Will EUR-USD Parity Repeat?Two men adventuring in the wild. They see a tiger racing towards them. They turn and start dashing away. Then, one of them stops to put on shoes. “What are you doing? The beast will outsprint you despite those” says the other. “I don’t have to run faster than the tiger” he retorts. “I just have to outrun you.”
FX stories are not dissimilar. Relative strengths and weaknesses facilitate price discovery between currency pairs.
On 1 January 2002, twelve EU countries move to euro in a historic event. Since December 2002, the euro has always traded above parity to the US dollar. The only exception is the last quarter of 2022.
EUR/USD has been above parity since late 2002 except for Q4 2022
Despite the collapse of regional banks, US corporations and consumers are in the pink of health. Cracks are starting to show in certain pockets but none too alarming (just yet).
In contrast, economic conditions in Europe are in sharp deterioration. Arguments abound on the direction of the euro ahead.
Following the rate decisions by the ECB and the US Fed last week, volatility in the Euro/USD pair has been trending to near 12-month lows. Low volatility equates to lower premiums on options. Periods of low volatility are opportune time for buying options.
This paper posits that euro will carry greater risk to the downside. That said, geopolitics and economics could turn favourably to the euro resulting in a rally. To seize opportunities presented by the price action, this paper posits a long straddle to benefit from low volatility & a euro that is set to move.
EURO SKEPTICS OBSERVE MANY PROBLEMS
Talk of the euro falling back to parity is once again creeping into the market murmurs. Google search on euro parity is at levels last seen in Nov 2022.
As reported by Bloomberg, last month, Nomura, Rabobank & ING analysts forecast the euro to get to levels marginally shy of parity to the USD. The likelihood of the euro hitting parity by early next year have more than doubled, as per Bloomberg options model.
Strong US economic fundamentals, rising US yields are bolstering the dollar. Rate differentials between the two tilts in dollar’s favour. US Q3 Real GDP was up by an annual rate of 4.9%, more than double the growth rate for Q2.
Additional tailwinds for greenback include sluggish Eurozone economic growth, concerns linked to Italy’s government debt, and slowdown in destination markets for Eurozone's exports.
OTHER ANALYSTS BELIEVE THAT EUROZONE PESSIMISM IS ALREADY PRICED IN
Disagreeing with euro sceptics are analysts with a view that Eurozone pessimism has been baked in.
Eurozone GDP fell by 0.1% in Q3. Despite feeble GDP data, market reaction was stoic. That points to an "invisible" floor for the euro. Lack of growth is priced in.
FOUR CHARTS CONTRASTING US EXCEPTIONALISM WITH GROWING EUROPEAN WEAKNESS
US GDP continues to expand at a remarkable clip given the size of the economy. In sharp contrast, Eurozone GDP growth is fragile and steadily losing steam.
US GDP racing ahead with Eurozone GDP losing steam
US inflation, while softening, is showing signs of spiralling up, thanks to its resilient and tight labour market. This puts the Fed on a hawkish stance supporting USD.
Inflation still above central bank targets but US inflation raging higher than in Eurozone
Meanwhile, the ECB might have headroom to ease rates thanks to slowing inflation and might be forced to loosen up to support growth and to stem economic contraction as shown below.
Composite PMI in US in expansion territory compared to sharp contraction in Eurozone
Monetary policy divergence between the Fed and the ECB has prevailed since early last year when the Fed was quicker relative to ECB to crank up rates.
Interest Rate Policy Divergence in US has continued to remain in favour of the dollar
In summary, the USD is poised to strengthen against the Euro, given strong GDP, higher US inflationary environment, sharp contraction in Eurozone, and continued monetary policy divergence.
TECHNICALS ALIGN WITH FUNDAMENTALS POINTING TO WEAKENING EURO
Momentum based indicators signal further weakness in the euro while oscillators point to strengthening based on near term mean reversion.
Overall, across twenty-five indicators curated by TradingView, eleven signal weakening, ten neutral, and four point to strengthening.
TradingView’s Technical Signals Dashboard point to euro weakness
CFTCs Commitment of Traders (CoT) report show that leveraged funds are net short. Asset managers who are still net long are gradually reducing their long positions.
In contrast to fundamentals, technical, and CoT reports, options market data points show that traders are bullish for euro to strengthen. Put-call ratio at 0.76 shows larger open interest on calls compared to puts.
That said, over the last one trading week, options traders are increasing puts compared to calls suggesting shifting market sentiments leaning towards a weakening euro.
Implied volatility based on options market is near 12-month lows with the conclusion of central bank meetings across both sides of the Atlantic. Low implied volatility makes premiums affordable.
CVol Index is at near 12-month low (Source: CME QuikStrike)
HYPOTHETICAL TRADE SET UP
Affordable premiums offer the best opportunity for buying options. When ambivalence prevails on the path ahead for the euro, traders could consider a long straddle to leverage volatility expansion and price action.
This paper posits a long straddle at a strike of 1.0845 on CME EUR/USD options expiring on 5th April 2024. A long straddle comprises of two legs: (a) long position in a call, and(b) long position in a put, at the same strike and expiry.
Each CME EUR/USD Monthly options contract delivers an exposure to 125,000 euros. Take the settlement prices as of November 3rd as an example, premiums for the (a) long call at 0.0182, and (b) long put at 0.0187, aggregate to 0.0369 for the long straddle. This translates into USD 4,613 in straddle premiums.
The straddle has two break-even points (BEP) at expiry. BEP on the downside is at 1.0476. BEP on the upside is at 1.1214.
The pay-off from the straddle is illustrated in the chart and table below.
Pay-off at Expiry from Long Straddle (Source: Mint Finance Analysis)
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
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