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As a long-ago MadTV skit illustrated, lowered expectations can be the key to happiness – in dating, and in life. Something similar applies in the currency markets, where – to paraphrase the behavioural investing expert Michael Mauboussin – traders need to assess the level of expected performance embedded in exchange rates and then assess the likelihood of a revision in expectations. If expectations seem poorly aligned with future results, volatility is likely ahead.

Our turnover-weighted measure of economic surprise indices, which represents the gap between consensus forecasts and official data across the major currencies relative to the United States, suggests that just such a misalignment could be in play now. After a sustained period of outperformance relative to expectations, incoming data is increasingly disappointing overly-optimistic forecasts, while data in other countries is coming closer to already-pessimistic forecasts.

To us, this backdrop suggests that the American economy could be entering a “muddle through” period that drives the dollar lower against its major peers – but first, a gradual unwinding of the “soft landing” narrative is likely to generate turbulence in markets. If we’re right – and with implied volatility levels well below historical averages – it might be a good time to consider upping hedge ratios. 

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