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FxWirePro: EUR/USD bullish/bearish scenarios amid tailwinds of 2018 and OTC indications

It is expected that EURUSD to gradually spike and approach the 1.23 level by the mid-year point. There continues to be the wide gulf between the European and US equity markets in terms of liquidity and gap between FX volatility. Not only are the cash markets much deeper in terms of daily turnover, but the derivative markets are also dominated by different drivers altogether. The reflections of structured products on volatility, skew, and dividends in Europe is much more pronounced compared to the US which has a much deeper flow market.

The currency market has been acting as the adjustment factor between countries positioned at different parts of the economic cycle clock built. It has been one of the few assets on which carrying long volatility positions has not been a constant pain. It has also led to a dramatic reversal in the correlation regime, leading to some significant discounts on equity options contingent to currency levels.

Tails of 2018:

• Faster Fed tightening, dollar funding shortage

• US Mid-term elections: Republican defeat

• Euro and US inflation relapse

• ECB buys €30bn pcm between Jan-18 and Sep-18, then tapers to €10bn until Dec-18, QE programme ends in 2018, first-rate increase mid-2019

• Correction in equity and credit valuations, house prices

• China de-leveraging, trade disputes, armed conflict

• Bank of Japan ends QE 

• Central bank policy mistake, intervention

Bullish scenarios:

Positioning for the end of QE by the ECB should be bullish EUR initially

But not if eurozone interest rates reach no inflection point 

Pricing in a peak in US interest rate cycle probably more conducive to tighter Euribor/USD libor spread

After the tax bill, a “lame duck” US president?

Last three US mid-term elections resulted in losses for the president’s Party 

US 2018 mid-terms will be held in November

Bearish scenarios:

ECB trapped as inflation and wages continue to disappoint 

Italian election brings downside risk, remember 2013

Real rate differentials are moving back in favour of the USD

Eurozone nominal GDP growth set to slow next year (ECB Dec-18 forecast)

US nominal growth to pick up in 2018 (Fed Dec-18 forecast)

EUR CFTC positions at historical high already

Well, all these fundamental developments are factored in EURUSD OTC markets.

Let’s glance at sensitivity tool and risk reversals that indicate mounting changes in the hedging sentiments in next 1m-1y tenors for bullish risks of the underlying spot FX prices.

This sentiment is substantiated by the positively skewed IVs of these tenors that have been signifying the hedgers’ interests of both OTM calls and OTM puts. Hence, this means that the ATM instruments have likelihood of expiring in-the-money within their respective tenors. Courtesy: JPM

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