schatz-UK Gilt spread has plunged to new cycle lows in the last few days – currently at -209 basis points versus around -100 bps in late April. The flattening out of EURGBP despite the relative rise in BoE hike expectations suggests some sterling vulnerability. It’s a bit of a wait for the next UK data of note, payrolls/claims/earnings data for June, don’t arrive until the week after next.

Chart: GBPUSD
GBPUSD has yet to show its hand after peaking just above 1.2800 and then rejecting a second attempt at that level over last week’s Bank of England meeting, a move that was rejected. Technically, the first real sign of weakness would be a fall back through the old resistance area around 1.2650+, but bears need a fuller rejection of the latest rally wave to argue that at top is in, and that would require the pair to punch back down through perhaps the 61.8% retracement of that wave, which is just above 1.2500. Soft US data that encourages lower US yields and a fresh wave of strong risk appetite (or at minimum, no significant risk-off) are likely needed to engineer a bull-trend confirming rally and close back above 1.2800. on that note, watching today’s US confidence and especially Friday’s PCE inflation data, with the data calendar for the US picking up next week.