Diverging Interest Rates Drive Forex Volatility

Forex traders were betting heavily on a higher dollar due to the US Federal Reserve raising interest rates. When the most recent Fed meeting ended with a promise of a slow rate increase or none for now, many Forex traders were caught in losing positions. The diverging interest rate policies of the US Federal Reserve and most other central banks is driving higher Forex volatility than seen in years. The Wall Street Journal reports that the Forex market erupts due to this divergence of central bank policies.

Central banks have lighted a fuse under the foreign-exchange market.

Volatility in currency markets has recently rushed up, as shifts in policy by major central banks spark massive bets. The turmoil marks a turnaround from recent years, when ultra-loose monetary policy around the world put markets into hibernation.

In the latest episode Wednesday, a message from the U.S. Federal Reserve that it is in no hurry to raise interest rates caused a big slump in the dollar, which has run up a huge rally so far this year. The euro surged more than 4% against the buck, its biggest jump in a single day in 15 years, according to Deutsche Bank. Early on Thursday, the European currency resumed its slide. The sheer speed of the round trip in the euro-dollar exchange rate-he world’s most heavily traded currency pair-left traders and investors reeling.

To the extent that that you were on the right side of USD EUR trading it was profitable and to the extent that you were not it was a bad day. Diverging interest rates are driving Forex market volatility and will likely continue to do so as central banks address issues across the globe.

Time for Stimulus Measures

The most heavily traded Forex pair is the USD EUR. The US Federal Reserve used a $85 billion a month quantitative easing program to help pull the US economy out of the recession to a point where employment is the highest in a decade or more. The European Central Bank is just starting its own quantitative easing program now while the Fed is likely to raise interest rates a little by June of this year. The ECB stimulus program is expected to drive the value of the Euro down as it helps European economies recover from the threat of renewed recession. DeutcheWelle reports the story.

The European Central Bank is beginning a trillion-euro program to stimulate growth and ward off deflation. The bank will start creating 60 billion fresh euros each month, using it to buy up private and sovereign bonds. The Quantitative easing (QE) program involves pumping euros into the economy – effectively freshly-printed money – to the tune of about 60 billion euros a month, each month until at least September 2016. Its total value is expected to be 1.1 trillion euros ($1.2 trillion).

The ECB program is similar in scope to that of the US Federal Reserve and will likely have a similar healthy outcome. Along the way interest rates will fall in Europe while they go up in the USA. Diverging interest rates will drive more market volatility as the Euro falls in fits and spurts against the dollar.

Higher Interest Rates in the USA

Bloomberg Business reports on how the Fed erased 1% of the dollar’s value in a single day. This is a clear example of how the prospect of diverging interest rates drive market volatility.

The Federal Reserve’s policy statement knocked 1 percent off the value of the dollar on Wednesday without even directly mentioning it.

The statement and updated economic forecasts Fed officials published after their meeting sent a clear message to markets: The greenback’s 24 percent surge since the end of June has complicated the Fed’s plans to tighten by holding down already too-low inflation and clouding the outlook for economic growth.

In January, exports fell from a year earlier for the first time since September 2009. That was information Fed officials didn’t have in their Jan. 27-28 gathering. In her press conference on Wednesday, Fed Chair Janet Yellen said “probably the strong dollar is one reason for that.”

As the US economy improves it invites higher rates by the Fed. However, the Fed does not want to cut off the expansion, especially of exports. Thus a rate increase will likely be small. Nevertheless when European rates and the Euro fall, market volatility will continue.