Drivers that may impact FX volatility in 2015

The year 2015 could be an interesting one for foreign exchange (FX) markets.

Why? The US is expected to implement its first rate hike since 2008, the Russian ruble is being hammered by traders due to the worsening economic environment there, Australia's Reserve Bank Governor wants the Aussie dollar to fall to 75c or lower, and Japan will continue to experiment with its three-arrows economic policy in an attempt to get people spending and investing.

So where could potential FX volatility come from? Let's take a look at some not-so-expected hypothetical outcomes to these situations below that might upset FX market consensus and create volatility:

  1. Sudden change in US interest rate expectations from ‘hike’ to ‘neutral’ would send US dollar lower: Currently the market for Fed Funds futures is pricing in a 62% chance of a US rate hike on 17 September, 2015. Recent (strong) GDP figures out of the US combined with a hawkish tone from the US Federal Reserve have primed the market to price in this first US interest rate hike since December, 2008. This is a big event, it’s well anticipated, but it could be founded on false expectations. Why? While the unemployment rate drops and keeps the US Fed happy, inflation remains low and could be headed even lower as commodity prices around the world plummet. While the S&P 500 is not too far from its all-time highs, the ‘non-listed US economy’ hasn't benefited from low interest rates nearly as much as the big listed firms in the past six years, and this is why I believe stubbornly-low inflation levels will persist. Watch for a change in the September 2015 interest rate hike expectations, leading to a delay in the US’s first interest rate hike since 2008 and a subsequent sell-off in the US dollar.
  2. Regime change in Russia would end the crash of the ruble: While rumours fly of the Russians launching new satellite defence systems and inserting threatening ‘nuclear’ language into their statements, the world is watching and waiting for a political outcome resulting from Western sanctions and falling oil markets. If the popularity of Vladimir Putin falls to a point where he succumbs to pressure from his own people as the economy suffers, a change of regime would see the ruble’s fall reverse, which would cause the recent 42% fall in the ruble to turn sharply. And even if Putin's popularity remains high (a dim view of Western sanctions from the Russian people could outweigh their economic blame for Putin's government), Putin may well step aside to save face and have someone else do business with the West.
  3. Uptick in Australian unemployment would drive RBA rates lower, pushing the AUDUSD lower: There is a paradigm in Australia that assumes that the RBA’s cash rate of 2.50% is ‘rock bottom’ and can only go higher from here. That could easily be tested. Australian property prices, and the banking sector that is leveraged to them, will likely hold up so long as Australian unemployment is kept in check. If, however, it were to move toward a late-‘90s-style 8% (currently 6.2%), the RBA would no doubt change its tone and cut. In addition to this, regionally we've got New Zealand hinting that their next rate move will be higher (making it an attractive relative value trade against the Aussie), energy and commodity prices putting downward pressure on inflation, and a horror May 2015 Federal Budget on its way. Besides managing the housing boom, which can only be curbed fairly using fiscal measures, why shouldn't the Reserve Bank of Australia cut?
  4. Abenomics runs out of steam in Japan, resulting in yen appreciation: Shinzo Abe has just won a snap election, which many Japanese were a bit confused by. He didn't necessarily need to do this to reverse the sales tax hike that is threatening to keep Japan in recession, and some are speculating that he wants the public to get ready for the third arrow of his experimental three-arrows economic policy, also known as Abenomics. As Abe's language speaks to the myriad Japanese savers who are not yet spending and investing, he will spend more time focused on the third 'structural' arrow of his plan. This is not as exciting to long USDJPY traders and may well cause FX traders to quickly flee the short yen trade and pull profits out of Japanese equities, which would see the USDJPY pair fall sharply.
Below you'll find year-to-date performance of the US dollar index (DXc1), US dollar vs. ruble (USDRUB), Australian vs. US dollar (AUDUSD) and US dollar vs. Japanese yen (USDJPY):

Source: Rivkin Trader, extracted 16 December 2014.

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