FX volatility patterns shift between low and high interest rate environments

Foreign exchange volatility exhibits distinct patterns across different interest rate environments, with implications for trading strategies and risk management. Historical analysis shows that low-rate environments, characterized by compressed yield differentials, often feature range-bound currency movements and profitable carry trades. During these periods, bid-ask spreads typically tighten as market makers face lower funding costs. Conversely, high-rate environments tend to generate increased FX volatility as divergent monetary policies create sharper currency movements. The current transition from ultra-low to normalized rates has already impacted volatility patterns, with implied volatilities rising across major pairs. Traders adapting to this shift are adjusting position sizes and implementing more dynamic hedging strategies. The analysis suggests that as central banks maintain varied policy stances, cross-currency volatility could remain elevated, particularly in pairs involving currencies with significant rate differentials. This environment favors momentum-based strategies over traditional carry trades.