Euro’s Volatility Kink Shows Traders Fixated on Homegrown Risks
(Bloomberg) -- After a month of being whipsawed by external forces, euro traders are starting to turn their attention to risks closer to home.
The euro’s volatility curve shows they’re putting emphasis on the European Central Bank’s September gathering, when policy makers could give an indication of plans to pare back emergency bond purchases. Traders are betting the event will drive bigger swings than this month’s annual Jackson Hole symposium for global central banks, which had delivered policy surprises in the past.
That’s in addition to wagers that volatility will remain elevated into the German elections -- another potential game changer for the common currency that could see the European Union’s largest nation adopt looser fiscal policy.
The various cross-currents are clouding the outlook for the euro, creating an environment ripe for volatility. While strategists expect the currency to rebound 2.6% from $1.1693 currently to $1.20 by the first quarter of next year, options signal the probability of that is barely more than a coin toss, according to data compiled by Bloomberg.
“The key upside risk to take EUR/USD above 1.20 is a renewal of the cross-asset reflation trade,” said Lars Merklin, senior analyst at Danske Bank, who is currently bearish on the euro. That could come if European growth proves strong enough to warrant a repricing of the ECB policy outlook, he added.
Since the ECB’s July meeting, the common currency has been swept up in the dollar’s gyrations. It fell to a nine-month low this week, as prospects of U.S. policy tightening and concern over the spread of coronavirus variants sent investors flocking to the safest assets.
While demand for the dollar in the run-up to Fed speakers at Jackson Hole will likely drive the euro lower in the short term, options show traders are shifting their focus to the European calendar.
The first big question is whether the ECB will make a major decision on the interplay of its bond-buying tools as soon as September or delay to later in the year. Currently, its pandemic bond-buying policy is scheduled to end in March, leaving only its older asset-purchase program, which is constrained by tighter rules.
“The possibility of new lockdowns in the autumn, as well as a 2023 inflation forecast short of the ECB pre-pandemic path, could make the ECB more cautious,” said Jordan Rochester, a currency strategist at Nomura International Plc.. The bank’s base case is for a reduction in pandemic bond purchases, and a delay in any decision to terminate the program to December.
Dollar Versus ECB
Still, euro bull and Commerzbank strategist Thu Lan Nguyen sees the dollar’s path -- rather than ECB policy -- as the most important factor for her forecast of $1.20 by year-end.
“The correction of the currently rather hawkish view of the Fed will matter more,” Nguyen said. “The ECB is likely to become slightly more expansionary even due to the pandemic development. However, the market has already such a dovish view of the ECB that it shouldn’t matter too much for the euro.”
Strategists surveyed by Bloomberg expect the euro to climb to $1.20 by the first quarter of next year, yet options traders see just a 55% probability of such a scenario.
Even if the September ECB meeting is uneventful, German elections to determine Chancellor Angela Merkel’s successor loom at the end of the month.
Three parties -- the conservative Christian Democratic Union, the Social Democrats and the Greens -- have a legitimate shot at the chancellery, with a three-way coalition that involves the Liberals likely to be needed. If the Greens surprise and emerge as the largest party, Nomura’s Rochester sees the euro gaining to $1.20 quite quickly.
“A switch to an SPD or even Green-led government would likely herald a substantial shift in economic and fiscal policy in Germany,” according to a RBC Europe team including Peter Schaffrik. “The race seems wide open.”
- The Fed’s annual Jackson Hole symposium is the highlight of a mostly quiet week. PMI survey figures for the euro area due Monday and Germany’s Ifo on Wednesday. Minutes from the ECB’s last meeting are due on Thursday.
- Sovereign supply volumes drop to around seven billion euros. Austria is scheduled to start its bills program next week, while the U.K. will tap its 2026 gilt for 3 billion pounds ($4.1 billion).
©2021 Bloomberg L.P.