(Reuters) - Investors have turned their most bullish on the euro since November 2016, with the Federal Reserve’s Tuesday interest rate encouraging some to price in further gains against the dollar.
The Fed cut, two weeks before its official policy meeting, means it has taken the lead in fighting potential economic damage inflicted by the coronavirus outbreak and expectations of more cuts ahead are weighing heavy on the dollar.
Those expectations are fuelling a rush into almost every other major currency, but especially those such as the euro whose central banks have little or no space for big rate cuts.
While markets now see a 90% chance the European Central Bank (ECB) will cut rates next week, it remains reluctant to rush into further policy easing
The euro is up almost 4% in the past 8 days EUR=EBS EUR1MRR=FN and one-month euro-dollar risk reversals show the implied volatility premium for euro calls over euro puts is the highest since the U.S. election in November 2016 at 0.8%.
(GRAPHIC: Risk reversals flip; euro bulls on top - here)
Calls give holders the right to buy a security at a pre-agreed price while puts confer the right to sell. Euro calls traded at a 0.4% premium on Friday and carried a discount the previous week.
“The currency market reaction following the Fed (decision) shows that yield differentials have come back into their own,” Gavin Friend, a strategist at National Australia Bank, said, referring to the narrowing U.S. yield premium compared to other currencies.
“Everything is telling you this could go further, You just can’t fight this at the moment.”
The yield premium paid by 10-year U.S. government Treasuries compared to German equivalents is now at the narrowest since 2017, having tightened 50 basis points.
(GRAPHIC: U.S./German bond yield gap - here)
The moves could be exacerbated by positioning — existing option expiries between now and March 31 reported through the Depository Trust & Clearing Corporation (DTCC) show very few options barriers above $1.1250.
So a break of that level would face less resistance from traders who would otherwise have sold euros to hedge positions.
That is possibly because traders, skeptical the euro could sustain its gains, were likely ‘short’ any options pricing euro upside. After all, the pair spent last year trading between $1.0879 and $1.1570, the narrowest range ever.
Still, the euro faces formidable hurdles in the medium-term, not least sluggish economic growth and falling inflation expectations. Nor will euro strength be welcomed by the ECB.
For now though, with more Fed rate cuts being priced, it should hold on to gains, options markets appear to be signaling.
Reporting by Sujata Rao and Richard Pace; Editing by Alexander Smith