New Lows in 3m Euro Vol; Spring Coiling for Big Spot Move?

Three month implied euro volatility, which is the benchmark in the options market, has fallen today to reach its lowest level since Sept 2008. At 10.59% it has dropped about 2 percentage points this year.

Even if one does not trade currency options, the option market may help in the price discovery process in the spot market. On one hand the decline in implied volatility could suggest that the market is anticipating a range trading environment to persist. Implied volatility eased in the first half of December, as the euro initially pulled back from the highs for the year, but then rose in the second half of December as the pace of the euro's decline threatened break key support around $1.4200. As the euro has recovered more than 3 cents off that pre-Xmas low, implied volatility has fallen like a rock.

On the other hand, some times it appears that volatility coils like a spring and then spot jumps. This continues to seem to us like an under-appreciated risk. We have argued that the December dollar advance was largely a function of short-covering into the end of the year, with momentum players jumping aboard. We expected the greenback's gains to be reversed early in the new year. The short-term speculative market still seems to be short euros and further gains seem likely. Our next target for the euro is in the $1.47 area and then $1.4800.

Outside of market positioning, which we argue is an important consideration, the main driver for the anticipated dollar setback is that once again the market appeared to get ahead of itself in terms of the trajectory of Fed policy. The eve of the Nov jobs data that was reported on Dec 4th, the June Fed funds futures--as a metric of expectations of Fed policy--implied an average effective rate of 28.5 bp. After the better than expected report, the implied Fed funds rate rose to 34.5 bp.
New Lows in 3m Euro Vol; Spring Coiling for Big Spot Move? New Lows in 3m Euro Vol; Spring Coiling for Big Spot Move? Reviewed by magonomics on January 13, 2010 Rating: 5
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