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Volatility assumptions look too low.

Resilience in the US has bolstered hopes for a soft landing that leaves financial markets and the real economy relatively undamaged. Global interest rate trajectories have converged, and long-term yields have dropped in line with signs of slowing inflation. The People’s Bank of China has kept a tight leash on the renminbi, while the Bank of Japan’s intervention threat has capped losses in the yen. A slowdown in the euro area has restrained the common currency’s gains against the dollar.

Except for Treasury futures—which have been roiled by shifting views on inflation, underlying growth, fiscal funding gaps, and changing Fed policy—trading ranges have subsided across a range of asset classes. Foreign exchange traders seem particularly unworried, with implied volatility in many currency pairs plumbing historic lows last reached just before the pandemic hit in 2020.

Implied volatility indices, z-scores

We very much doubt this state of affairs will last. Relationships between asset prices and economies remain riven with contradictions. Growth trajectories seem likely to diverge more fundamentally in the year ahead, and yield differentials are unlikely to remain stable. Volatility will return, and with it, big moves in currency markets.

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