The coronavirus epidemic has delivered a jolt to previously sleepy foreign-exchange markets.
Currency trading had mostly been calm in recent years, as a degree of certainty about the outlook for U.S. interest rates and other factors, such as the low cost of insurance against major foreign-exchange moves, suppressed volatility.
The fast-spreading virus has interrupted that equability. The Cboe/CME FX Euro Volatility Index, a measure of expected turbulence in the dollar-euro futures market derived from options prices, has surged 21% over the past week, extending this year’s advance to 44%.
The Cboe gauge of implied volatility in the dollar-yen futures market has risen even further, jumping 72% in 2020. Japan’s yen has moved up or down an average of 0.44% against the dollar in the spot market since the start of February, according to FactSet, almost double the average daily swing of 0.24% that took place in the preceding 12 months.
One reason why volatility has returned: The epidemic led investors to predict that the Federal Reserve would shift course and lower borrowing costs, instead of maintaining rates at current levels. They were proved right Tuesday when it cut its target interest rate by half a percentage point—the first rate reduction to take place between scheduled meetings since the financial crisis—to shield the economy from a potential downturn in global growth.
This change of direction has upended bets that rates would remain significantly higher in the U.S. than in other major economies.
The gap between expected borrowing costs in different economies often, though not always, dictates moves in currency markets because money managers typically seek to invest where they think they can earn the greatest returns.
“One of the drivers of low volatility was the expectation of interest rates from central banks to be on hold for the foreseeable future,” said Jordan Rochester, a currency strategist at Nomura. “Now we have the potential for central-bank rate cuts, predominantly from the Federal Reserve in the U.S., and this would narrow the interest-rate differential between the U.S. and its partners.”
As the threat of a pandemic began to loom last week, stock markets reeled and economists slashed their forecasts for global growth in 2020.
Bank of England and European Central Bank have all said they stand ready to tackle the economic and financial impact of the coronavirus. The Fed has more room to reduce borrowing costs because it currently targets a higher rate of interest than policy makers in Japan, the eurozone and the U.K.
Finance ministers and central-bank governors from the Group of Seven countries said Tuesday they were prepared to cooperate to guard against economic risks stemming from the epidemic, though they stopped short of stating specific actions.
With less certainty about the gap between rates set by different central banks, option sellers have pushed up the price of insuring against currency moves, Mr. Rochester said. In turn, that has boosted the level of implied volatility.
Currency swings have also become more pronounced in emerging markets, many of which are closely tied to China’s economy through commodity exports and supply chains. Implied volatility for a basket of emerging-market currencies has risen 26% in 2020, according to an index calculated by JPMorgan Chase & Co.
South Africa’s rand, one of the worst-performing currencies this year, has gained or lost an average of 0.85% against the dollar since the start of February, compared with an average daily move of 0.61% in the prior 12 months.
Still, currencies remain calmer than stocks. The Cboe Volatility Index, a gauge of expected turbulence in large-cap U.S. equities, has surged 135% in 2020 and the S&P 500 followed up its worst week since the financial crisis with its best day in more than a year on Monday.
Although the epidemic has raised the prospect of changes to monetary policy, many investors expect central banks to act in tandem. This “herding” accounts for around two-thirds of the undershoot in currency volatility, according to analysts at JPMorgan Chase & Co.
“We wouldn’t count on a return to 2016-levels of foreign-exchange instability as central banks gear up for another round of easing,” they said.
Write to Joe Wallace at Joe.Wallace@wsj.com
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