Excell with Options: EUR/USD Parity possible – purchase puts or pass?
Executive summary
With differing economic outlooks and several market catalysts approaching, there is debate if the U.S. Dollar will continue to strengthen against the Euro. Rich examines two FX option strategies to express either opinion.
- Bullish ratioed risk reversal
- Bearish ‘Butterfly’
By many accounts, 2022 has been a year where we have reverted to some old styles, some old norms, some old concerns, and some old price levels. We have seen a revival of psychedelic stripes and Bohemian chic fashion. We have soaring gasoline prices and shortages in many parts of the world. We may be reverting to a new geopolitical order that resembles times before the fall of the Berlin Wall. Many economists point to the inflation levels that we haven’t seen since the 1970s. Even in financial markets we are seeing some reversion to levels that we have not seen for many years.
The EUR/USD spot market has been in a declining trend since the Great Financial Crisis. Prior to 2008, with the U.S. housing market in shambles, there were many that thought it was the end of dollar hegemony. In 2007, there were dollar warnings from the likes of Warren Buffett and Bill Gates. Even Gisele Bundchen demanded to get paid in Euros and not dollars. The EUR/USD hit a high of 1.60. It has been a different story since that time. Perhaps it was because the U.S. acted more quickly than Europe to refinance the banking system. Maybe it was the emergence and strength of the U.S. technology stocks. Possibly there is some other rationale for why it has occurred but since that peak, the EUR/USD spot has seen a series of lower highs and lower lows. As you can see in Figure 1, the market did get down to the 1.05 level back in 2015-2017 and held. This time around, we are hearing many of the same ideas thrown out as then. For example, will EUR/USD breach ‘parity,’ a level we have not seen since 2002?
Figure 1: EUR/USD 20-year market
It appears there are two issues weighing on the EUR relative to the USD right now. The first is the soaring prices of food and energy, which admittedly are hitting both areas, but are hitting Europe harder than in the U.S. because its primary source of energy has been more disrupted. The other issue has been that the Federal Reserve has been hiking rates sooner than the European Central Bank (ECB) and the expectation has been that it would continue to be more aggressive. Therefore, on both a relative economic outlook and an interest rate differential viewpoint, the USD has been favored relative to the EUR. Perhaps this could be changing. Recently, several members of the ECB have suggested that the ECB should begin raising rates and should begin with a 50-basis point hike. As Cameron Crise of Bloomberg Macro Man points out in a May 24 editorial, post these comments, there has been a very rapid pricing of rate hikes into the short-term interest rate futures curve in Europe. There have already been hikes priced into the U.S. STIR curve, but in fact over the near term, there are now more hikes priced into the Euribor curve than the Eurodollar curve.
Figure 2: Eurodollar versus Euribor
Of course, nothing is set in stone for either of these markets. In fact, each central bank has a very different reaction function. The ECB has a single mandate and that is price stability. Up until now, in the face of very high inflation, it has chosen to look at high prices as a tax on consumers and expected prices to come lower. As prices have not stabilized, the ECB is poised to act. On the other hand, the Federal Reserve has a dual mandate. It also has a price stability mandate but has a full employment mandate, too. As a result, it must worry about growth and inflation. With layoff announcements from many technology and retail firms, rising jobless claims and now falling inflation expectations, the aggressive rate hikes priced into the Eurodollar market are now being questioned by some in the market. This hasn’t changed the pricing in the market yet, but there is more of a debate among participants than there was before. Remember, markets move at the margin, and right now, perhaps the ECB expectations relative to the FOMC expectations are beginning to switch.
There is a good amount of uncertainty on all fronts. Market practitioners have been tested on their ideas in all asset classes this year. There is no reason FX shouldn’t be the same. A month or two ago it seemed to be a very strong consensus that the dollar would continue to strengthen against all currencies, but notably against its fellow reserve currencies EUR and JPY. Markets don’t like uncertainty and respond by taking implied volatility higher. You can see from the QuikStrike graph in Figure 3, G5 FX vol has moved higher all year long and EUR/USD volatility has not only moved with it but has mostly driven the move. Despite the potential difference of opinions on the future direction and magnitude of central bank policy, we see that this level of volatility has come off the highs of the year, but still looks high relative to the last two years.