US Election Uncertainty Begins to Impact Forex Markets

Currency markets are beginning to react to the forthcoming U.S. election, with signs of increased foreign exchange volatility evident six months prior to the November 5 vote. Notably, this heightened anxiety is manifesting in the options market, particularly concerning the Chinese offshore yuan.

On Tuesday, the difference between six-month and three-month implied volatility for the yuan escalated sharply, marking a significant increase from the prior Friday. This spread reached 1.20 percentage points, a substantial jump from 0.73, representing the most significant rise since such records began in 2011.

Market dynamics suggest that traders are preparing for a “binary scenario” depending on the election outcome. A victory for Donald Trump could trigger significant volatility and a sharp decline in the offshore yuan, echoing the market’s response in 2016 when Trump first ran for president. During that election, the Mexican peso became a focal point for assessing currency-market sentiment, experiencing heightened volatility following Trump’s victory.

Currently, it appears the Chinese yuan may play a similar role to the peso in 2016, putting options traders on high alert. The spread between six-month and three-month volatility, with the former spanning the election date and the latter expiring in August, highlights the market’s significant apprehension about the election’s effect on currency fluctuations.

Political risks for the Chinese yuan are particularly acute, possibly due to Trump’s previous threats to impose steep tariffs, potentially as high as 60%, on Chinese imports. Such a scenario could drastically alter trade dynamics, potentially driving the yuan to fluctuate between 7.7 and 8.3 against the dollar in a severe decoupling scenario.

Concerns are not limited to the yuan. The Mexican peso and the euro are also experiencing shifts in volatility. The peso’s six- to three-month volatility spread has widened significantly, though it remains below its yearly high. The euro’s volatility spread has reached levels last seen in November 2021.

Trump’s broader trade policy proposals, including a potential 10% tariff on all foreign imports, have stirred further market unease. Christine Lagarde, President of the European Central Bank, has cautioned Europe to brace for possible tariffs and challenging decisions ahead.

In light of these developments, financial strategists like Meera Chandan from JPMorgan & Chase Co. are advising a cautious approach to currency investments, recommending a reduction in dollar positions while still maintaining some exposure through options as a protective measure against ongoing market uncertainties.