Euro Options Show a Year More of Pain on Record Flow
Derivatives traders see at least a year of pain for the euro even after the currency surged the most in eight months following the approval by European Union leaders of measures making it easier for Spain and Italy to obtain aid.
The 17-nation euro rallied as much as 2 percent against the dollar on June 29, yet option traders are still the most bearish ever on the currency versus the greenback over the next 12 months compared with the next 90 days. More than 50 economists and strategists surveyed by Bloomberg cut their median year-end estimate to the lowest since at least 2007.
While EU officials granted immediate relief to the debt markets of Spain and Italy, German Chancellor Angela Merkel maintained her opposition to joint bonds backed by the region’s governments to help lower borrowing costs and fix the crisis that has led to five nations seeking bailouts. Two rescue funds, the European Financial Stability Facility and the yet-to-start European Stability Mechanism, may only amount to about 20 percent of the debt of Italy and Spain.
“This is still going to be a drawn out affair,” Jeff Applegate, the chief investment officer at Morgan Stanley Smith Barney, which manages over $1.7 trillion, said in a June 29 interview. “On a long term basis what you need to make the euro a survivable currency is fiscal-policy union in Europe, and you are a long way from that. The value of the euro will go lower.”
Applegate, based in New York, said the euro will drop to less than $1.20 in the next year, from $1.2667 last week.
As the region struggles with its debt, Europe’s economy will probably shrink this year for the first time since 2009, contracting 0.4 percent, according to the median forecast of 30 analysts surveyed by Bloomberg.
Investors have pulled an average 8 billion euros ($10.1 billion) of assets from the region per month in the six months through April, after adding six times as much on average in the half year through last July, a record reversal, according to Deutsche Bank AG, the world’s biggest foreign-exchange trader.
While there was progress at the summit, there was no “silver bullet,” George Saravelos, a currency strategist at Deutsche Bank in London, said in a June 29 telephone interview.
The euro fell 0.7 percent to $1.2578 at 11:13 a.m. New York time, from June 29 when it closed 1.8 percent higher. It’s down 3 percent this year. The shared currency slipped 1.2 percent to 99.79 yen today. It was 0.5 percent lower in a basket of 10 major currencies based on data compiled by Bloomberg. The euro, which began trading at about $1.17 in January 1999, has ranged from 82.3 U.S. cents in 2000 to $1.6038 in 2008, averaging about $1.21 over its lifetime.
One-year options show that the premium for puts, which grant the right to sell the euro versus the dollar, over calls, which confer the right to buy, is the highest relative to three month contracts since Bloomberg began tracking the data in 2003.
The gap between the so-called 25-delta risk reversal rates reached 1.06 percentage points. The difference between the two gauges has averaged less than 0.1 percentage point since 2003.
Risk reversals measure the difference between implied volatility, or a gauge of price and demand, on similar puts and calls. Traders pay a premium for puts when they expect the euro to decline.
“That’s a premium worth paying,” Neil Jones, head of European hedge-fund sales at Mizuho Corporate Bank Ltd. in London, said in a June 26 phone interview. “The euro will exist in the long run, but things have to get worse first. A fall in the euro to $1.15 isn’t particularly aggressive, and parity is possible. Historically, the euro has traded much lower.”
The level of the spread between the two different maturity risk reversals is 3.88 standard deviations from its mean. Greater than three standard deviations is defined as occurring less than 0.3 percent of the time in a statistical model of data that follows a standard normal distribution.
Investors betting against the euro may be underestimating the determination of Europe’s leaders to push through reforms, said Gavin Friend, a London-based markets strategist at National Australia Bank Ltd. The dollar may weaken at the prospect of the Federal Reserve creating more money and buying bonds, a policy known as quantitative easing, he said.
Last week’s EU summit was “an encouraging step, though there’s clearly more to do,” said Friend, who expects the euro to climb to $1.33 by year-end.
Investors and traders may now turn their attention to the dollar, sending it lower on the prospects of more QE from the Fed when it next meets Aug. 1 to decide monetary policy, Friend said.
After the policy makers agreed on June 20 to extend its $400 billion Operation Twist program by swapping an additional $267 billion of short-term securities for longer-term debt, Chairman Ben S. Bernanke said in Washington that the central bank is “prepared to take additional steps if appropriate.”
The euro’s advance on June 29 was its first in five days as 13 1/2 hours of talks in Brussels ended with EU leaders paving the way for cash-strapped lenders to tap Europe’s bailout funds directly once they establish a single banking supervisor. Until now, they had to get aid through their governments, piling pressure on already stretched national coffers.
The European Central Bank will play a role in the new supervisory body, officials said. They also agreed to drop a requirement that taxpayers get preferred creditor status on emergency loans to Spanish banks. Other steps included agreeing to use rescue funds to stabilize markets under some conditions.
Spain’s 10-year bond yield tumbled the most since Aug. 8 at the end of last week, though at 6.33 percent was about 2 percentage points more than the average 4.30 percent the past decade. Italian bond yields were about 1.4 percentage points above their average.
The rescue funds, the EFSF and the ESM, which may have 500 billion euros available for bond purchases, are dwarfed by the combined debt of Italy and Spain, which totals about 2.4 trillion euros, Bloomberg data show.
“What is missing? The list is long, but to mention the important ones: For one, the ESM got a bigger mandate, but not more money,” economists at New York-based JPMorgan Chase & Co. said in a June 29 report. “It will thus run out sooner.”
Strategists have cut their euro forecasts by more than 5 percent since April. The median analyst prediction compiled by Bloomberg is for the currency to end the year at $1.23, down from a forecast of $1.30 on April 30.
The average monthly withdrawal from euro area stocks and bonds in the six months through April by domestic and foreign investors compared with a peak average monthly inflow of 47 billion euros in the period ended July 2011, according to Deutsche Bank.
Spain lost the most foreign investment in April since the start of the euro amid the turmoil. Non-residents withdrew 24.6 billion euros of stock and bond investments, the most since at least 1999, the Bank of Spain said June 29.
“The reversal in the investment flows shows an easing of demand for European assets given the euro-zone crisis, which is creating all of this uncertainty,” Deutsche Bank’s Saravelos said. The euro may weaken to $1.20 by the end of 2013, he said.
While investors cut bets on the odds of a monetary union split, they are still more than 50 percent, according to Dublin- based Intrade.com data. Wagers last week showed a 61 percent chance of the bloc disintegrating by December 2014, down from 70 percent in November. The odds were 39 percent in February.
“While the latest announcements by the EU may impart some market stability, the situation in Europe remains fragile, and I expect to see renewed weakness in the euro at some point,” Stephen Jen, a managing partner at hedge fund SLJ Macro Partners LLP in London and a former economist at the International Monetary Fund, said in a June 29 interview. “When it happens, the prospective depreciation will likely be disorderly.’
Demand for euros may wane further if the ECB in Frankfurt cuts interest rates this week for the first time since December.
Policy makers led by President Mario Draghi will reduce the main refinancing rate by 25 basis points to a record 0.75 percent on July 5, according to the median forecast of economists surveyed by Bloomberg. The Fed’s benchmark has been in a range between zero and 0.25 percent since December 2008.
The euro fell as much as 0.5 percent on June 28 as a report by the Nuremberg-based Federal Labor Agency showed that unemployment in Germany, Europe’s biggest economy, rose in June for the fourth month this year. Retail sales fell in May, slipping 0.3 percent from April, the Federal Statistics Office in Wiesbaden said the next day. Economists predicted a gain of 0.2 percent, a Bloomberg News survey showed.
“The euro will remain under continuous pressure,” said Ulrich Leuchtmann, the head of currency strategy at Commerzbank AG in Frankfurt, who sees the euro depreciating to $1.21 at year-end. “Politicians will find it hard to come up with a convincing solution, and the ECB will have to come in again and again. This is something that cannot be good for the euro.”