After calm trading conditions and fairly narrow trading ranges since the start of the year, currency markets are bracing for more-volatile market moves this week that may overshadow the Federal Reserve's rate-setting meeting.
With the Fed widely expected to leave rates near zero and make few if any changes to its post-meeting statement, events abroad and in the domestic political arena will keep currency investors on their toes. These events include any further steps by China to rein in lending, another round of credit jitters in the nations that use the euro, developments in U.S. bank-overhaul plans, as well as the delay in the Senate's vote to reconfirm Ben Bernanke as Fed chairman.
Last week, volatility jumped: The dollar touched the strongest level against the euro since July before giving back some ground. The yen, the biggest beneficiary in the recent flight-to-safety environment, rallied to a one-month high against the greenback.
"Until Feb. 16, when the [European Union] issues their assessment of the Greek budget, there's going to be a lot of volatility," said Ihab Salib, who oversees more than $3 billion as head of international fixed-income at Federated Investments Inc. in Pittsburgh. He doesn't expect that the euro will "necessarily" weaken, but volatility will "definitely" be high.
The Chicago Board Options Exchange's volatility index, or VIX, a proxy for investor sentiment, spiked Thursday to the highest level in a month, to as high as 21.93.
"We had been on a downward trending path in terms of the VIX and G7 currency volatility," said Camilla Sutton, currency strategist at Scotia Capital in Toronto. "A recent spike up in both reflects that markets are no longer content that prices are going to stay in these ranges that we've been in, and that the path of prices on the horizon will be more volatile."
The J.P. Morgan G-7 volatility index rebounded to 12.15 Friday, after slumping to 11.5 on Jan. 14, the lowest since September 2008. An increase in volatility reduces the appeal of carry trades, when investors borrow cheap money in low-yielding currencies to fund purchases of riskier assets, as price swings may erode profits from those bets on interest-rate differential.
"As volatility rises and risk aversion comes back to the markets, carry trades come under pressure as investors get quite nervous," Ms. Sutton said.
Late Friday in New York, the euro had strengthened to $1.4139 from $1.4094 late Thursday. The dollar weakened to 89.87 yen from 90.41 yen, while the euro moved to 127.07 yen from 127.42 yen. The U.K. pound weakened to $1.6114 from $1.6199. The dollar weakened to 1.0414 Swiss francs from 1.0421 francs.
All eyes now will be on the Federal Open Market Committee's interest-rate decision and statement, due out Wednesday at around 2:15 p.m. Eastern time The expectations are that rates will be left unchanged and there will be no change announced in the Fed's asset-purchase program, scheduled to end in March.
"The likelihood is for the Fed's statement to be very similar to the previous one," said Dale Thomas, head of currencies in London at Insight Investment Management, which oversees about $32.2 billion. "I don't think what the Fed says, unless they make massive changes, is going to make any difference whatsoever."
The prospect of China tightening its policy and the euro malaise will continue to dominate sentiment in currency markets, Mr. Thomas said.
Meanwhile, the cost of insuring Greece's debt against default rose to a record Friday amid worries about the country's large budget deficits. Greek authorities said they plan to sell dollar-denominated debt to help shore up finances.
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