Why is FX volatility lagging behind stocks?
October was always expected to be a tricky month for the markets as the Fed's QE3 program comes to an end. However, as equity markets sell off on the back of confusion and uncertainty about the Fed's next steps, downside in risky FX could be limited if the Fed continues to show concern about USD strength.
The recent bout of market volatility has muddied some of the usual correlations that we have come to expect during periods of rising risk aversion. For example, oil has been declining in line with the USD, although a falling dollar usually pushes up the price of oil. Likewise, USD/JPY has traded sideways even though the Nikkei, which shares a close positive correlation with it, is lower on the week.
If the equity sell-off continues, we would expect further declines in the riskier G10 currencies, and we would expect to see the volatility of risky crosses like NZD/JPY jump as these crosses start to sell off.
However, how far forex joins in with the sell-off could depend on the dollar. If the USD's upside is limited due to Fed fears about inflation, don't expect the forex market to react in the usual way, as a muted dollar could limit the downside for risky FX pairs.
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