Brexit Eclipsing Fed-ECB Split as Top Risk for Euro: Analysis

A potential U.K. exit from the European Union is now emerging as the biggest risk for the euro, if option prices are anything to go by, Bloomberg strategist Vassilis Karamanis writes.

The odds of a so-called “Brexit” shaking confidence in the Union are being perceived as more negative for the single currency than even the theme of U.S.-Europe monetary-policy divergence. Option risk reversals, a gauge of market positioning and sentiment, that capture the U.K.’s June 23 EU-membership referendum show a surge in pessimism toward the euro, even as shorter-, longer-dated contracts don’t.

Shortest-tenor euro options versus the dollar show a retreat in bearish sentiment toward the single currency, with the Federal Reserve in no hurry to raise interest rates and the European Central Bank signaling reduced scope for further cuts. One-week 25-delta risk reversals are now positive, indicating a pickup in confidence in the euro, while one-month rates trade near parity.

While similar measures based on longer-term options show a bias toward dollar bullishness, they have pared advances since early February.

The intermediate three-month tenor that captures the U.K.’s EU referendum show a sharp jump in euro-bearish bets that didn’t reverse even after Fed Chair Janet Yellen’s recent dovish remarks. That signals “Brexit” concerns are now influencing option prices more than Fed and ECB policy prospects.

Currently, the probability of a Fed rate increase in June has declined to 20 percent from 38 percent a week ago, while chances of ECB cutting by another 10 basis points by year-end remain steady at 39 percent. Investors are paying the most ever in order to hedge against price swings in the pound versus the dollar over the course of a year compared with the euro.

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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