- Hedge funds and asset managers are positioned for the euro to outperform the dollar, but we think these positions could be vulnerable as the dollar picture has turned more positive..
- CME data on option strikes suggests demand for upside strikes in EUR/USD. The U.S. debt ceiling debate is a critical event risk that could affect the dollar path in the near term.
- The FX volatility curve using CME options data suggests investors are no longer in “fear” mode.
The U.S. dollar has performed well in May, clearly outperforming both the euro and Japanese yen. Earlier concerns around U.S. regional banks faded, while key U.S. data such as payrolls improved. The larger risk is a potential U.S. debt ceiling crisis. But even there, FX markets are pricing a resolution. As well as the dollar strengthening, both equities and bond yields have risen.
On positioning, hedge funds have turned net long euro from short a month earlier (Chart 1). Meanwhile, they remain short yen against the dollar, but by less. Elsewhere, hedge funds have increased their shorts in sterling, the Swiss franc and the Australian dollar, reduced their shorts in the Canadian dollar and turned long New Zealand dollar.
Meanwhile, asset managers have increased their net long euro positions and reduced their net longs in the yen (Chart 2). Elsewhere, asset managers are net short Australian dollar, Canadian dollar, and New Zealand dollar and roughly flat in sterling and the Swiss franc.
Aggregating investor conviction, we find both hedge funds and asset managers are long euro and short Australian dollar but have conflicting views on the yen.
Macro Hive take: we hold the opposite view to investors on the euro. We think much of the bullish euro news is priced, the region’s manufacturing data is starting to turn down, and markets are over-pricing Fed easings. Therefore, we expect euro weakness. The Japanese yen could benefit if U.S. debt ceiling issues escalate, so the currency is likely to be very event driven.
Option strikes
At the start of May, EUR/USD was attempting to break above 1.10, but has since fallen. Hedge funds and asset managers are attempting to fade this decline and instead positioning for EUR/USD to retest 1.10, according to CME data on option strikes:
- There is notable net demand for EUR/USD calls with strikes at 1.10, 1.14 and 1.15 (Chart 3). Investors remain optimistic that EUR/USD will trade back to 1.10, at least.
- On the downside, the key level appears to be 1.075, where there is large net demand for EUR puts.
What to watch: the debt ceiling remains pivotal to the direction of the dollar. As a result, the X-date will be important as the US Treasury could start to run out of cash, requiring more evasive action. The dollar may weaken if concerns of a debt crisis escalate. Meanwhile, on the European side, markets are pricing at least another two 25bp hikes. If European growth data continues to weaken, they could scale back these expectations, which could see further euro downside.
FX investor risk appetite
CME has a range of FX volatility data to help investors track the level of volatility. We can also use FX volatility data to determine investor risk appetite. We find the shape of the FX volatility curve useful in this regard. When shorter-dated FX implied volatility is higher than longer-dated volatility, this suggests investors are worried or in panic mode. In contrast, when shorter-dated FX volatility is lower than longer-dated volatility, this suggests investors expect calm markets. The latest data finds:
- FX volatility curve inversion in April proved short lived. Investors are finding comfort in economic data holding up, with little impact from the Fed’s hiking cycle. This suggests investors are no longer in “fear” mode (Chart 4).
- This aligns with CME CVOL volatility indices, which have followed a similar dynamic, largely continuing their trend lower from their steep inversion in March.
- Outside FX, equity volatility has been falling, while rates volatility remains historically elevated.
Overall, this suggests FX markets are unconcerned about the debt ceiling crisis.
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