Divergent monetary policies ruffle flat calm in FX markets

Reuters

* Months of calm in markets may be about to end

* Expected monetary policy shifts to create volatility

* Investors bet on further weakness in the euro

By Anirban Nag

LONDON, Aug 27 (Reuters) - Months of dead calm in financial markets that have crushed trading volumes and hit bank profits may be drawing to a close as currency investors gear up for volatility triggered by monetary policy shifts in major economies.

Occasional convulsions due to war and other political risks notwithstanding, the volatility on which traders thrive and make money has all but evaporated this year.

Bond yields have fallen steadily, stocks have traded near multi-year highs all year and, in the $5-trillion-a-day foreign exchange market, the most active currencies have been stuck in tight ranges.

But that may be about to change.

The dollar's rise to a 13-month high against a basket of currencies has driven the euro to a near one-year low, prompting some investors to seek protection against future swings in the currency pair. Investors who have long predicted a strengthening dollar wonder whether it may finally be happening.

The new trend reflects the fact that the U.S. Federal Reserve is edging towards higher interest rates while the European Central Bank (ECB) is set to loosen policy.

ECB chief Mario Draghi last week flagged the chances of more action, triggering speculation that the bank is veering towards asset purchases, or quantitative easing, to ward off the threat of deflation. In these circumstances, analysts say, the euro and the dollar could see sharp moves.

"The abnormal low volatility regime that we saw this summer is coming to an end. The divergence of monetary policy between the Fed and the ECB is behind this, but for a move higher, the catalyst we probably need is a sharp rise in short-term U.S. rates," said Peter Kinsella, currency strategist at Commerzbank.

The dollar index hit a high this week, gaining momentum after Fed minutes showed policymakers debating whether rates should be raised earlier or not.

Fed Chair Janet Yellen acknowledged those concerns last week, while stressing the need to move cautiously on raising rates. As a result, yields on two-year Treasuries rose more than 8 basis points, their biggest weekly gain since June last year.

Reflecting some of that anxiety, one-month implied future volatility for euro/dollar hit 5.8 percent on Wednesday, its highest since early June and up from near record lows of around 4.2 percent struck early in August.

One-month implied volatility for dollar/yen has also risen to around 6 percent, from around 4.4 percent, also a record low, struck in late July.

"Most participants have become overly comfortable with the low interest rate environment and (they) should now revisit their risk management strategies," said Illimar Mattus, CFO at Armada Markets, a currency and precious metals trading firm.

"Changes in the interest rate outlook, and ultimately the rise of interest rates, should bring an end to the low-volatility environment and introduce higher risk to the market."

BEARISH EURO BETS

With short-term interest rate differentials moving in the dollar's favour, the euro hit a near one-year low of $1.31525 on Wednesday while the yen languished near seven-month lows.

But the euro's losses, of 1.5 percent this month, have garnered more attention. Investors are looking to bet on further weakness by buying put options to sell the euro at lower levels.

Traders said there had been steady demand for euro puts, or options betting on more weakness in the single currency against the dollar. Options betting the euro will drop to $1.31 on Sept. 5 - the day after the ECB's next policy decision and on which U.S. jobs data is released - have been put in place, they said.

Investors are awaiting euro zone inflation data on Friday. Analysts polled by Reuters expect annual price increases to have slowed to 0.3 percent in August from 0.4 percent in July. That would be well below the ECB's declared danger zone of 1 percent and its target of just under 2 percent.

Kinsella said euro/dollar risk reversals, a gauge of demand for options betting on a currency rising or falling, are likely to show more bias for dollar strength in coming weeks as the euro's weakness gathers pace.

"The market certainly feels nervous of further volatility in the euro from here, and it feels like some demand may be switching back for euro puts again," said an options trader at a North American bank.

(Editing by Susan Fenton)

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