Gertrude Chavez – Dyfuss and Saqib Ahmed Iqbal Ahmed

NEW YORK, (Reuters) – Volatility in foreign currency markets is rising as speculation on the aggressiveness of central banks to tighten monetary policies in response to surging inflation increases the dollar. This can exacerbate global currency swings and increase the risk of a soaring dollar.

The Deutsche Bank (DE: Currency Volatility Indicator, which tracks expectations for FX gyrations, shot up in the last weeks from its lowest level in three months to its highest since March. This was driven by currency gyrations, including those in the U.S. Dollar, Euro, and Japanese Yoen, as well as other currencies.

The swings can be attributed to the differing outlooks of central bankers, who are working at different rates to normalize their monetary policies after some cut interest rates last year and took extraordinary measures to protect their economies from the COVID-19 epidemic. Expectations of higher rates tend to boost a currency’s allure to yield-seeking investors.

GRAPHIC: Frisky FX: https://fingfx.thomsonreuters.com/gfx/mkt/zdvxonbrqpx/Pasted%20image%201637679371646.png

Investors may be able to trade currencies with one another in an increased gyration on foreign exchange markets. Investors who experience too much volatility could be forced to reduce their risks and cause problems for foreign companies looking to return their profits to their home currency.

While volatility levels are still relatively low, many investors feel that the current volatility will continue to rise. The volatility in the bond market, which is also heavily driven and driven by expectations about rates, has been rising for several weeks.

A lot of people are taking measures to safeguard their portfolios from excessive market swings. This has driven hedging activity for many currency pairs up to its highest point in several months.

“We have divergence of policy, divergence of inflation rates … divergence of economic growth rate,” said Lisa Shallet, chief investment officer at Morgan Stanley Wealth Management. “Divergence is expected to dominate the 2022 game and investors have begun to see the benefits.”

The recent volatility is largely due to an increase in dollar strength. This rally has been fueled by bets on the Federal Reserve’s ability to reduce its bond-buying program and ultimately raise interest rates faster than other central banks.

This year’s U.S. dollar is at its highest annual gain for six years, rising 9.1% against euro. It also rose 11.6% against Japan’s yen, and 7.0% against Australia’s dollar.

GRAPHIC: King dollar: https://graphics.reuters.com/USA-MARKETS/lbvgnbewdpq/chart.png

Richard Benson in London is the co-chief investor officer at Millennium Global Investments. In the face of rising U.S. growth, and inflation, the Fed will tighten monetary policies next year quicker than the European Central Bank.

“The underlying fundamental view is that the Fed is raising interest rates over the next 12 months, and the ECB is not,” he said.

Fed funds futures, which reflect investors’ monetary policy expectations, on Wednesday had factored in a 100% chance that the Fed will raise rates by next June. Eurozone rates futures, however, fully price a 10 basis point hike by December 2022.

COVID-19 fears are also driving currency movements. These worries weigh on euro and other European currencies because of another wave in the pandemic. It is also helping to boost the Swiss franc which has been a popular choice during uncertain times.

Concerns over a potential war with Ukraine have tripped up the Russian ruble in recent weeks, while Turkey’s lira has plunged 25% this month after President Tayyip Erdogan pressured the country’s central bank to pivot to an aggressive easing cycle, potentially sparking a full-blown crisis in the country.

Some investors take steps to protect their portfolios from further currency swings, as volatility is on the rise.

Banks use implied volatility to price 3-month euro/dollar options. It was highest since March. This suggests that banks are looking for ways to hedge against currency-pair fluctuations. The demand for options to protect against currency pairs dollar-yen currency gyrations is at its highest level in one year.

Bernhard Eschweiler is an economic advisor with QCAM Currency Asset Management. However, he believes the dollar will rise and has recommended that investors consider derivatives to counter currency market swings. He said that markets could be given a boost by worsening inflation and COVID-19 flare-ups, as well as an increasing energy scarcity.

“There is no shortage of potential shocks,” he said.

Bipan Rai from CIBC Capital Markets North America, head FX strategy, stated that volatility in foreign currency tends to increase as the Fed moves closer to increasing rates.

“If you are an asset manager with exposure in major currencies that could diverge due to what the Fed will be doing next you, then you will want to have some protection in place,” he said.