Volatility on offer
As we approach year end, traded ranges have remained relatively narrow despite significant macroeconomic themes developing. Looking ahead beyond year end, we note the options market continues to severely underprice volatility versus historical standards. Within such an environment, broader risk appetite remains constructive. As a result, the carry trade has continued its march forward. There have been structural as well as idiosyncratic tests to this popular trading strategy so far this year, however, it still seems alive and well despite inevitable price pressures.
The carry trade, as a reminder, involves gaining an exposure to a higher-yielding currency, funded by a lower-yielding currency. This strategy thrives in lower-volatility environments where investors have the confidence the hold onto more volatile currencies for want of an exposure to their underlying rate of interest. This strategy has dominated 2025, particularly once the initial fallout of Trump’s liberation day had passed. The start of a journey to normalise interest rates in the United States has allowed the carry trade to remain steadfast despite some exogenous shocks.
The latest government shutdown served to sustain this theme as a lack of data and concerns over public consumption reinforced expectations for the central bank to bring down rates. The Fed is now expected to front-load much of its remaining normalisation as it targets rates within a more neutral territory. Market pricing suggests much of that adjustment could be concluded by Q2 2026. This is because currently recession indicators remain sanguine. However, any deterioration in the data, particularly data of an economic nature, could still unsettle the forward curve from here.
Discussion and Analysis by Charles Porter
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