ECB’s resolve to hike rates sets the stage for euro whiplash

VOLATILITY in the euro has calmed after a tumultuous 2022, and is sliding at the fastest pace ever. This has led some currency players to think the currency is worth starting to bet on in greater swings.

Now that inflation has eased and the Federal Reserve has taken its foot off the pedal on rate hikes, global investors agree that things should quieten down for the euro. But European policymakers have continued to push back against this market positioning, setting the stage for renewed volatility in the currency.

The currency’s implied volatility over the next year, at 8 per cent, is well below its past-year average. This comes after it surged above 11 per cent in the wake of Russia’s invasion of Ukraine.

For Societe Generale currency and derivatives strategist Oliver Korber, the current situation looks like an opportunity: “We are now almost at the lows since the outbreak of the war in Ukraine, and this is an important level, which will likely act as a floor.”

He noted that “with hawkish comments from the European Central Bank (ECB), and more hikes in Europe to come now, there will be likely more turbulence in euro-area rates”, adding that this would likely be channelled into foreign-exchange volatility between the euro and US dollar.

This week brought several surprises for euro traders.

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First came a report that the ECB was considering a slower pace of interest-rate hikes, driving down the currency on Tuesday (Jan 17), before a recovery on Wednesday as weaker-than-expected US economic data hit the greenback.

Then, a series of ECB speakers insisted that policymakers would not let up in efforts to return inflation to their target, given that prices remained far too elevated. President Christine Lagarde said that “stay the course” was her new mantra. This led a gauge of one-year volatility to rise on Friday, as traders amped up bets on rate hikes.

Roberto Mialich, a foreign-exchange strategist at UniCredit, said: “The major risks to the drop in long-term volatility include unexpected news regarding the Fed or the ECB, prompting a repricing of current market expectations.”

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“That’s as well as the usual lingering risks from geopolitics or Covid-19 contagion,” he added.

Global currency volatility, as measured by a JPMorgan index, dropped this year. This came after it slid in the fourth quarter of 2022 at the fastest pace since the aftermath of the Covid pandemic. The euro experienced an even sharper move – its quarterly slide in implied volatility was the biggest on record.

Even so, actual or realised volatility in 2022 was much higher, at well above 10 per cent. The gap between the two suggests that options are at their most underpriced levels since the global financial crisis. This could see some traders opt for relatively cheap bets.

Oliver Brennan, currency volatility strategist at BNP Paribas, said there was room for implied euro volatility to rise, given that the currency was among the lowest of the Group of 10 currencies. He added that there was a minimal premium built in for risks around any escalation of the war in Ukraine and energy prices.

Plenty are warning about complacency. Some of the world’s largest asset managers, such as BlackRock, Fidelity Investments and Carmignac have expressed worry that markets are underestimating both inflation and the ultimate peak of rates, similar to a year ago. Doing so would leave traders glued to data, such as that on US employment.

Tim Brooks, head of currency options trading at market-maker Optiver, said: “A few weaker prints could be a catalyst for longer-term volatility to bounce back.” While a slow cutting cycle from the Fed would reduce volatility, “other central banks’ actions could be a far greater driver this year”, he noted.

Positioning could also exacerbate moves. Money markets have priced in the ECB rate peaking in July, and then the Fed cutting by the end of this year. Options traders have switched to bet on a weaker US dollar. Both of these have been suppressing longer-term volatility.

“Such positioning suggests a pro-risk consensus is building, meaning adverse risks could create large shocks,” said BNP Paribas’ Brennan. BLOOMBERG