What the Options Market is Telling Us about the Euro

The euro's decline is relentless and the foreign exchange market is becoming disorderly. This is how the spot price action feels and this is what the options market is confirming.

The standard metric is 3-month volatility and it is quoted a little above 14.6% currently. To put this in perspective, during the 9/11 period 3-month euro vol reached about 14.4% and in late 2008, it reached almost 25.5%. Three-month vol reached almost 16% last week.

This high volatility alone is destabilizing. It makes commerce more difficult. It makes cross border movement of capital more difficult. The flexibility of the foreign exchange market, which has at times been almost a mantra of the G7/IMF in practice means disastrous spikes in volatility.

The correlation between volatility and spot is one metric that helps identify the strength of the trend. Thus far in 2010, the euro and 3-month vol is inversely correlated 69%. That is as the euro falls, vol has tended to rise. This makes intuitive sense given the pace of the move and the fact that the euro is at levels not seen in years. Last year, the correlation stood at 3.1% and in 2008, the correlation was almost -24%. The current reading illustrates how power of the euro's decline.

The impact of the euro's decline on other markets is also evident. Year-to-date, the euro is inversely correlated with the S&P 500 more than 60.5%. Last year the correlation was nearly -13% and in 2008 it was -25.5%.

The correlation between the euro and the volatility of the S&P 500 (VIX) has shifted to -58% this year from almost +30% last year and almost +29% in 2008. Yet in recent weeks this correlation has swung back deep into positive ground as systemic risks have re-surfaced.

Another sign of the extreme state of the foreign exchange market is the pricing of euro puts and calls equidistant from the money. Put-call parity says that puts and calls equally distant from the forward strike should be priced similarly. To the extent they are not, it reveals a skew in the market. Risk-reversals are revealing even if none does not trade or follow the currency options market.

Currently the 25-delta (50 delta is at the money so 25 delta is somewhat out of the money and is a standard measure in the options market) risk reversal shows euro puts trade at a 2.8% premium over euro calls. This is about as skewed as the euro options market was in Oct 2008, when the fallout from the collapse of Lehman was most pronounced. Last week, the risk-reversals briefly traded above 3%.

This is very extreme. Until the recent financial crisis, during periods of euro weakness, the puts rarely traded even 1% more than euro calls. In 2008, the stress in the risk reversals was evident for about a quarter. The extreme readings now have lasted since last November. Recall, it was the erosion of the risk reversals early last November that we detected as an early warning sign of the euro's pending weakness.

Lastly, consider that the most recent leg down in the euro began in mid-April. The euro has declined about 11.3% since or a 63.2% annualized rate. This annualized rate is among the largest of any leg down the euro has recorded in its brief history. The only decline we have found to rival this is the decline from late Sept through late Oct 08, when the euro declined at an annual rate of a little more than 83%.

We noted that European officials, like Euro-group head Junker, are less concerned with level than pace of the euro's decline. Yet we argue the hurdle to invention is obviously higher. Not only hasn't there been intervention yet, but there was no intervention even in the aftermath of Lehman's collapse.

In fact, since the advent of the euro there has only been one bout of coordinated intervention and that was to support the euro in the fall of 2000. From late Sept 00 through late Oct 00, the euro declined almost 8.5% (61.3% annualized pace) and the intervention more or less coincided with the cyclical euro low.

During the earlier crisis and again now, officials have shown a penchant to address the market imbalance with currency swaps rather than intervention. The thinking is that these are not the old-fashioned currency crisis, but a question of securing funding. While this assessment seemed fair enough, the risk is that it morphs into a bona fide run on a currency.

There is some thought that maybe some European officials would like to intervene. It would seem that they can count on Japan for support. In recent weeks two government panels in Japan have called for yen weakness to combat deflation. Yet Japanese officials have been loathe to implement unilateral intervention. Perhaps the sticking point is the US stance. After the recent bouts of European schadenfreude (taking pleasure at some one else's misery) that blamed the financial 07-09 financial crisis on Anglo-American capitalism, reluctance by the US to intervene may be understandable.

However, under what conditions could the US sanction coordinated intervention? If US officials were to conclude that the euro's decline/dollar rise was a risk to the economic recovery or that it posed systemic risk, rather than being a symptom of such risk, then intervention would seem more likely. This survey of indications from the options market warns that a continued drop in the euro may bring forward precisely those considerations.