Fireworks On The Way
Growing fears that central banks will have to push ahead with tightening even as the economy slows are triggering widespread expectations of recession. In financial markets, these fears are being played out in flat or inverted yield curves and now a fall in commodities as demand destruction is seen outweighing the early-year supply shocks from the war in Ukraine.
In FX, recession fears are starting to take their toll more broadly on the pro-cyclical currencies, including the euro. And with the Fed showing no signs, as yet, of a pivot away from front-loaded tightening, the dollar has pushed to twenty-year highs. EUR/USD has broken to a new cycle low – now within two big figures of parity.
Psychological levels play a major role in FX markets – and no doubt amongst policymakers and the electorate alike. Just look at the way USD/CHF fell 5% within a week of touching highs of 1.00 both in May and June. Equally big psychological levels play a major role in the FX options market, where barriers or triggers can effectively either nullify or bring to life option structures once a particular level is hit.
One example here could be a speculator wanting to position for a lower EUR/USD, but wanting to cheapen the structure by having a ‘Knock-out’ at 1.00. Should 1.00 trade, the speculator’s position evaporates and questions whether he/she wants to re-apply bearish EUR/USD strategies down at these levels. Were 1.00 to break we would expect volatility to pick up sharply and most likely EUR/USD to gap lower.
How low could EUR/USD go over the next four weeks? Here we look at the FX option markets for expected ranges. Based on the current pricing of EUR/USD implied volatility, a one standard deviation move could see EUR/USD as low as 0.9873, while perhaps a worst case, two standard deviation outcome could see EUR/USD as low as 0.9545.
What combination of risk sentiment and monetary policy could send EUR/USD below parity?
In our short-term fair value model, we use rates and equity factors to estimate at what level EUR/USD should be trading on a daily basis. Our calculations show that the large majority of EUR/USD moves can be explained by a combination of moves in global risk sentiment, gauged by the performance of the MSCI World Index, and the 2-year EUR-USD swap spread, which mirrors the Fed-ECB policy differential.
When taking only these two factors into account – i.e. assuming other variables remain unchanged – we can estimate where EUR/USD will trade based on risk sentiment and monetary policy dynamics