BofA: Potential For Rates And FX Vols To Recouple Over '24

Bank of America write “relatively high implied volatility levels in the rates space vs other asset classes has been a significant feature of the market dynamic over the last couple of years.”

• “This decoupling makes sense in a context where the outlook for the US economy is relatively contained in between soft-landing scenarios and scenarios of steady resilience, where rates are the main shock absorber for the broader market dynamic.”
• “The role of rates as the main shock absorber is likely to fade over '24 as the Fed starts to deliver on policy easing and risks to the outlook stay skewed to the downside. FX vol may take some of that mantle from the rates space. We expect: (1) lower vol in the rates space, with the left side of the grid leading the way, and a potential re-steepening of the term structure of rates volatility; (2) FX volatility to stay supported and for levels to come off the low '23 base.”
• “A wide range of outcomes support hedging tail scenarios (hard landing or re-acceleration, in particular). We see scope for clients to express these tail hedges in the relatively cheap FX vol space, particularly vs a relatively rich rates vol context. The potential for a recoupling of FX and rates vol may also support contingent hybrid expressions where longs in FX vol are financed by selling rates vol (through carving out portions of the range of outcomes).”