FX Volatility In 2027: In Need Of Shock Therapy

(MENAFN- ING) Whatever happened to FX volatility?

Despite wars in the Middle East and Continental Europe, an energy-driven inflation spike and growing fears over an AI bubble, FX volatility is close to its lowest levels in over a decade. If moves in spot exchange rates are the ultimate driver of traded volatility, then the recent stasis in spot USD/JPY in the face of a 6% drop in the Nasdaq tells the story. In short, if exchange rates aren't moving, why should the market pay up for volatility?

It is not as though FX volatility is low in all markets. AI concerns have seen equity volatility spike, while surging energy prices, central bank tightening, and fears about debt sustainability have all seen interest rate volatility remain elevated.

FX volatility has remained muted Source: ING, Refinitiv

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The lack of spot FX movement or spot follow-through cannot simply be blamed on some kind of separation between geopolitics and macro. This year's war in Iran has driven a massive hawkish repricing at the short end of yield curves and turned easing cycles on their heads. And in this outlook, we argue that if there is one theme that FX markets should take seriously, it's global monetary policy cycles.

Any pickup in FX volatility more likely from equities than bonds

One of our key calls for 2027 is that we don't expect a significant pickup in FX volatility. Markets have built up considerable tolerance for US policy and geopolitical headlines, and may be even more willing to fade US political risk if a Democrat-led Congress and weaker Republican support constrain US President Donald Trump's room for aggressive policy action.

If volatility does break higher, we think equities are a more likely trigger than rates. Historical evidence supports that view, with equity volatility consistently showing greater pass-through into FX than rates volatility (chart below).

Sticky global inflation and prolonged monetary tightening are more plausible risks than a major equity selloff. Yet we don't think even a high-inflation scenario would be enough to recreate 2022-2023 levels of FX volatility. Policy rates entered the Iran war from much higher levels than at the end of the pandemic, while fiscal support is smaller and labour markets are looser. The ingredients for another 2022-23-style rates shock simply look less potent.

Greater FX shock potential from equities Source: ING, Refinitiv

"> Structural factors: Growth in financial assets playing a role?

When thinking about factors that could be suppressing volatility in spot exchange rates, we suspect the growth in the asset management industry could be playing a role. Both assets under management and cross-border positions have continued to surge over recent years. Using World Bank and Bank for International Settlements (BIS) data, we now estimate that global holdings of equities and bonds are worth around 300% of global GDP. As the BIS reported back in 2025, FX trading volumes were about 70 times the volume of global trade in 2025, roughly double the ratio of 1992.

These financial FX flows, including portfolio hedging and rebalancing, can be an important source of FX liquidity when they are gradual and diversified. But correlated hedging or rebalancing can amplify FX moves. The latter was the case during the Trump tariff shock in March/April 2025.

Stock of global equity and fixed income holdings Source: World Bank, BIS, ING

"> Structural factors: FX engineering playing a role?

One of the big trends in FX trading over recent years has been the 'internalisation' of FX flows – the concept being that a bank can deliver steadier, better pricing for customers by offsetting client flow with other internal client flow/hedging activity without having to go to external liquidity venues.

We suspect there is quite a lot of overstatement of the extent of 'internalisation' out there, where banks may be including dealing on 'lit' venues (transparent order books) as part of their internalisation activity. Undoubtedly, the advent of non-bank liquidity providers to lit venues has been a major contributor to the depth of market pricing, as has the growth of algorithmic pricing engines. The design of these algo pricing engines, which pull back from putting large volumes through in thin conditions, has probably contributed to calmer conditions, too. Indeed, it seems that when volatility conditions pick up, the buy-side prefers to use algos to execute rather than paying the wider spreads associated with principal liquidity transfers.

But before we conclude that FX volatility is dead, evidence shows that major events – Liberation Day in April 2025, or the start of the Iran war in February 2026 – can still have a big say in FX markets. Below, we show some data on the depth of the EUR/USD market starting in 2025. The chart shows the impact on EUR/USD, in USD pips, one minute after a trade has gone through. We show the impact of four size buckets, equally weighted: $0-1m, $1-5m, $5-10m and $10-30m.

Big events do still impact market depth, which could be due to some non-banks pulling liquidity from lit venues.

So, while the above factors could be contributing to lower volatility, our conclusion is that volatility is not dead and jump risk or fat tails will still be a fact of life in FX markets.

Big shocks did cause market depth deterioration Source: ING

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