ECB's Decision to Increase Rates Paves the Way for Volatile Euro Movements

Volatility in the euro has calmed down after a tumultuous 2022, and it is now sliding at the fastest pace ever. This has led some currency players to think that it is worth starting to bet on greater swings.

‍
There is a general agreement among global investors that the economy will calm down now that inflation is easing and the Federal Reserve is no longer raising interest rates. However, European policy makers are pushing back against this market positioning, which could lead to renewed volatility in the euro.

‍
Olivier Korber of Societe Generale sees an opportunity to hedge risks, with the common currency's implied volatility over the next year well below its past-year average at under 8%. This is after the volatility surged above 11% in the wake of Russia's invasion of Ukraine.
Korber, a currency and derivatives strategist, said that we are now almost at the lows since the outbreak of the war in Ukraine. This is an important level, which will likely act as a floor. With hawkish comments from the ECB, and more hikes in Europe to come now, there will be likely more turbulence in euro-area rates. This is likely to be channeled into euro-dollar FX volatility.

‍
This week has been full of surprises for euro traders. First, a report came out that the European Central Bank is considering a slower pace of interest-rate hikes. This drove the euro down on Tuesday, but it recovered on Wednesday after weaker-than-expected US economic data caused the dollar to drop.

‍
A series of ECB speakers have insisted that policy makers will not let up in their efforts to return inflation to their target, given that prices remain far too elevated. President Christine Lagarde told Davos that "stay the course" was her new mantra. This has led to a rise in one-year volatility as traders bet on rate hikes.
According to Roberto Mialich, a foreign-exchange strategist at UniCredit SpA, the major risks to the drop in long-term volatility include unexpected news regarding the Fed or the ECB, which could prompt a repricing of current market expectations. Other risks include the usual geopolitical risks as well as the risk of further contagion from the Covid-19 virus.

‍
In a recent interview, Christine Lagarde stated that inflation is currently much too high and that the ECB needs to stay the course in order to bring it down. She noted that the ECB's current policies are having a positive impact and that it is important to maintain them in order to achieve the desired results.
Currency volatility has been on the decline this year, with a JPMorgan Chase & Co. index showing a drop in the fourth quarter of 2022. This is a sharp reversal from the previous quarter, when volatility was at its highest level since the pandemic began. The euro has seen the biggest drop in volatility, with the fourth quarter of 2022 seeing the biggest quarterly decline on record.

‍
Even though actual or realized volatility has been much higher in the past year, at well above 10%, the gap between the two now suggests that options are at the most underpriced levels since the global financial crisis. This could encourage some traders to opt for relatively cheap bets to get exposure to being long volatility.
Oliver Brennan, currency volatility strategist at BNP Paribas SA, believes that implied euro volatility could move up, as it is currently one of the lowest among the Group-of-10 currencies. He believes that there is only a minimal premium built in for risks around any escalation of the war in Ukraine and energy prices.

‍
There are plenty of people warning about complacency. Some of the world’s largest asset managers, such as BlackRock Inc., Fidelity Investments and Carmignac, worry that markets are underestimating both inflation and the ultimate peak of interest rates, just as they did a year ago. This will leave traders glued to data, such as the US employment figures.

‍
"A few weaker prints could be a catalyst for longer-term volatility to bounce back," said Tim Brooks, head of currency options trading at market-maker Optiver. While a slow cutting cycle from the Fed would reduce volatility, Brooks said that "other central banks' actions could be a far greater driver this year."
Michele from JPMorgan is urging people not to get caught off guard by cooling prices. She says that people need to be prepared for the possibility that prices could start to drop in the near future.

‍
Positioning could also exacerbate moves in the markets. Money markets are pricing in the ECB rate peaking in July and then the Fed cutting by the end of this year, while options traders have switched to bet on a weaker dollar. Both of these factors have been suppressing longer-term volatility.

‍
According to BNP Paribas' Brennan, the positioning of markets suggests that a pro-risk consensus is building. This means that adverse risks could create large shocks.