May 17, 2018 / 5:26 PM / a year ago

Options market points to more pain for the euro vs dollar

LONDON, May 17 (Reuters) - Investors are more bearish on the euro over the next six and 12 months than at any time since November, the options market shows, its outlook darkened by concerns over politics in Italy and the dollar’s huge rally against almost every other currency.

Two populist parties are set to form Italy’s next government, and markets fear that could lead to a spending binge in the highly indebted euro zone member. Investors were spooked this week by a leaked coalition plan - subsequently denied - that the parties would demand debt forgiveness from the European Central Bank.

At the same time, the dollar is enjoying a month-long surge as U.S. bond yields hit seven-year highs and the Federal Reserve is seen raising interest rates at least twice more this year, widening the U.S. rate premium with other developed nations.

The euro has hit a five-month low against the greenback, but the price on euro put options relative to call options has risen to the highest since last November, according to six and 12-month risk reversals.

Risk reversals are a gauge of the difference in demand for puts and calls. A put option allows a buyer to profit from a fall in the asset’s value or hedge against its decline. Call options indicate bets that an asset will rise in value and are also used to hedge.

“All (option markets are) saying is markets are starting to get concerned, they are looking less convinced about the euro. On that basis it looks to have been caused by the Italy story,” said Peter Kinsella, FX and rates strategist at Commonwealth Bank of Australia.

While option pricing suggests investors still remain much more positive on the single currency than on average, increased bearishness this month stands in contrast to the predictions of most analysts, who have stuck to their forecasts for a stronger euro by the end of 2018.

One- and three-month risk reversals have fallen to their lowest since February, implying more euro weakness in the short term after the dollar rally forced speculators to unwind record bets on a stronger single currency.

But the latest rise in put option prices on a 6-month and 12-month basis suggest companies hedging currency exposure further out, as well as longer-term investors, are also growing nervous about the euro’s direction.

Aside from Italian politics, another reason could be fading expectations for a mid-2019 ECB rate rise and the possibility that its timeline for withdrawing stimulus will be postponed.

U.S. economic data on the other hand has been buoyant, keeping Fed rate rises on track.

The 12-month euro risk reversal traded at -0.075 on Wednesday, Thomson Reuters data showed. That compares with record highs in January 2018 of 0.6 and more than -2 in early 2017, when euro bears were out in force.

Six-month risk reversals show a similar story.

“The conviction about where the euro is going to be is weakening,” said Chris Turner, ING’s global head of strategy.

ING has cut its forecast for euro/dollar to $1.20 from around $1.25 for the end of the second quarter and to $1.23 from $1.28 for the third quarter end, but kept its end-of-year forecast at $1.30.

“If we get a bounce back in (euro zone) activity in the second quarter, we could hopefully get back to a scenario where the rest of the world is back on its feet and the U.S. is not an island of growth,” Turner said.

Reporting by Tommy Reggiori Wilkes Additional reporting by Saikat Chatterjee Editing by Hugh Lawson

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