FxWirePro: What states EUR lower vols? Fair interpretations of two-decade lows

The 1Y/5Y vol curve slope in EURUSD is a whisker away from all-time highs and is worth watching closely for a top since 1Y vol tends to pivot more than 2% pts higher from such peaks.

The largely range bound exchange rates in USD/Asia and the Euro-bloc continued to exert pressure on the front-end of their vol curves.

The latter ensured that our 1M in 2-week EURUSD FVA instituted before the October ECB on the view that post-meeting roll priced into the vol curve was too steep expired at a small loss mid-week.

Increasing steepness of vol curves is not just a sub-1Y phenomenon. One liquid long-dated G7 surface that we are closely monitoring for signs of extreme curve shape is EURUSD, where the 5Y –1Y vol spread is close to all-time wides (refer above chart).

This is not a traditional RV dislocation in the strict sense of the term, since the curve is fair relative to the level of vol i.e. the entire curve move in recent months can be explained by the cratering of 1Y vol; by extension then, normalization of the curve should be led by a reversal higher in the latter.

This back-end vol slope in EURUSD is worth tracking closely because the last two major peaks in curve steepness in 2014 and 2016 acted as major mean reversion pivots for 1Y vol over coming months (refer above chart). The current slope (1.8 % pts.) is 0.3 pts. below prior peaks, our intent is to start legging into EUR 1Y ATMs perhaps 0.3-0.5 vols lower from the current market once we see a 2-handle print on the curve.

Given the depth of the Euro option market, owning EUR vol from near two-decade lows constitutes the most scalable FX risk premium normalization trade for 2018 in our view.