24.02.2024

Europe: How Markets View Unity vs. Disintegration

Given the unsettled nature of U.S., U.K. and continental European politics, it strikes us that options markets are unusually sanguine.  Of course, EURUSD and GBPUSD options markets are hardly alone in assigning low prices to put and call protection. 

Other currency pairs like the Australia dollar-U.S. dollar (AUDUSD), Canadian dollar-U.S. dollar (CADUSD) and Japanese yen-U.S. dollar (JPYUSD) are also trading near historic lows.  Moreover, options on equity index futures, government bonds and precious metals are also priced near historic lows.

The common denominator that may explain the low level of implied volatility on options across four asset classes is the massive monetary expansion undertaken by the Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan and other central banks.  Easy monetary policy has generated enormous amounts of cash and may be making it exceptionally easy for buyers and sellers of various currencies, bonds, stocks and metals to transact with one another without prices moving significantly.

Meanwhile, the Bank of England is considering raising rates for the first time since 2006 while the ECB contemplates further tapering the pace of its asset purchases.  None of these factors will necessarily create a short-term explosion in volatility.  That said, issues that the markets have been poo-pooing, such as the progress (or lack thereof) in Brexit negotiations, the Catalonian independence movement, Merkel’s attempt to build a coalition, the situation on the Korean peninsula and the state of affairs in the U.S. Congress have the potential to generate increasingly stronger market reactions.

In the past, equity-market volatility has lagged movements in Fed rates by 12-24 months.  Given the tendency of volatility to follow monetary policy tightening with a 1 to 2-year lag, it’s not much of a surprise currency and other markets have shown such a muted response to recent developments in Europe and elsewhere, thus far.  After all, the Fed has only been tightening in earnest for the past nine months.  Presumably, the strongest impacts of it draining liquidity from the system won’t be felt until 2018, at the earliest.

Even in the short-term, however, there are still reasons to be concerned that European currency options markets are too complacent:

  • The progress of Brexit negotiations remains a major question mark given the fragility of Prime Minister Theresa May’s governing majority.  A ‘soft Brexit’ could send GBP soaring.  A ‘hard Brexit,’ or U.K. political turmoil could send GBP plunging back towards post-referendum lows.
  • The Catalonian situation could become increasingly volatile with the possibility of Catalonia’s government declaring independence against the wishes of Spain’s Prime Minister, and the King.
  • A CDU/CSU/FDP/Green coalition in Germany could prove unwieldy and unstable and could hamstring Merkel and Macron’s efforts towards deeper European integration.
  • Italy could hold elections soon that could throw another spanner in the works in Europe.
  • Macron’s popularity has dropped below 40% as he attempts to enact key reforms and push for deeper European integration.
  • The ECB’s eventual tapering of its asset purchase program could also send markets on a wild ride, especially if the central bank is no longer seen as being willing or able to backstop Spain and Italy’s debts.
  • Transitions from Fed Chair Janet Yellen and ECB President Mario Draghi to new leaders could also create volatility exceeding what options markets have priced.

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