The Three Things Fueling FX Market Volatility Throughout 2015

The dearth of currency market volatility in 2014 that sank to historic lows last summer appears to be consigned to history. Put simply, there are too many economic and geopolitical variables that erupted over the latter half of the year that ignited the FX market, and those themes will carry over into 2015.

The U.S. Federal Reserve’s decision to turn off the liquidity tap last October, and signals to the market it is preparing to embark upon the normalization of monetary policy next year, is one of the three primary drivers of market volatility.

Likewise with the Bank of England (BoE) when it eventually hikes its key interest rate after the Fed does. Truly sustainable market volatility requires the Group of Seven’s central banks to establish rate divergence. We appear to be on that path in light of the aforementioned Fed and BoE, and as the European Central Bank girds itself to dive headlong into quantitative easing if Germany can be convinced, the Bank of Japan (BoJ) will continue to print yen to prop up Japan’s tepid economy.

Currency Market Shackles Loosened

Geopolitical turmoil and uncertainty surrounding the world’s economic growth are also causing markets to jump as investors assess intermittent intraday risk-on and risk-aversion trading strategies. That does little to aid central bankers fretting over the potential for a sharp fall in asset prices that could in turn derail their efforts to foster growth. But these are two predominant factors that will persist throughout 2015.

However, central bank officials do have the opportunity to tweak their respective policies provided they’re flexible and clearly communicated to the market. There will be monetary policy errors along the way and a certain amount of panic-driven herd mentality when investors start to panic. But expect policymakers worldwide to remain guarded and at the ready to soothe jittery investors when stormy conditions erupt. Lest we forget, in an era of monetary interventions markets will be primed for volatility when a central bank attempts to exit the low-rate environment.

For the past two years, the FX market has been handcuffed by central banks’ low-rate monetary policies. Aside from the U.K. and U.S., if global growth remains tenuous at best, the popular lower-for-longer central bank pledge will stay cemented. Rate divergence will still occur though as long as the U.S and U.K. don’t stray from their perceived courses.

Emerging Markets Concerns

The International Monetary Fund, the World Bank, and the Organization for Economic Cooperation and Development have all cut growth forecasts for 2014 and 2015. Here divergence among recovering economies is crystal clear. The critical ingredient impacting developing and developed economies is China. The newly minted world’s largest economy and its actions will weigh heavily on all asset classes. Emerging markets will undoubtedly feel the pinch. They’re hit by diminishing foreign direct investment when geopolitical events unfold, and that squelches investors’ appetites for riskier investments.

Major Geopolitical Events to Watch

From a geopolitical perspective, the general federal election in the U.K. on May 7, 2015, is one of the most relevant to market volatility. It’s been said the outcome of this vote will be the most hotly contested on the British Isles since the U.K. emerged from the ashes of World War II. If the U.K. Independence Party upsets Britain’s political applecart as it is seemingly poised to do, the possibility of the U.K.’s withdrawal from the European Union becomes a real possibility. Canada, too, is scheduled to hold its federal election in the latter half of 2015, followed by the U.S. in 2016, but it’s widely expected the status quo will prevail in both countries.

Beyond those three nations, the ongoing unrest in Ukraine courtesy of Russia and the latter’s collapsing economy, the West’s uncertain outcome of the Mideast conflict with the Islamic State (aka ISIS), and the potential for political fallout in both Russia and the Mideast as a result of plummeting oil prices will keep markets on edge.

The Commodities Question

Stunted global economic growth has reduced the demand for all commodities. Base and precious metals prices have receded as supply has overshot demand, in turn punishing commodity-sensitive currencies and economies.

Garnering most of the headlines of late has been the dramatic slide in the price of oil in the latter half of 2014. Oil prices have hit lows not seen since 2009. Precipitated by a slowdown in China’s economy, it remains to be seen if the Organization of Petroleum Exporting Countries’ supply constraints will drive up the price again, especially after the U.S. increased its shale oil production thanks to technological advances in extraction. But questions abound over the longevity of the shale oil boom stateside remain unanswered. After all, for shale oil producers, the cost of fracking (the process used to extract oil or gas trapped in subterranean rock) is more expensive than conventional drilling. Moreover, the good times for shale oil producers may not last. It’s been said that by the end of this decade, shale oil production in the U.S. could flatten as underground supply is depleted.