El-Erian: Currency Volatility May Surge as Central Bank Policies Diverge

Thursday, 28 Aug 2014 07:47 AM

By Dan Weil

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While many commentators are focusing on the dangers of overheated stock and bond prices, the real problem may lie in the foreign exchange market, says Mohamed El-Erian, former CEO of fund giant Pimco.

The recent period of low volatility among currencies could end with a bang, as central bank policies begin to diverge, he writes in the Financial Times.

And this increasing volatility in foreign exchange markets "could well pose a big challenge to the sustainability of investor gains elsewhere in financial markets."

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The JPMorgan Chase Global FX Volatility Index fell to 5.29 percent July 3, the lowest close in figures dating back to 1992.

Since last year, the Federal Reserve, Bank of England (BOE), European Central Bank and Bank of Japan have been easing in unison. But the BOE is expected to raise interest rates as soon as late this year, and the Fed is expected to move as soon as early next year.

Foreign exchange traders and investors often to gravitate to currencies with the highest rates, as they can earn more from fixed-income holdings in those currencies.

"Due to the potential for technical tipping points, FX movements can be surprisingly sharp once they start in earnest. Corporate hedging activity is often pro-cyclical, meaning companies are more likely to protect themselves against unfavorable currency moves only after these have started to hurt," El-Erian, chief economic adviser to Allianz, explains.

"Judging by recent policy and technical signals, the forex market may be about to exit an unusual phase of low volatility," he adds.

The low volatility has depressed currency trading volume. But rate hikes by the BOE and Fed could push both volatility and trading volume higher, says Marc Chandler, global head of currency strategy for Brown Brothers Harriman.

"Maybe in the middle of next year, volume will increase again," he tells Institutional Investor. He doesn't think we've seen the peak of currency turnover yet.

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