EUR/USD: Volatility signals questioned after energy shock – Commerzbank

FXStreet Insights Team FXStreet

Commerzbank’s Thu Lan Nguyen argues that despite what is described as the greatest threat to energy security in history, implied EUR/USD volatility remains unusually low. She links expected FX volatility to monetary policy expectations and notes that similar-sized rate repricing in US and Eurozone limits expected differential moves. Nguyen is less optimistic than markets about ECB responsiveness, seeing scope for corrections and stronger EUR/USD swings.

Options market underpricing EUR/USD risk

"... the implied exchange rate volatilities currently priced into the options market are almost shockingly low. The 3-month implied volatility for EUR/USD is trading significantly lower than it was at the start of the crises in 2020 and 2022, or even shortly after Liberation Day last year. How can this be explained, and is it justified?"

"The source of (expected) volatility can generally be found in expectations regarding monetary policy. If a strong monetary policy response - i.e., significant interest rate cuts or hikes - is expected - meaning that a significant change in the carry differential between currencies must be anticipated - then a corresponding revaluation of the exchange rate must also occur. The greater the expected change in the interest rate differential, the greater the exchange rate change."

"Interest rate expectations for the US and the eurozone have also changed significantly with the outbreak of the Iran war. However, at the moment, the magnitude of interest rate changes in the two currency areas is quite similar (just over 50 basis points). A significant change in the interest rate differential is therefore not expected."

"It may be that this time the ECB will not wait until inflation is already approaching double digits before raising interest rates. However, the hurdle for interest rate hikes is likely to be higher than the market currently assumes."

"In this respect, there is potential for a correction and thus also room for stronger exchange rate movements."

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

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FXStreet Insights Team

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