Currency traders are betting that Donald Trump's policy agenda will reignite volatility in the US$7.5 trillion-a-day foreign exchange market. Following his recent election, the volatility gauge for the euro-dollar exchange rate surged, with hedge funds quickly acquiring options contracts that will pay out if currency swings intensify. Strategists have also revised their currency forecasts significantly in response to the heightened uncertainty surrounding Trump's potential impact on markets.

While it is still uncertain how swiftly Trump will roll out policies such as trade tariffs, which could severely affect currencies like the euro, investors are increasingly confident that unpredictability will be a prominent feature of his presidency. Another factor is the unknown response from other countries to Trump's actions and the subsequent countermeasures that could further disrupt markets.

Julian Weiss, head of G-10 vanilla FX options at Bank of America, noted, "It's an environment where FX becomes particularly interesting," emphasising that demand for long-term products has risen sharply. "Any hedge fund across the globe, even if they have an equity focus, all of a sudden we're seeing FX exposure being put on."

This shift marks a stark contrast to the calm of recent years, when central banks' coordinated interest rate hikes and cuts resulted in limited market movement. With Trump's "America First" policies expected to fuel domestic inflation, traders are anticipating a widening gap in policies between the Federal Reserve and its global counterparts. This divergence is predicted to push major currency pairs like the euro-dollar out of their narrowest range in years.

In response to the US election, banks have significantly lowered their forecasts for the currency pair, with expectations for a slide toward parity. "We would expect Trump's likely policies to create greater room for macro-economic divergence, which would lead to bigger FX moves," said Dominic Bunning, head of G-10 strategy at Nomura.

The market's expectation of a stronger dollar under Trump also supports the case for increased hedging costs, as the correlation between the greenback and volatility peaks when the US dollar is in high demand. Options traders at NatWest Group Plc have observed a notable concentration of activity on bets regarding moves in the euro, Aussie dollar, and yen against the dollar, while traders at UBS Group AG highlight a strong interest in wagering on Chinese yuan weakness.

"Currencies with the greatest perceived exposure to tariffs and Trump's policies will continue to be favoured from a volatility perspective," said Henry Drysdale, co-head of currency options trading at NatWest.

However, there is a risk that much of the anticipated volatility will already be priced into the market ahead of Trump's inauguration, resulting in softer-than-expected currency fluctuations over the longer term. This was largely the case during Trump's previous presidency, where many of his policies, such as trade tariffs, took longer than expected to implement.

This time, with Republican control of both the House and Senate, policies may be enacted more swiftly and decisively. Additionally, the unpredictability of Trump's regular Twitter updates could cause day-to-day currency movements, a phenomenon familiar to traders from his last term in office.

"2025 will be a year of volatility and uncertainty," said Shahab Jalinoos, global head of currency research at UBS. "We don't yet know what will transpire under Trump and there are so many crosscurrents."

Bloomberg