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Dollar Drives a Surge in Currency Volatility and Trading Volume
Divergent central bank policies are fueling the dollar’s rise and the upturn in forex activity, and traders expect the trend to continue.
In the foreign exchange market, things can change in a hurry. Trading volume slumped through much of last year as volatility hit record lows in July. Volatility has since snapped back, driving volume up to a record high.
Whats driving the turnaround? Look no further than the dollar. The greenback, which advanced to a seven-year peak against the yen in December and an 11-year high against the euro last month, is fueling the rise of both volatility and volume.
The last few years everyone had the same monetary policy, says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York. It became clear as last year progressed that there was divergence, sending the dollar broadly higher.
The Federal Reserve Board responded to a strengthening economy by terminating its quantitative easing program in October, whereas the Bank of Japan and the European Central Bank have launched or expanded their bond-buying programs because of weakness in their economies. U.S. gross domestic product expanded 2.4 percent last year, while the euro zone economy grew only 0.9 percent and Japans economy shrank in the second and third quarters of 2014. After dropping to an all-time low on July 3, JPMorgan Chase & Co.s Global FX Volatility index has more than doubled. Average daily volume totaled $4.8 trillion in October, up 21 percent from a year earlier and up 17 percent from six months earlier, according to data from six central banks, including the Fed, the Bank of England and the Bank of Japan.
This volume in turn spurred more traders to return to the market. Currency intervention by central banks, including those of Denmark, Switzerland and Russia, has also boosted volume, notes David Gilmore, a partner at Foreign Exchange Analytics, a currency research firm in Essex, Connecticut. There are some big footprints from central banks.
Among the winners from the rising trading volume are banks, which are the principal market makers. Fragmentation stemming from automated trading platforms and high frequency trading limits the benefit to financial institutions, however. Banks have to share with high frequency currency funds, says Gilmore.
For that reason, according to Chandler, the increased volume doesnt necessarily mean more liquidity. What the bump-up in volume does mean is more opportunities for currency speculators, whose ranks largely consist of hedge funds. The relationship is somewhat circular. The real volume comes from speculators, Chandler says. And that volume leads to more volume. Overall, the increased volume appears to have been helpful for speculators. Currency hedge funds enjoyed their best January returns since at least 2008, according to Chicago-based Hedge Fund Research. Currency hedge funds generated returns of 3.4 percent last month, compared with 0.5 percent for long and short stock funds, according to BarclayHedge, an alternative investment research firm in Fairfield, Iowa.
For U.S. companies, the picture isnt so pretty. Many of them suffered earnings setbacks in the fourth quarter because of the dollars ascent. A strong greenback lessens the value of companies foreign revenue in U.S. currency terms, and they have to pay up if they want to hedge against a rising dollar. This hurts corporations, because hedging is more expensive, thanks to the volatility, Chandler says. Legitimate hedgers get hurt.
So whats the outlook for volume? Experts predict it will continue to rise, particularly if the Fed raises interest rates around midyear, as many central bank watchers expect, says Gilmore. Were not early in the strong dollar trend, but maybe at the midpoint, he says. That gives us six months or longer. I think that will support volume.
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