(Bloomberg) -- The global currency market is vulnerable to a liquidity crunch later this year as financial conditions tighten and economic growth slows, Bank of America Corp. warned.
Even after the market emerged relatively unscathed from the latest banking turmoil, implied volatility in major currency pairs jumped this month as concerns about the US banking sector weighed on the dollar and drove the yen higher. Still, the move was “far from crisis levels,” strategists at BofA said. Volatility remained lower compared with late last year, when a surge in demand for the US currency drove euro-dollar one-month implied volatility to the highest levels since early 2020.
While the Federal Reserve’s dovish stance last week calmed markets following the collapse of Silicon Valley Bank and the takeover of Credit Suisse AG by UBS Group AG, there is a risk that volatility could ramp up again in the coming months, particularly if inflation stays high, BofA strategists Michalis Rousakis and Howard Du wrote in a note.
“The lagged effect of bank-credit tightening has yet to fully play out and the economic cycle is likely entering a contractionary phase for growth,” they said.
Spreads between bid/ask prices for all major currencies widened this month. This had limited impact on price movements, BofA argued, as its measure of options volumes in the middle of the month was well below levels seen in late September, when the dollar surged following the UK mini-budget, and was supported by a hawkish Fed.
But as more US regional banks curb lending to consumers, BofA expects price pressures to remain elevated for longer, which could increase volatility down the line. Traders are now betting that the Fed may be done with tightening, and will cut rates by 50 basis points by the end of the year.
“If inflation proves to be overly sticky, spot liquidity will likely be tested again,” Rousakis and Du said.
©2023 Bloomberg L.P.
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