Comment: Currency volatility set for dramatic increase

Comment: Currency volatility set for dramatic increase

Jerry Haworth, director and co-founder of 36 South, the global macro/volatility hedge fund, says currency volatility is about to explode as Central Banks continue to keep an iron grip on interest rates in response to the global financial crisis.

Central Banks have two control levers which they can use to control events related to their financial flows. One controls the level of interest rates while the other controls currency rate. Economic theory dictates that Central Banks can only hope to control one of these “policy levers” whilst the other is left free to find its own level in response.

It is clear that the interest rate policy lever is the one Central Banks wish to hold steady. In response to the global financial crisis, their own funding requirements, how expensive the interest burden on government debt has become and, lastly, to forestall a depression or significant deflation, Central Banks have set interest rates artificially low. The unavoidable consequence however is that currencies will start to oscillate more and more wildly, like a suspension bridge starting to self-destruct under increasingly severe harmonic wave action.

Notwithstanding that, each country is going to endure different pressures and will undertake different policy actions in response to their own situations. Australia and New Zealand, whose Central Banks have the sole mandate of keeping inflation under control, will opt to raise rates sooner, as has already been seen. The corresponding rise in the value of their currencies will lead to a feed-back loop which will eventually lead to greater and greater volatility.

In addition, the prevalent view is that we are in the throes of a V-shaped recession and that the world economic ‘regime’ is intact. But, if this not true and something fundamental has changed the economy will roll over into a W-shaped recession. If this is the case, further fuel will be added to the currency volatility as we enter into previously uncharted economic waters. The potential for “black swan” like currency movements would then be probable.

Ultimately, capital will vote with its currency ‘feet’ and, given the recent mobility of capital, no Central Bank will be able to control the flows, alone or in unison, against the tsunami of world capital moving in concert.

Savvy investors are already moving to put strategies in place to hedge against the corrosive effects of currency volatility or, indeed, to profit from it.

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