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Emerging-market currency volatility erases war-time spike

Emerging-market currency volatility erases war-time spike
An electronic ticker is displayed outside the Philippine Stock Exchange (PSE) in Bonifacio Global City (BGC), Metro Manila, the Philippines, on Monday, 2 July 2018. (Photo: Carlo Gabuco/Bloomberg)

Options traders have cut their expectations of currency volatility in emerging markets to levels seen before Russia invaded Ukraine in February 2022.

The JPMorgan Emerging Market Volatility Index, an indicator of foreign-exchange swings three months ahead, fell to 8.86% on Friday. That was the first time since the war began that the measure closed below 9%, and marked the lowest level for the gauge since October 2021.

The lowering of traders’ anxiety about emerging-market currencies signals optimism the US dollar’s downward trend this year will continue. As the Federal Reserve takes a mini pause in interest-rate hikes, and some developing nations halt them, money managers expect the global tightening cycle that began more than two years ago to peak and reverse.

“This is a sign of the times where interest rates are converging to or at the terminal levels,” said Simon Harvey, head of FX analysis at Monex Europe Ltd. “At high nominal levels and against a backdrop of cooling inflation conditions, the probability of larger-than-expected rate hikes or an upwards reassessment in terminal rates is dramatically lower. And this lower rate volatility is mapping into currency markets.”

Though 2023 was expected to be a year of high volatility, it’s turning out to be anything but. Realised swings in the MSCI Emerging Markets Currency Index are coming in at 3.3% on a 66-day rolling basis, corresponding to the three-month tenor. That compares with a high of 6.6% in December. This reduction in realized volatility is also a factor in improving sentiment in the options market. 

Underpinning this move is a near 2% drop in the dollar this year as US Treasuries increasingly price in a less hawkish Fed. The two-year US yield has risen only 29 basis points even though the Fed has raised its benchmark rates by 75 basis points. The gains are being consolidated in June after policymakers halted a run of 10 rate hikes that began in March 2022.

The emerging-market currency index is up 2% in 2023, driving a carry return of about 6% when combined with interest-rate differentials.

However, risks to its outlook for the rest of the year haven’t gone away. The Fed has signaled it may raise rates twice more before taking a decisive pause. Inflation remains stubborn in some emerging economies. And China’s stimulus plans may weigh on the yuan, which has the biggest weight in the currency index.

Still, narrowing volatility measures suggest traders are getting more confident that a big selloff in emerging-market currencies is unlikely. 

“Carry is a huge buffer,” said Guillaume Tresca, Global EM Strategist at Generali Insurance. “That helps volatility to remain low. It is the emerging-market currencies with the largest carry which have been the best spot performers year-to-date.” DM

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