Forex volatility picks up as FX takes cues from the bond market

The foreign exchange market is in focus right now as traders finally start to take their cues from the bond market. The euro has been one of the biggest losers in the FX market this week, as financial markets are finally realising that central banks will not raise interest rates at the same time. This is leading to widening bond yield spreads, which we believe will be the driver of the FX market as we move to the end of the year. When bond yields start to be the key driver of FX, expect more volatility in the weeks ahead. 

Why the EUR is under pressure 

The euro has been struggling this week and has fallen to multi-month lows, EUR/USD fell to its lowest level since July, while EUR/GBP has been under even more pressure and dropped to its lowest level since February 2020 - the peak of the first wave of the coronavirus crisis. Although EUR/GBP has been in a downtrend since peaking above 91.50 at the end of 2020, its decline has accelerated this month, and this pair has fallen more than 170 pips in a week. GBP was given a boost by the stronger than expected UK inflation data released earlier this week. The headline inflation rate rose to a decade-high of 4.2% last month, and there were gains for the core inflation rate as prices were driven higher by the rising cost of energy, fuel and second-hand cars. Inflation has also been rising in the Eurozone, in October, the consumer price index rose to 4.1%, its highest level for more than 12 years. However, the market is expecting the ECB to react in a very different way to the Bank of England and the Federal Reserve on the back of rising inflation pressures. During a speech to the European Parliament earlier this week, ECB President Christine Lagarde said that raising interest rates too quickly could pose a major threat to the Eurozone economy, this is why the market is expecting the ECB to be the laggard when it comes to raising interest rates compared to the BOE and the Fed. 

Problems for the ECB 

It is more difficult for the ECB to walk away from its covid-era stimulus because of two factors: firstly, the legacy of inflation in the currency bloc under-shooting the ECB’s 2% inflation rate, and secondly, the ECB will be conscious not to trigger bond yield surges for highly indebted nations like Italy and Greece, especially when Continental Europe is facing a rising number of Covid infections and a worrying fourth wave of the virus. The key driver of a weaker EUR/GBP is the yield spread, as we mention above. Right now, the German sovereign 10-year bond yield is -0.245%, whereas the 10-year UK Gilt yield is 0.98%. that is a spread of nearly 98 basis points in the pound’s favour. Since the sovereign bond yield is one of the factors that give intrinsic value to a currency, it is hard to see how EUR/GBP can recover any time soon. 

GBP to benefit from BOE’s lift off 

The different pace of interest rate normalisation has been a key driver of the bond and swaps market this week. The markets are preparing for a December rate increase from the Bank of England as inflation surges, and as the labour market appears to be unharmed from the end of the furlough scheme. The market expects rates to rise to 0.25% next month from their current 0.1%, while the markets are increasing their wagers that the Federal Reserve will start to raise interest rates in summer 2022. The BOE is expected to be the first of the major central banks to raise interest rates, and this is why we think GBP/USD could rally into year-end. GBP/USD has been choppy since reaching a peak above $1.42 at the start of June. After falling earlier this month on the back of the shock decision by the BOE not to raise interest rates at this month’s meeting, we think that there is plenty of upside room for sterling vs. the USD. $1.3680 and then $1.3820- the high from 20/21 October are key medium-term resistance levels to watch out for. Although 10-year UK gilt yields are 65 basis points lower than US 10-year Treasury yields, we think that the pace of increase for UK yields could be higher than US Treasuries as we wait for next month’s BOE meeting. 

The dollar index has performed strongly, and although it took a breather on Thursday, it remains at a 16-month high. The key driver of a stronger dollar index has been a weakening of EUR/USD and a strengthening of the USD vs. the Japanese yen. 

Japanese inflation in focus

The yen will be in focus late on Thursday when National CPI data is released for October. Core inflation is expected to decline to -0.6%, however, annual headline inflation is expected to rise to 0.5% from 0.2% in September. While this level is far below the levels of inflation in its G10 peers, prices have been rising rapidly in Japan as they have been elsewhere, and global price pressures have pulled Japan out of the deflation territory that it was in earlier this year. The trend is higher for headline inflation in Japan, which is good news for the Bank of Japan, who are constantly fighting a battle against deflationary pressures. If we see stronger than expected inflation from Japan, then we could see the yen rise strongly at the end of the week. JPY was the strongest performer in the G10 space on Wednesday as market sentiment wobbled on the back of global inflation fears. We expect the performance of the yen to be mixed in the short term, with more JPY gains likely for AUD/JPY, however, USD/JPY and GBP/JPY may continue with their upward trajectories. 

TRY: how to solve a problem like President Erdogan? 

Elsewhere, Bitcoin is lower at the start of trading on Thursday and is down approx. 1% vs. the USD. Unsurprisingly, there was strong resistance around the $68,000 mark, also the weakness could come from the recent rise in volatility in the G10 FX space. Overall, we think that Bitcoin is likely to repeat attempts to break above $68,000, however, this will only happen when risk sentiment is strong.  Also in focus on Thursday is the beleaguered Turkish lira. It has been in a steep downtrend since September, however, there has been a big acceleration of the TRY’s decline this month. The lira is down 30% vs. the USD so far this year. It reached a fresh record low early on Thursday, as it continues to break new records for all of the wrong reasons. The Turkish central bank is expected to cut interest rates for the third successive time on Thursday, with a 100bp cut expected. This would bring the interest rate down to 15%. While interest rates are far higher in Turkey than they are in Europe and the US, the market is ditching the TRY because inflation is rising at 20% annually. With another rate cut expected, the fear is that Turkey is teetering on the brink of hyper-inflation and a currency crisis partly brought on by President Erdogan. Whenever he opens his mouth it seems like the TRY falls further. On Wednesday, President Erdogan promised to “free” the Turkish people from the “scourge” of higher interest rates, this sent the Lira into freefall, as financial markets now have little faith that the central bank will do anything bar President Erdogan’s wishes and cut rates. Analysts think that Turkey should be raising rates to combat its inflation problems. While President Erdogan focuses on lower interest rates, foreign currency debts are due to be paid back this month to the tune of $10bn, the decline in the TRY has made this significantly more expensive. Thus, the weakness in the TRY is down to the market’s view that President Erdogan is mismanaging Turkey’s economy, and until he stops pressuring the central bank to cut interest rates, and unless the central bank takes radical action like a one-off hefty rate rise, we do not see the TRY recovering any time soon. 

As you can see, the FX market is in focus, after months of stock markets hogging the limelight. This is where we expect volatility to be focussed in the coming weeks, so ensure that you keep an eye out for currency moves as we move into year end.