Risk Swings Weaken FX Options’ Focus on Central Banks: Analysis

Central banks no longer in the driving seat.

Persistent financial-market unrest is eroding the dominance of central banks as the top drivers of currency option prices. Traders now assign increasing importance to short-term risk perceptions based on global economic developments, Bloomberg strategist Vassilis Karamanis writes.

Since the Federal Reserve ended its asset-buying program in late 2014, option volatilities had been driven largely by central-bank policy action. Yet, recent market movements show that trend is now weakening.

Euro-dollar options are so far unruffled by the prospects that the European Central Bank could further ease policy next month, potentially sapping demand for the single currency. The so-called volatility smile, a graph that plots expected fluctuation rates priced across call and put options, for one-month contracts that capture the March 10 ECB meeting show little change in investor sentiment.

Volatility Smile 
Volatility Smile 
Source: Bloomberg data

Since yesterday, one-month options are capturing the March policy reviews of the Fed and the Bank of England. As expected, demand rose for similar-maturity contracts in major currencies, yet they failed to set new highs or normalize volatility curves that have been inverted.

One-month euro-dollar implied volatility has risen only as high as 12.33 percent, short of this year’s peak of 12.64 percent on Feb. 11, even as the tenor captured upcoming meetings by both the Fed and the ECB.

A similar measure for the dollar-yen pair traded as low as 13.94 percent yesterday, well below the 2 1/2-year high of 16.27 percent on Feb. 12. Volatility curves of the pound and the yen against the dollar were inverted, while those of the euro and the Swiss franc picked up in the one-month maturity.

Source: Bloomberg data

The diminishing influence of central banks on foreign-exchange options reflects trends in other markets, where traders are challenging the effectiveness of policy makers’ guidance. The Fed’s projection of four rate increases this year contrasts with futures that signal just 40 percent chance of a single rise in 2016.

In the currency spot market, the yen rallied as much as 9.6 percent within only two weeks of the Bank of Japan announcing its adoption of negative rates, while dollar-bearish sentiment against the yen in options remains strong across tenors.

The euro is trading comfortably above its 233-day moving average even as ECB officials have been signaling their intent to meet expectations for further monetary stimulus.

Note: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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