Summer holidays are winding down, time to get back to business. At least if you’re a currency trader. As Bloomberg reports, “the cost of hedging in the currency market is rising after the summer lull, with traders positioning for wider price swings around Friday’s key US jobs report.”
Federal Reserve head Jerome Powell has raised concerns about downside risk to employment, opening the door to a potential rate cut. A soft jobs report would underscore the impression of a likely cut.
Already, according to the Bloomberg report, “euro-dollar implied volatility rose to the highest level since June on Thursday, and is on track for the strongest close since April”.
Of course, the labour market isn’t the only source of volatility. As the Bloomberg piece points out, “a broad gauge of expected swings in Group-of-10 currencies hit a one-month high this week as risks stacked up, from UK fiscal worries and French politics to geopolitical tensions, a string of central bank meetings, and worries over the independence of the Fed.”
The latter point – about Federal Reserve independence – raises broader questions about the tools we use to anticipate changes to monetary policy – and economic interventions more broadly.
Mixed signals
Whatever one’s theoretical stance on central bank independence, for traders, the priority is predictability. In principle, insulating monetary policy from the electoral cycle aims to prevent short-term political pressures, like boosting growth before elections, from compromising long-term inflation control.
While global central banks and their monetary policy committees vary in hawkishness, they generally follow a predictable playbook: signal their economic outlook clearly and intervene gradually, in line with their specific mandates.
In this context, the US president’s unprecedented efforts to intervene in the composition of the Fed Board threatens to upend monetary policy as we know it.
One might then quite reasonably ask why market volatility has not even been higher. After all, Turkey’s experiment with unorthodox monetary policy saw “the lira strongly depreciating against the dollar and inflation shooting up”.
What the market knows
One explanation is that Federal Reserve independence has not yet been fully tested, and US institutions remain resilient. The alternative is that markets are underestimating, or ignoring, the scope of the threat to the economic status quo.
Another reading was mooted by Columbia Law School professor Lev Menand on a recent episode of the Odd Lots podcast. Menand suggests current White House policy is a recipe for an asset bubble: “We get a lot of leverage in the financial system because we deregulate bank balance sheets, and we lower shorter interest rates. That’s going to lead to lots of credit expansion.”
In effect, this is the new Trump trade: asset prices inflated by deregulation and political pressure on the Fed, while the underlying risks build beneath the surface.
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