FX Market Volatility Will Return with Vigor in 2015

Central bank interest rate divergence, geopolitical events, and global growth expectations have been the three primary drivers of FX market volatility in late 2014, and these themes will continue to dominate the currency trade well into 2015.

With so many economic and geopolitical variables in play, it is highly unlikely the FX market will succumb to the historic volatility lows witnessed in the summer of 2014. Moreover, the U.S. Federal Reserve’s decision to turn off the liquidity spigot has propelled currency markets.

Central bank policymakers remain on guard, however. They’re eager to soothe anxious investors who fret about the state of the global economy in an era of monetary intervention that has left financial markets primed for volatility whenever one of the major central banks changes tack.

And though bank officials remain concerned that a sharp fall in asset prices could derail ongoing efforts to foster growth, the possibility leaves them ample room to correct unintended errors in judgment, and to withstand investor herd mentality when panic rises. That puts the onus squarely on central bankers to be clear and concise in their public communications.

Rate Divergence Will Spur Volatility

A more sustainable sense of market volatility will come about once the Group of Seven central banks’ monetary policies diverge further than what we’re experiencing presently. There is a strong possibility the European Central Bank will initiate a sovereign bond-buying program in the first quarter of 2015 provided Germany approves of the measure. If that happens and it is followed by the Fed’s first real rate hike in the first half of the year, and subsequently the Bank of England (BoE) by the third quarter, market volatility will flourish anew.

With that said, intermittent intraday volatility driven by risk-averse investors will continue, fueled by geopolitical strife, and it will weigh heavily on economic growth data in Europe, Russia, Asia, and the U.S.

Meanwhile, a lack of wage pressure stateside and in the U.K. is pushing post-recession rate hikes in both regions further out the curve. Aside from the U.K. and U.S., if global growth remains tenuous at best, the popular lower-for-longer central bank pledge will stay cemented, but divergence will occur as long as the both countries stay their respective economic courses.

Commodity Prices under Pressure

The low-rate environment the world has been subjected to the last few years has led investors to reach regularly for high-yielding FX carry trades, dividend stocks, and eurozone periphery and emerging market bonds. Tighter monetary policies in the U.S. and U.K. will lead to an unwinding of long-term positions in currencies, equities, and bonds. That, in turn, will force a massive global portfolio rebalancing that is sure to create ripples in the water.

Higher U.S. short-term yields will lean on emerging market currencies, stock market indices, commodities, and precious metals (gold and silver in particular). On the subject of commodities, stunted global growth has reduced the demand for the likes of oil, iron ore, natural gas and so on. Base and precious metals prices have fallen as supply outstrips demand. Oil has been hit hard by China’s economic slowdown, and it remains to be seen if the Organization of Petroleum Exporting Countries’ supply constraints will spur price growth, especially after the U.S. increased its production of shale gas and domestic oil thanks to technological advancements.

Emerging Markets Stuck in a Hard Place

Regarding geopolitics, there are a number of factors to bear in mind as we inch into 2015. The list is long and it will continue to grow. The most notable risk events to watch at this juncture includes a general election in the U.K. in May, the long-running conflict between Ukraine and Russia, the war against the Islamist State, or ISIS, in the Mideast, and the risk of worldwide contagion posed by the Ebola virus.

Put simply, global economic growth will continue to take fractured steps in 2015. The International Monetary fund, the World Bank, and the Organization for Economic Cooperation and Development have all curtailed their economic forecasts for this and next year. For investors, it is important to understand that it is China’s economy and Beijing’s actions that will ultimately determine the path of all asset classes.

Emerging markets will struggle as they do; trapped by diminishing foreign direct investment and global investors’ rush to safe-haven assets when fear grips far and wide. Once the Fed and BoE make their big interest rate moves in 2015, investors’ appetites for riskier investments and emerging markets will recede more.

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