One of the most powerful themes in markets this year has been the steady weakening of the dollar, especially against the euro and other major currencies.. Since the March breakout, EUR/USD has been on a one-way path to highs set in early July, rallying more than 13%. The strength of the rally has likely drawn many FX (and non-FX) participants into a long EUR position. However, the technical charts are showing some signs of weakening lately. In the top circle of the chart, you can see that the pair has consolidated its recent gains but remains well above the support level. More worrying is the MACD in the middle circle rolling over and suggesting a change in trend. The bottom circle suggests the futures were overbought and still remain in the upper echelon of RSI readings over the past year. EUR longs or contrarian traders may potentially find a reason they want to enter into a hedge or a bearish options play by seeing this chart. Before they do, they may want to look into if this has any fundamental backing.

Ask anyone what drives a currency pair, and you will likely be told either interest rate differentials or relative central bank policy. In order to test this theory, I can use the interest rate differential in the two-year part of the curve because these contracts typically are driven by and embed ‌expectations for central bank policy. In fact, the spread between the German and U.S. 2-year yields has a tight relationship with EUR/USD. Looking at this over the past five years, I can see that it was the 2-year spread that led EUR lower in 2022 and then back higher in 2023. Right now, the 2-year spread has disconnected from EUR/USD spot, suggesting there could be downside in the currency pair.

Why is the bond market potentially not as excited about the move in the EUR/USD? Perhaps it’s due to the relative performance of the economy. The economic surprise index is a measure that calculates how well economic data comes in relative to expectations. It does not look at the absolute performance of the economy, but the relative performance vs. expectations. I analyze it on a short-term basis because the pair is quite mean-reverting. When the data is better than expected, expectations rise, and when the data is worse than expected, expectations fall. Now, if you look at the differential between how European data is coming in vs. how U.S. data is coming in, you can see how the EUR/USD may behave in the short-term, as investors always care about marginal change. In fact, there is a decent fit in these two series. I can see that coincident with the recent high in the EUR/USD pair, European data has been coming in relatively worse than U.S. data. Perhaps investors are changing their perceptions of what the central banks should do in the coming meetings?

Another principle is that capital flows to where it is most favorably treated. While this includes all asset classes, traders often think of it more from an equity market perspective because these markets dominate retirement accounts, brokerage accounts and the media headlines. Early this year, many that changing U.S. policy would lead to a weakening dollar and money flowing out of the U.S. and into Europe and Asia. In the first quarter of the year, this seemed to be the case. However, since Liberation Day in early April, while the dollar has continued to weaken, European stocks have almost entirely surrendered their relative gains compared to U.S. stocks. Is capital flowing back into the U.S. and out of Europe, possibly due to  AI or other factors? If so, is the EUR/USD currency pair about to struggle?

One factor that could be influencing economic data, central bank expectations and investor expectations in the stock market is the price of oil. In this chart, I invert the price of oil as I compare it to the EUR/USD pair. Europe is more negatively impacted by higher oil prices because it must import its raw materials and energy. The U.S. is energy-independent and has become more of a “petro-currency” because it produces the marginal barrel of oil on the world stage. On a relative basis, Europe is hurt by higher oil prices while the U.S. is neutral or maybe even benefits from higher oil‌ prices. I shouldn’t be surprised to see the relationship in the chart above. As oil has recently moved higher on the back of geopolitical tensions in the Middle East, is this another catalyst for a move lower in EUR/USD?

Let’s turn to ‌volatility markets to see how they may be pricing in a move lower. In the top chart, I examine the CVOL Index and observe that after the spike in volatility during the EUR/USD rise in April, while futures have continued to move higher, volatility has since decreased and volatility  is now within the middle range of its three-year history, essentially returning to “average” levels. However, the bottom chart may be more telling. It looks at the relative pricing of upside (EUR call) vs. downside (EUR put) options. As is usual in FX, the skew ratio is heavily dependent on the trend in the futures price. I can see the strong co-movement of the two series over the last few years. Once again, traders see a divergence. Futures prices continue to be near the highs, while the skew ratio has come back to almost even (a level of one suggesting calls and puts at the same volatility). This suggests either investors are selling inflated call levels or buying relatively cheap puts. The options market suggests that futures prices could head lower, and the overall cost of options are not that demanding.

This year, as EUR/USD has risen, another significant trend has emerged: the open interest in the EUR/USD futures and options has also increased Investor interest in ‌currency futures has come alive on the major moves in the FX market. This tells traders that there is plenty of volume and liquidity to execute their trades.

Going under the premise that many may be long EUR either as a speculative long or as a core position that has been left long (unhedged) given the strong trend higher in EUR/USD, I looked for a good hedge for the rest of this month. Why? Technically, EUR/USD looks like it may be rolling over. This could be driven by interest rate differentials, relative economic data performance, the movement in oil‌ or relative equity performance. All point to lower EUR/USD, at least in the near term. With an ECB meeting on July 24 and an FOMC meeting on July 30, I wanted to find a hedge as either or both events can serve as a catalyst. I looked at the WE5N5 contract, which expires on Wednesday, July 30, after the second of the two catalysts. With calls and puts being priced similarly, I chose to sell a 1.18 call and use the proceeds to buy 2 1.16 puts. While the strike of the put is further out of the money, given the divergence of EUR/USD futures vs. the historical drivers of performance, if it moves lower, the move could be large. By buying puts slightly more out of the money, I can buy more of them and still have the hedge be zero cost. The top chart shows what a long EUR/USD futures hedged in this fashion would look like. On a move lower, after getting to the 1.18 strike, Profit & Loss flattens. The biggest risk is on a move down to the long strike at 1.16. However, if it keeps going from there, the extra long put kicks in and P&L starts to turn positive after the 1.1450 breakeven. Thus, even with an initial long futures position, assuming no trades, one could make money on the move below 1.1450 and up to 1.18, with the risk being a move down to and stopping at 1.16.

Let’s assume a trader has no position on, but they use the same options trade. In this case, their expected return would look different. Their P&L would be flat up to 1.18 as it is a zero-cost structure. However, above 1.18, they would lose on a 1 to 1 basis as if they were short futures. On the downside, they do not make any money until futures move below 1.16 but after that point, a trader could make money on a leveraged basis because they own not one but two puts. You can see this as the line moves higher on a 2 to 1 slope below the strike. There is risk on a move higher, but given futures have already disconnected from fundamentals, this may be a risk worth taking.

The liquidity and volume in EUR/USD futures and options combined with daily expirations gives traders flexibility to either hedge an existing position, or tactically trade to take advantage of potential futures moves, and do so in ways that may offer a better reward to risk than futures alone. The products and tools at CME Group give traders everything they need to be successful.

Good luck trading!

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