Executive summary

With both the ECB and FOMC at a crossroads in their policy decisions, Rich Excell looks at EUR/USD and assesses whether this pair will rally or continue its steady path lower.

Image 1: Daily Ichimoku Cloud chart for EUR/USD

Since this summer, the EUR/USD currency pair has been on a steady path lower, having hit a high close to 1.13 in July, and now lingering just above 1.05. In many ways, it has been the consummate risk-on/risk-off currency pair – rallying for most of 2021, having a difficult 2022 but then rallying again from the fall of 2022 into the highs this summer, similar to other assets in the investing world. What is behind this move?

Image 2: EUR/USD compared to the difference between bund yields and Treasury yields

I’ll work through potential drivers of the currency pair one by one to see if I can begin to tell the story of what has driven it and what it may mean going forward. The first argument given for currency markets tends to be the interest rate differential argument. While the EU has no good pan-European yield benchmark, I choose to use bund yields, with German bunds being a large source of the supply of government bonds, but also a preferred destination for investors into Europe. If I compare the yield on German bunds to U.S. Treasuries, can I ascertain any pattern compared to EUR/USD?

While it is not a one-to-one comparison, I can see that broader trends in rate differentials appear to have had an impact. From 2013 – 2019, the spread between the two bond markets steadily eroded with EUR/USD trending lower for most of that period. From 2019 – 2021, bund yields widened vs. the U.S., with a big jump around the coronavirus. EUR was a bit higher over that time. From 2021 – 2023, while there has been some volatility in EUR/USD, on net it is still largely at the same level. In the same way, while bunds initially widened vs. Treasuries, now this spread has collapsed and is back to where it was a few years ago. 

While there is a debate about the directional of Treasury yields from here, it would seem that U.S. Treasury bears may also be bears on EUR/USD, as wider spreads (more negative on this chart) would point to lower EUR.

Image 3: ECB balance sheet as a percent of GDP vs. Federal Reserve balance sheet as a percent of GDP overlaid vs. EUR/USD

It may not just be central bank rate moves and interest rate differentials that an investor must consider. Since the Great Financial Crisis, central banks have also used balance sheets to impact financial conditions in their respective regions. Thus, we can compare the change in balance sheet as a percent of GDP in each region and see what this relative change means for currencies as well. 

In the chart above, I compare the ECB balance sheet to the FOMC balance sheet. While on a month-to-month basis there may be no direct correlation, we can see that when there are large relative moves, they tend to coincide to trending moves in the currency pair in the opposite direction. For example, from 2016 – 2019, the ECB grew its balance sheet as a percent of the economy much faster than the Fed. Traders perhaps perceived this as a debasing of the currency, as the EUR weakened vs. the dollar over this period. Then, during the coronavirus, the Fed was much more aggressive growing its balance sheet. Subsequently, the dollar weakened vs. the euro and the pair moved higher. 

What will happen going forward? We cannot be sure. Both central banks are reducing balance sheets, though the pace of growth is a bit faster in the U.S. than in Europe. In addition, there is reason to believe the ECB sees higher inflation currently as a tax on consumers that will potentially slow the economy, particularly as it may be a little more nervous into winter. The FOMC, on the other hand, has been vocal about its commitment to bring inflation lower. If either of these are an indication, it may suggest a more aggressive FOMC in reducing its balance sheet, which would be bearish for EUR/USD.

Image 4: SXXP vs. SPX relative index performance compared to EUR/USD

As I traded FX for over 10 years, I recognized that it wasn’t as much the academic reasons that we learn that impacts FX markets. Instead, it was often the relative investment possibilities that attracted investor flows, and therefore impacted FX markets. This is particularly true in emerging markets, where I see a very high correlation between investor flows into stock and bond markets from global investors and the performance of local currencies. However, it is not just in developing countries, but also in developed countries. When global investors see more opportunity to earn returns in various stock markets, money flows to that region and the currency is impacted. 

In the chart above I can see that from 2017 – 2022, the SPX outperformed the SXXP as demonstrated by the white line steadily moving lower. The EUR/USD currency pair followed suit though it did noticeably dislocate around 2020 – 2021. By 2022, it was back in line. Then, I see European stocks begin to outperform from 2022 until early 2023. This corresponded with a rise in the EUR over this period. This relative performance has begun to suffer again. With the world potentially becoming more unstable, investors may prefer the relative safety and lack of cyclicality in the SPX. This would also potentially point to a lower EUR.

Image 5: EU vs. U.S. consumer confidence vs. EUR/USD

What might be driving the relative stock performance? One indicator might be consumer confidence. In this chart I created an index that compares the German ZEW Indicator to the Conference Board consumer confidence. I can see that the relative outlook for the economies based on survey data has done a pretty good job of suggesting the path forward for the EUR/USD. 

It is difficult to forecast how this may look going forward, however, we do know that the ZEW has been consistently moving lower all year long. The U.S. Consumer confidence index on the other hand, has been more volatile but has really been treading water. Thus, if there is any trend to discern in the near term, it may be that the outlook for the German economy is a bit more downbeat than the U.S., which could impact equity returns, and therefore investor flows.

Image 6: EU vs. U.S. Purchasing Manager Index vs. EUR/USD

What else may impact the relative stock markets? I did mention that U.S. stocks are less cyclical when we look at the index composition of sectors for each market. However, this may not be the only reason. Another reason U.S. stocks may look more attractive is that the U.S. economy looks a bit more attractive on a relative basis. 

If I compare the EU PMI to the U.S. PMO (white line above), I can see that as the EU economy grows on a relative basis, this favors the EUR. As the U.S. economy grows on a relative basis (line lower), this benefits the USD. It makes sense given the relative stock chart above. The economy leads earnings, and earnings drive stocks. If one believes one economy will be better, there is reason to believe one may prefer that stock market and therefore prefer that currency. Empirically, that is what we have seen over time. With a U.S. economy that is calling for soft landing or even no landing, this may argue in favor of a weaker EUR/USD currency pair.

Image 7: EUR/USD weekly Ichimoku Cloud chart on top and weekly candle chart with moving averages on bottom

Putting this all together, let’s look now at the weekly EUR/USD chart. When I look at the Ichimoku chart with the MACD and RSI as well, a few things stand out to me. First, not only has the price broken into the Ichimoku Cloud, which is an approximate measure of where investors are long or short, but the lagging span (red line) has also broken into the cloud suggesting that the weekly momentum for this pair is starting to wane. In addition, the MACD line has turned down and is pointing lower. Finally, the RSI is not oversold telling me there can be more to this trend. 

Looking at the weekly candle chart on the bottom, I see that in the move higher from late 2022 until the summer 2023, the pair stopped right at the one year moving average and now has broken below the one month and three month moving averages as well. This suggests the 2022 – 2023 move was a countertrend move that now is about to resume on its downtrend.

Image 8: CVOL Indices for all currency pairs

Now I turn to the options market to see how I can potentially set up an idea that I can trade. My first stop, as always, is the CME Group CVOL Index. From here I can see what sort of risk is being priced into the options market. We can see that really across the board, with the exception of MXN, implied volatility is generally on the low end of where it has been the last 12 months. This is true across all products and for EUR/USD with the CVOL just above eight vs. a range from six – 13 for the past year. This tells me that long option ideas potentially will be more interesting because there is less risk being priced into the markets right now.

Image 9: EUR/USD CVOL compared to the underlying

I now compare a time series of CVOL to the underlying price in order to see if there is any correlation between the two. As I look at this chart over the past two years, I see a negative correlation. As EUR/USD moves higher, CVOL tends to move lower. Conversely, as EUR/USD moves lower, CVOL tends to move higher. This is consistent with the currency pair moving into or out of a more comfortable range for traders and investors alike. 

With my bias toward a lower EUR/USD, this would seem to suggest that I expect volatility to move higher from here. Thus, long volatility strategies are starting to make sense to me. 

Image 10: EUR/USD skew compared to the underlying

Now I look at the skew that can also be calculated from the options market and found in the CME Group CVOL tool. Looking at a time series of skew compared to the underlying, I can see that skew is positively correlated to the underlying. As EUR moves higher, skew moves in favor of the calls. As EUR moves lower, skew moves in favor of the puts. Again, given I have a bias toward a lower EUR, I would think that skew will continue to move in favor of the puts from here, which means that not only would volatility move higher overall, but the volatility of the put strikes would move higher relative to the volatility of calls. Thus, I want to “derive” into a long volatility position, as lower EUR would mean higher volatility. If I move into a position that accumulates more vega as the futures move lower, I will be able to more successfully trade out of the position.

Image 11: Expected return chart for a January EUR/USD 1.04 – 1.06 strangle

With futures at 1.0588, I want to both get long volatility, as I expect a lower EUR which has led to higher volatility, but also bias my strangle toward lower strikes, so that my position will gain in vega as we move lower. I do this by skewing my strikes a little lower. Why do I do this? If I start with strikes that are equidistant around the future, as we move lower, my put strike will become at the money and my call strike will move farther out of the money and lose more vega. The call vega will be lower even if skew does not favor it. Importantly too, the put is now at the money, so it will not see the same move higher in volatility as an out of the money put would see. If I start with a lower delta, I will get positive impact from both a move higher in volatility and a move higher in skew. In addition, my call, which start as at the money, is lower volatility now than an out of the money call is. It should hold onto its volatility better than an out of the money call that moves much further out. I am doing this in order to give me more flexibility in either trading out of the position, or in being able to take off one side of the strangle should I change my directional view at some point.

Image 12: Matrix that looks at the PNL of the strategy for different moves in futures and volatility

How will this position hold up for various moves in the futures or moves in volatility? I can get this information by using the Matrix within Spreadbuilder from QuikStrike. I am plotting the PNL for my strangle for these various moves. What am I looking for? The red areas are the areas I lose money, the green areas are those where I make money, simply on a mark to market basis, not assuming any delta hedging of the position. 

As you can see, for most of the matrix, this position is making money should futures move in either direction. I am also making money for any move higher in volatility. If volatility moves lower, I only make money if the futures move at the same time. Where do I lose? Futures between 1.03 – 1.06 and volatilities falling. This is my biggest risk – futures heading lower and volatility falling. Empirically, that has not been what we have seen over the last two years, but that does not mean it cannot happen. Overall, this matrix gives me confidence that I can make money in this position. 

Image 13: Matrix of PNL for strangle position compared to futures movement and time

The biggest enemy for any long volatility position is of course time – theta, also known as decay or rot. When long volatility, the longer it takes for the idea to play out, the more the trader’s position will suffer from theta, costing the trader money. Of course, if it sits for a while, but then moves, one can still make money; however, as traders accumulate theta bills, it becomes harder and harder to stay in that position. We can see that in this matrix that looks at PNL for the strangle compared to futures moves and time. We can see a lot more red (negative PNL) on this screen. The longer it takes for this idea to work, the less likely it is for the trader to make money as we see with an expanding cone of red. This is the trader’s biggest risk in this trade. 

Despite this risk, given that implied volatility is near the low end of the last 12 months, and given there are macroeconomic and flow reasons for me to favor a lower EUR/USD, I feel good about the setup for this trade. CVOL and skew have both tended to react to moves in EUR, with lower EUR meaning higher volatility and skew favoring puts. I have crafted my position to take advantage of both of these. 

Ultimately, a trader has to have a view and have that view be correct to make money. That view can be on a direction, or it can be on volatility. It can be on magnitude of a move or on the timing of the move. If these views line up with how the market reacts when those views play out, a trader can structure an idea to take full advantage of the direction and pace of the move. This may be one of those times. As always, there are risks but traders know that and prepare for those risks at the time of trade. That is what risk management is all about. 

Good luck trading. 

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