The options market is signaling the threat of a breakup in the 17-nation euro bloc is disappearing as the price of insurance against wild swings in the region’s single currency fall to a five-year low.
Butterfly options that protect against both gains and declines slid to the lowest since March 2008 on Feb. 4. Implied volatility on three-month options on the euro-dollar exchange rate has risen about half as much as a broader gauge of currency volatility this year.
The currencies of nations with top credit ratings have dropped against the euro over the past six months as concern eased that Europe’s currency union would unravel. The bonds of Greece, Portugal, Ireland, Spain and Italy -- the region’s most indebted-economies-- have been the best performers among sovereign debt in that period, indexes tracked by Bloomberg and the European Federation of Financial Analyst Societies show.
“People are talking about the great rotation out of fixed income and into equities now, but the real great rotation we’ve been seeing is a rotation back into the euro,” said David Woo, head of global rates and currencies research at Bank of America Merrill Lynch in New York. “You could argue that this is a climax to the normalization of risk that began last summer.”
Bank Repayments
Stress in European funding markets has eased since July, according to the Bloomberg Financial Conditions Monitor, the same month European Central Bank President Mario Draghi pledged to do whatever it takes to preserve the monetary union. The Euro Financial Conditions Index exceeded zero in September for the first time since August 2007. It’s highest close this year was 0.665 on Jan. 25.
Draghi lent more support to so-called peripheral debt markets in September when he unveiled an unlimited bond-purchase plan, called Outright Monetary Transactions, or OMT. The bonds of Greece, Portugal, Ireland, Spain and Italy have risen at least 11% in the past six months, leading gains among 26 EFFAS indexes of sovereign debt.
On Jan. 30, 278 financial institutions returned 137.2 billion euros ($183 billion) in the first opportunity for early repayment of the ECB’s initial three-year loans, part of its Long-Term Refinancing Operation. The ECB’s first of two three-year loan operations totaled 489 billion euros. Banks have continued to make repayments in the weeks following.
Euro’s Advance
The shared currency has appreciated 4.1% over the past three months and 7.2% over the past six, according to Bloomberg Correlation-Weighted Indexes, which track 10 developed-nation currencies. It has climbed more than 10% on a trade-weighted basis since Draghi’s pledge in July.
Draghi spurred gains in the euro last month when he spoke of “positive contagion” in financial markets and a return to economic growth later this year. The ECB cut its benchmark rate to a record low of 0.75% in July.
“Concerns of a break-up of the single currency and general global economic concerns have eased,” Alan Wilde, head of fixed-income and currencies in London at Baring Asset Management, which oversees $53 billion, said in a telephone interview on Feb. 14. “Some of these tail risks have dissipated as actions have been taken and markets have gained more confidence.”
The gross domestic product-weighted average of 10-year government bond yields in Italy, Spain and Portugal has collapsed since July. That narrowed their premium to rates in seven AAA rated countries outside the currency bloc to 2.54 percentage points, close to the least since July 2011.
Allocation Moderating
Australia, Canada, Denmark, Norway, Singapore, Sweden and Switzerland have top AAA grades and stable outlooks from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings.
The currencies of Canada, Australia and Singapore have tumbled against the euro by as much as 9.6% in the past six months. Denmark’s krone is linked to the shared currency. Finland, another top-rated nation, is in the euro bloc.
“Capital was flowing out of the euro zone -- some went to the Swiss franc obviously, some went into other currencies like the Australian dollar,” said Andrew Salter, a foreign-exchange strategist at Australia & New Zealand Banking Group Ltd. in Sydney. “That allocation is now moderating” as the ECB has stepped behind the peripheral-bond markets.
Bond Buying
Since the ECB made its unlimited bond-buying proposal, peripheral-debt yields have retreated even though no euro members have yet taken up the central bank’s offer, which grants support for countries that sign up to economic reforms.
Net portfolio investment in Spain climbed for a fourth month in November to reach the highest since May 2006.
“I’m long on the euro and short on the Australian dollar,” said Akira Takei, head of the international fixed- income department in Tokyo at Mizuho Asset Management Co., which oversees about $35 billion. “The ECB has made it clear that it won’t let its member states default on their debt.”
Takei said he holds more Italian and Spanish notes than his benchmark index and sees the euro strengthening to $1.42 this year. The median estimate of analysts surveyed by Bloomberg is for the euro to end this year at $1.31. The shared currency gained 0.3% to $1.3387 at 12:49 p.m. in New York.
Draghi told reporters on Feb. 7 the euro’s appreciation is a sign that confidence has returned to the currency. While the exchange rate isn’t a policy target, it is “important for growth and price stability,” he said.
Economy Shrinks
The currency bloc’s GDP shrank 0.9% in the three months ended Dec. 31 from a year earlier, the statistics office said last week. That was a fourth quarterly contraction and the deepest decline since 2009.
“The crisis stage in Europe is coming to an end but the debt problem hasn’t been completely resolved,” said Daisaku Ueno, a senior foreign-exchange and fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities Co. in Tokyo. “I doubt that the euro region has recovered enough to embrace both austerity and a stronger currency, so the euro isn’t likely to continue its rally against AAA currencies.”
The currency options market has dialed back perceived risk in the euro to five-year lows by some metrics. The one-year euro-U.S. dollar option butterfly was 0.328% on Feb. 15, and closed at 0.308 on Feb. 4, the least since March 2008.
Implied Volatility
The butterfly measures the gap in implied volatility of out-of-the money options, or those presently with no intrinsic value, and those that would allow investors to buy or sell the euro at close to where the exchange rate currently trades, so- called at-the-money options. The value of the butterfly gets larger as demand to hedge against wide swings in the euro-dollar exchange rate increases.
The three-month 25-delta risk-reversal rate showed a 0.25 percentage point premium for euro puts -- which grant the right to sell the common currency versus the dollar -- over calls on Feb. 1. That was the smallest since October 2009.
Hedge funds and other large speculators have reversed bets on the common currency this year, after their net wagers on the euro’s slide reached to a record in June. The difference in the number of bets large speculators have on a gain in the euro versus the dollar and those for a fall, so-called net longs, was 37,952 this month, according to the Washington-based Commodity Futures Trading Commission data.
As recently as the week ended Jan. 8, there was a net short position, which touched a record level of 214,000 in the week ended June 5.
“People had priced in a currency crisis for the euro and realize now that is just not going to happen,” Eimear Daly, a currency-market analyst at Monex Europe Ltd. in London, said in a Feb. 13 interview. “Draghi put a floor under the currency.”
