Euro Options Costly as Volatility Hits 6%, EUR/USD May Drop

Key Takeaway

• Euro volatility surged to nearly 6% due to political risks and strong US economic data, with EUR/USD potentially dropping to 1.0580.
• French parliamentary elections introduced a political risk premium, elevating options prices and causing a selloff in bonds and the euro.
• Strong US non-farm payrolls data keeps the euro under pressure; upcoming Fed decision and inflation data are crucial for its short-term direction.

Euro Volatility Increases

Recent political developments in Europe and strong US economic data have led to a significant increase in euro volatility. Traders have quickly factored in a political risk premium to euro-zone assets following the weekend's parliamentary elections in France. This has resulted in a pronounced shift in the euro’s volatility curve, particularly at the front end. One-month volatility has risen to nearly 6% from 5%, indicating that currency traders are now considering the possibility of EUR/USD declining to as low as 1.0580, compared to 1.0606 on Friday.

Ven Ram from Bloomberg notes, "This week’s inflation data out of the US and the Fed’s dot plot will also influence the currency’s trajectory in the short term." The Fed fund futures are currently pricing in about 36 basis points of Fed loosening this year. Should the Fed reveal a dovish dot plot suggesting that two rate cuts are possible, the futures' pricing may shift, impacting the euro, albeit modestly.

Political Risks and Market Reactions

The political landscape in Europe has added another layer of complexity to the euro's outlook. The recent French parliamentary elections have introduced a political risk premium, which is expected to keep options prices elevated over the next month. This political uncertainty has led to a selloff in both bonds and the euro, reflecting market participants' concerns.

Sebastian Boyd from Bloomberg highlights, "Interest-rate swap traders expect the Federal Reserve to out-cut the European Central Bank and other peers in the first half of next year, a dovish setup that hasn’t been reflected in the dollar." The ECB’s June rate hike, which was anticipated due to explicit forward guidance, now appears premature. Simon White argues that the ECB may even need to reverse this rate hike, leaving the euro weak while the central bank is unable to ease as much as the Fed.

Impact of US Economic Data

The euro's trajectory has also been influenced by strong US economic data. Last week’s non-farm payrolls data indicated that the US economy remains robust, which has kept the euro under pressure. The strong US jobs data has weighed on expectations for the euro’s prospects, making its outlook appear overstretched.

Vassilis Karamanis from Bloomberg states, "Political risks will take the back seat for spot traders when compared to monetary policy dynamics; Wednesday’s Fed decision is what now matters the most." The upcoming Fed decision and US inflation data are expected to play a crucial role in determining the euro's short-term direction.