Living with Volatility
The foreign exchange market, with global daily turnover of some US$5.3 trillion, is by far the world's largest financial market—and its importance is only expected to grow. One leading global wealth management company has suggested daily volumes could reach $8 trillion within the next decade.
"The growth of foreign exchange markets is likely to continue," agrees Professor Mark Taylor, dean of Warwick Business School in the U.K. One of the main drivers, he says, is the continued growth of international trade and investments, though he notes that "a large amount of forex transactions are not for goods or services—or indeed for external financial transactions—but is proprietary trading."
It is generally accepted that efficient currency markets provide an essential lubricant to global trade and investment, while floating exchange rates act as shock-absorbers during macroeconomic shifts. Yet Michael Kitson, an economist at the University of Cambridge Judge Business School in the U.K., sees "an increasing disconnect between forex markets, now driven more by speculative behaviour, and the real economy."
"This makes exchange-rate movements less predictable," Mr. Kitson adds, "and it is this inconsistency, rather than pure volatility, that seems to be growing." A recent example was the euro-dollar spot rate's rollercoaster ride in early June, rising 2% on the day that more positive data on euro-zone inflation was released (see chart) and then gyrating more than 1% as the market struggled to establish a new trading range.
Much of that turbulence was caused by traders unwinding overcrowded positions that assumed the euro zone's continuing slide towards deflation—for many investors, a "one-way bet." The first data suggesting otherwise caused the euro to surge, triggering stop/loss fire sales that pushed it even higher.
"Uncertainties over the timing of interest-rate rises tend to unsettle markets," Prof. Taylor says. And then there are extreme events, he adds, such as when the policy of pegging the Swiss franc to the euro was abandoned [see chart). Many major market players—including the big Swiss banks—suffered huge losses.
Patrick Teng, founder and chief dealer of Singapore-based Six Capital, predicts: "Financial markets across all asset classes will be volatile and daily swings unprecedented," adding that the 50% plunge in oil prices "is just the tip of the iceberg."
Chiara Banti, lecturer in finance at the University of Essex in the U.K., who has studied the relationship between liquidity and volatility, believes that "we have seen higher volatility since the financial crisis." And it is not just macroeconomic uncertainties or fast-moving global capital flows that are responsible.
"Given its size, the forex market is considered to be highly liquid," Dr. Banti observes. But she has found that higher volatility can trigger illiquidity because it impacts on the funding market, making it more expensive for dealers to hold a position.
"Dealers are increasingly seeking to match customer orders in-house, without themselves having to step in and provide liquidity," she notes. But when markets move sharply, such risk-aversion may suddenly drain liquidity and widen bid-ask spreads, thereby fuelling even greater volatility.
Mr. Kitson argues that "excess liquidity globally is generating price volatility." Huge capital flows seeking better returns in a low-interest-rate environment only increases instability; and with the negative feedback between volatility and liquidity when markets are stressed, it looks like we are all in for a bumpy ride.
"Debating the causes has become a secondary issue," Mr Teng says. "What matters now is how best to manage andbenefit from increased volatility. We need to look the future rather than the past."