Is the dollar vulnerable to rising volatility?

The powerful uptrend in the dollar had been the key theme for the FX market in Q3, however, its performance at the start of Q4 has been fragile compared to what we have come to expect, and it may start to unsettle markets.

During Q3 the dollar was able to rally even though geopolitical risks were heating up as Russia/ Ukraine tension escalated. The dollar thrived as the Fed pondered its next move after the end of QE3, which is due to come to an end later this month. Perceived Fed “hawkishness” combined with relatively low volatility proved to be optimal conditions for the greenback to make multi-year highs.

However, as the Vix index gets closer to the August spike above 17, the dollar is starting to get jittery, as you can see in the chart below. One reason why the dollar is lower today is due to the resurgence in the yen. USDJPY hit the psychologically important 110.00 level on Wednesday and after twice trying to break through this level it gave up the fight and fell to a low of 108.32.

Geopolitics could also start to have an impact. Earlier this week the markets seemed to brush off the protests in Hong Kong. However, as China hardens its stance towards the protestors, markets are starting to react. While earlier this week the selloff was mostly centred in the Hang Seng, today most Asian markets are lower. The Nikkei fell more than 2.5%, which dragged USDJPY with it. The trade-weighted yen, which made a 6-year low on 18th September, has started to pick up. So far, the rise has only been moderate; however, further yen gains could be dependent on the on events in Hong Kong. If the protests escalate, and we get an response from China, and potentially the West, then the yen could roar back into life as a safe haven.

If this happens then it could seriously dent USDJPY’s chance of extending gains above 110, it could also accelerate the recent decline in global equities as markets may shudder at the thought of geopolitical risks that concern China.

This does not mean that the dollar will crumple; we still think it could have further to go against some EM currencies and also versus the EUR. GBPUSD has fallen to a three week low today after Bank of England newbie Kristen Forbes said that the data does not yet show “sufficient” inflation pressure to warrant a rate rise.

While there could be more life in the dollar up-trend, we are watching out for three main risks:

1, Can the dollar rally if we get another sub-150K payrolls report on Friday?

2, Protests in Hong Kong could disrupt the rally in USDJPY.

3, Inflation.

The last point is worth keeping an eye on. The BOE’S Forbes mentioned that inflation is not “sufficient” to warrant a rate hike, we have also noticed a subtle shift in rhetoric at the Federal Reserve, with uber dove William Dudley saying that he would rather see prices above 2%, and the economy “running hot” for a while before he votes to hike rates. If Dudley and co. at the Fed need to see an increase in inflation before they raise rates, they may have to wait some time. There seems to be a global disinflationary impulse, manifested mostly in the Eurozone, that may start to spread across the Atlantic as energy prices are falling, and WTI is below $90, which could keep prices low for some time.

Although we don’t want to stand in front of a powerful dollar uptrend, we would urge some caution as a few risks start to build for the greenback. Watch US CPI reports as well as events in Hong Kong. For now dollar weakness is mostly centred in USDJPY, but October could prove to be a tricky month for the greenback.

Conclusion:

As you can see in the chart below, recent spikes in volatility (since 2012) have coincided with dollar weakness. However, back in 2010, at the height of the Eurozone sovereign crisis, volatility spiked, but the dollar moved higher as EURUSD fell sharply. Thus, if ECB’s Mario Draghi manages to talk down the EUR later today then the dollar could be protected if we see another spike in the Vix. However, as risks rise globally, the dollar’s push higher may not be as easy as it was in September.