FX Volatility Poised to Remain Elevated Heading into the Summer of 2023

The activity in the currency markets picked up in 2022, with all major central banks hiking rates. FX had been dominated by low volatility for years in a row. Zero or negative interest rates, combined with markets flushed with liquidity, suppressed currency exchange rate volatility.

Such market conditions are now in the rearview mirror of traders, and they need to adapt to a period of uncertainty. Forex volatility is likely to stick around, since the current environment no longer favors stable price movements.

Higher economic uncertainty

Global economic activity is slowing, despite some encouraging news like the China reopening. Tighter monetary policy and poor consumer confidence have an impact on consumption, industrial production, and corporate profits and that sets the bottom line here.

Unemployment in major economies continues to remain low, suggesting that companies are generally reluctant to lay off workers, after struggling to attract them in the post-COVID era. However, in the absence of monetary and fiscal impulse, the economy can only rely on an increase in productivity to continue expanding at the same pace.

Moreover, economic uncertainty is not evenly distributed across the globe. While the USA seems to be faring well, the same cannot be said about most major European countries, where inflation continues to be high. Such differences are likely to materialize in the FX exchange rates in the longer run, according to analysts working for easyMarkets, one of the leading retail brokers.

Monetary policy divergence

Central banks also need to adapt to economic conditions, so the persistent tightening seen in 2022 might not continue. The Bank of Canada, the Reserve Bank of Australia, and even the Federal Reserve refrain from anticipating ongoing hikes. Instead, new tightening measures will probably depend on ongoing economic data.

Financial markets will closely monitor indicators such as retail sales, GDP growth/contraction, inflation, and unemployment, in order to assess whether central banks might find themselves needing to continue tightening. The option of shifting to an easing stance is naturally also on the table, and that calls for investors to keep a close eye.

No forward guidance from central banks

High economic uncertainty prompted central banks to ditch forward guidance, leaving markets to guess what might be the next steps. This adds to currency volatility, considering any time an economic indicator surprises on the upside/downside, the market will have to price in future tightening or monetary policy accommodation.

Central banks have been wrong in anticipating the inflation spike as of late, and now seem to be obsessed with improving their credibility. Rather than take a guess and end up being wrong once again, the approach is to assess each batch of data and conduct monetary policy based on the numbers. This is not a comfortable position for retail traders or financial institutions that are active in FX, since any important economic data could lead to a trend change.

(Devdiscourse's journalists were not involved in the production of this article. The facts and opinions appearing in the article do not reflect the views of Devdiscourse and Devdiscourse does not claim any responsibility for the same.)