In contrast to many investors’ expectations, FX market volatility has continued to fall over the last few weeks. Although currency volatility is still above the pre-Lehman lows of 2007, it is well below the average levels recorded in the last years of the so-called “great moderation”.Source: Bloomberg, data as of December 5, 2012
Two key factors are driving this: Monetary accommodation and the reversion of many key currency relationships toward equilibrium. On the former, investors have absorbed the clear message from key central banks that monetary policy will remain very accommodative well beyond 2013. This is manifesting itself in a renewed expansion of global high powered money. With money multipliers more stable, there is greater likelihood that this growth in reserves flows through into broader measures of liquidity and credit. Our proxy measures for global M1 and M3 growth suggests that this is already beginning to occur.
Source: Bloomberg and various central banks, data as of October 2012
Meanwhile, many G10 currency pairs are now close to levels consistent with estimates of “fair value”. EURUSD at 1.30 is in the middle of our estimated fair value range of 1.25-1.35. This implies that most other European currencies are also close to fair value. In addition, the AUD, CAD and NZD are all overvalued, but investors are assuming that these pro-growth currencies will continue to be the main beneficiaries of easy monetary policy.
The one G10 currency that has seen a rise in volatility and potentially the beginnings of a new change in underlying trend is the Japanese yen (JPY). The currency has been overvalued for a prolonged period despite persistent economic weakness. In addition, our proprietary leading economic indicator for Japan is now the weakest of the G10. Deflation has not eased in response to the limited new action that the Bank of Japan (BOJ) has undertaken in 2012. Meanwhile, long-term support for the JPY from external surpluses has now eroded with the current account recording a deficit for the first time in modern economic history.
Pressure on the BOJ to take a much more aggressive anti-deflation stance has intensified greatly with the upcoming general election on December 16th. Polls indicate that the leading candidate is Liberal Democratic Party leader and former Prime Minister, Shinzo Abe. Mr. Abe has stated a desire for the BOJ to implement a formal 2% inflation target in line with other central banks. Because inflation in Japan is currently much lower than 2%, this would be a key development as it would imply that much more aggressive monetary easing would be necessary to achieve the inflation target.
With volatility in other currency markets continuing to decline, investors have jumped on the JPY story and have started to build short positioning. Therefore, there is a risk that profit-taking in early December could lead to some correction lower in USDJPY. However, it is interesting to note that expectations of JPY weakness for next year are markedly lower than in previous years.
Data as of November 30, 2012
This suggests that investors and strategists are not excessively bearish on the JPY and that poor fundamentals and a more dovish BOJ will weaken the currency in 2013.