FxWirePro: Defensive themes of EURO, 6m vols to intensify on Europe elections

Europe faces one constitutional referendum (Italy in December) and three to four national elections next year: Netherlands in March, France in April/May, Germany by October and possibly Italy.

There are good reasons to think that eventual ballot box outcomes will buck the current populist trend and turn out Euro-benign, but that will not prevent option markets from pricing in hefty day-weights for those events.

The Brexit referendum offers not only a parallel in terms of the quantum of event risk – 1Y ATM vols climbed as much as 5 % pts. from their lows over a 6-month span – but also a lesson on the timing of such event risk pricing: while run-of-the-mill data releases or central bank meetings only enter the market's consciousness with 4-6 weeks remaining, a binary event like Brexit began to factor into GBP option prices 8-9 months ahead of the referendum.

Odds are that twice-bitten-forever-shy vol markets reeling from the Trump shock will now pull forward that time table, lift 6M-1Y expiry EUR vols that span European election dates, and bull-steepen the vol curve even if shorter expiry implieds remain well-anchored by tight ranges on spot Euro. The French elections (7-months out) appear to be potentially the most disruptive of the ones on the calendar.

The clean vol expression of the view is to own EUR- and JPY- cross vols against high beta currencies. The challenge is twofold:

Firstly, Sourcing these cross vols is non-trivial because of liquidity challenges; and

Secondly, Trade construction is important, since outright vol buying may not always be feasible on levels, and it may become necessary to buy either risk reversals in lieu of ATM vols or spreads of high-beta vols against their lower beta brethren (e.g. AUD/JPY vs. EUR/JPY gamma spreads recommended as a pre-election hedge) for entry level and carry-efficiency reasons.