Over the past few years, the global markets have seen a long-term contraction of price volatility as several key structural factors have changed the dynamics of the way certain markets are traded. For currencies, this has meant that average trading ranges have become significantly smaller in the past several years. Some of these shifts will undoubtedly place continued downward pressure on overall price movements, but the outlook for the coming year will greatly depend on more recent developments.  In fact, we could see a pickup in volatility through early 2007, while the overall trend could continue lower in the long term.

Structural Changes Define Overall Trend of Falling Ranges

To understand what has happened, we must look to the underlying factors that have led us to considerably lower trading ranges through the past several years.

1. Central bank intervention in the currency markets have led to smaller overall price movements, as officials move to stabilize their own currencies in the interests of national economic well-being.
2. Shrinking interest rate yield spreads have driven overall volatility lower, as smaller carry-trade margins force specific currency pairs into range-bound trade. Without large yield differentials, currencies become less prone to extended price moves.
3. Comprehensive financial derivatives markets have reduced the need for large multinational corporations to repeatedly open and close hedging positions in the spot foreign exchange markets. This leads to more stable positioning and subsequently smaller price fluctuations in the currency market.
4. Market Liquidity has seen significant gains over the long run, as growing popularity of foreign currency trading has pushed greater amounts of capital into the interbank market. As markets boast a greater number of buyers and sellers, price action has become significantly less choppy.

Of these four major reasons, we can see that there have been a number of long-term structural shifts that have led volatility lower over the long term. These structural changes will likely continue to place downward pressure on currency price ranges through 2007 and the years to follow. Looking at individual explanations, however, there remains one underlying force that is arguably not part of a long term move.

Namely, shifting interest rate differentials seem to be far more of a medium-term effect and a change in this trend could easily lead to sharper volatility through the coming calendar year.

What to expect for volatility or ranges in 2007

Going into 2007, traders will need to determine whether daily ranges will continue to slim as the months wear along or if a rebound of volatility is around the bend in order to pick the correct trading style. While the structural changes mentioned above are still developing for the forex market, the state of yield spreads may be the number one defining factor ââ,¬â€œ at least for the first quarter.

One of the primary tools for valuing free-floating exchange rates, interest rate differentials also happen to be the most frequently changing dynamic for the currency market. As different economies experience different rates of growth and inflation, monetary policy authorities respond differently through interest rate policy. A noteworthy example is the US dollar which was put on a steady diet of quarter point rate hikes starting in June of 2004. From a lowly 1.00 percent yield, the benchmark interest rate was lifted all the way to 5.25 percent. This has quickly closed the interest rate gap for a number of pairs like GBPUSD and NZDUSD and in turn diminished the overriding gleam of carry trade flows. When there is a large benefit in one direction for carry, steady trends (and subsequently bigger ranges) will often build behind the momentum as traders jump on the band wagon. The chart below is an example of the opposite effect, which is also the most current.  As the Federal Reserve steadily increased the Federal Funds rate, the Monetary Policy Committee in the UK changed its rates sparingly. By mid-2006, the yield spread was nearly at par and unsurprisingly, average ranges contracted.

On the other hand, current yield gaps donââ,¬â"¢t play nearly as important a role to volatility as does expectations of where spreads will go in the future. Since the FOMC tacked on its last hike in June of this past year, economic data has aroused heavy speculation of a backtracking cycle of cuts from the group. This increased the marketââ,¬â"¢s sensitivity to the universe of first and second-tier economic indicators. Economic expansion at nearly a third of the pace only three quarters before and a housing market sinking like a stone are just a few reasons why the warnings sirens have gone off and the market has turned overwhelmingly bullish interest rates. However, this has provided a unique opportunity over the past few weeks. With futures linked to short-term interest rates pricing in a level of 4.00 percent by the yearââ,¬â"¢s end, any positive surprises in data provides an inordinately large reaction in the majors. The Non-Farm Payrolls released this Friday was a perfect example. Even though there have been a few economic indicators that have roused large daily ranges, the masses have yet to abandon their dollar-bearish outlook. This could allow for more pleasant surprises from the economy to drive volatility higher before positive prints stop all together or the bulls start to even out over the next few months.

While the dollar and its respective interest rate policy is a prime example of interest rate projections and volatility, it is not the only currency. For the Japanese yen, speculation regarding overnight lending rates in the island nation is exactly the opposite that of the dollar. After having only recently lifted the benchmark rate off of historic lows, market participants and economists have rallied around expectations for the Bank of Japan to follow through with a string of gradual rate hikes that would challenge the yenââ,¬â"¢s title as the primary carry trade short. However, challenging this optimistic outlook have been pieces of disappointing economic data released over the previous weeks. These dour prints have led to significant boosts in volume for yen pairs as fundamental data diverges with the overall marketââ,¬â"¢s steadfast expectations.

Where Will We Go in the Long Run?

As speculation over monetary policy becomes increasingly one-sided, the possibility for contradictory indicators will remain buoyant.  However, the catalyzing relationship between expectations and interest rate policy will not likely last for long. Eventually, highly speculative predictions of a change in policy will die down as officials start to live out the markets expectations or economic data cools and alleviates the seeming necessity for a response. Typically, these cycles last for only a few months at a time. When the dynamic goes out of fad, the longer-term structural changes will once again take charge. Ranges will be depressed by more complicated derivative products, an increase in liquidity as retail traders shift from more traditional trading products and central banks look to manage their reserves and local currency more actively.

Richard Lee is a Currency Strategist at FXCM.