Mid-Year Currency Market Review: Shadows Under the Scorching Sun

Morning FX

This year, there is an interesting phenomenon in the forex market—the correlation between many currency pairs, including the RMB, and interest rate differentials has significantly decreased. It feels as if the entire market is revolving around the stock market and risk sentiment.But beneath the scorching sun, there are also some little-known shadows.

For example, the recent UK Financial Stress Index (UK CISS) has risen markedly. Considering global risk-on sentiment, the upward movement in UK financial stress seems somewhat unusual. From a narrow perspective, this is mainly due to the Labour Party's heavy defeat in local elections, the rise of right-wing parties (Reform Party), and the market’s renewed focus on the “UK rate hikes + increased debt pressure + weaker GBP” consensus trade…

From a broader perspective, the UK may not be an isolated case. According to data, the ultra-long bond yields in G7 countries have now generally equaled or surpassed the highs of the 2022–2023 rate hike cycle. In particular, European nations (including the UK) are seeing 30Y government bond yields more than 50bps higher than last cycle’s top, yet the Eurozone economy is nowhere near its 2022 level. Clearly, fragility exists.

Based on the prevailing mainstream market views and pricing data, the second half of the year may be characterized by sticky oil prices and sticky interest rates. Given that financial fragility already exists, a necessary inference is that some exogenous variables (such as political elections) could trigger tightening in financial markets. In fact, there is a political event in Europe in the second half of the year that is significantly more important than the UK local elections—the French Senate election (late September). This is another potential flashpoint for financial market vulnerability…

Some argue that high oil prices are not a big deal, as continued stock market increases can “cure all ills.” Such a view is perhaps overly optimistic—from MSCI data, most global stock indices have yet to fully recover to pre–US-Iran war levels. Moreover, only a handful of indices become cheaper as valuations rise; for most, higher valuations simply mean stocks are getting more expensive, and at a certain point, “rising” itself becomes the risk.

From a long-term historical perspective, the combination of high oil prices, high interest rates, and low volatility is extremely rare, yet currently the forex G7 volatility index is at an historically low 10th percentile. How should we interpret such low volatility? Is it a period of tranquility brought about by persistent stock gains? I am more inclined to believe it is the extreme compression before a spring rebounds… From a risk-balance perspective, the USD exchange rate may not be weak in the second half of the year, and may even strengthen moderately; meanwhile, after a round of shakeout in gold, its safe-haven function may gradually return.

To summarize today’s sharing:

1. This year, there is an interesting phenomenon in the forex market—the correlation between many currency pairs, including the RMB, and interest rate differentials has significantly decreased. It seems the entire market floats around risk sentiment, yet beneath the scorching sun, there remain little-known shadows;

2. The UK Financial Stress Index (UK CISS) has surged recently. Ultra-long bond yields in G7 countries have now generally matched or exceeded the highs of the 2022–2023 rate hike cycle. Clearly, fragility objectively exists. If the second half of the year’s global baseline assumption is sticky oil prices plus sticky rates, such fragility is expected to persist;

3. Currently, forex G7 volatility is at an extremely low level, historically just the 10th percentile. Looking at history, the combination of high oil prices, high rates, and low volatility is very rare. Is this tranquility from persistently rising stock prices, or compression before a spring rebounds? I tend to believe, from the perspective of risk balance, that the USD exchange rate may not be weak in the second half of the year, and could even strengthen somewhat. Meanwhile, after a round of shakeout in gold, its safe-haven properties may gradually return.