Euro: Policy risks could revive swings against US Dollar - Commerzbank

Commerzbank’s Thu Lan Nguyen notes EUR/USD has settled around 1.12 after dropping from 1.16, with options-implied volatility falling again. She argues that limited changes in relative Fed and ECB expectations and a broader trend of smaller interest-rate cycles and synchronised business cycles have dampened FX swings. However, she warns that calm in FX markets is not justified given rising geopolitical and fiscal risks.

Low volatility masks growing macro risks

"After falling from levels around 1.16 at the end of September, EUR/USD now appears to be settling comfortably around 1.12. And the market evidently assumes that it will remain there for the foreseeable future. Three-month implied volatility priced in the options market has recently declined again."

"As mentioned in recent weeks, the market expects both central banks to raise rates more or less in lockstep over the coming months. At the same time, the overall amount of additional tightening still expected is fairly limited. Most recently, perhaps two to at most three further rate hikes were priced in, with the trend lately pointing lower."

"This implies that the weaker the monetary policy impulse and the more flexible the real economy, the less reason there is for exchange rates to “overshoot”. A world of more firmly anchored inflation expectations, less pronounced interest-rate cycles and more synchronised business cycles should therefore, in principle, provide less scope for large exchange-rate swings."

"So is the current calm in FX markets justified? Not at all. Central banks may currently be providing fewer impulses, but this leaves more room for governments to differentiate themselves through fiscal and economic policy."

"The US administration in particular has recently shown that it is quite prepared to pursue radical policy paths. Risks therefore remain, they currently may just be hard to predict..."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)