Europe: How Markets View Integration Versus Disintegration

How markets view integration versus disintegration

Originally published in the October 2017 issue

Opposing forces championing integration versus disintegration are assailing Europe. In the past two years both sides have scored important victories. Britain’s Brexit, Spain’s Catalonian independence referendum and the entry of the nationalist Alternative fur Deutschland (‘AfD’) party to the German parliament, or Bundestag, were victories for proponents of lesser European unity. The electoral defeat of far-right forces in the Netherlands and the victory of Emmanuel Macron in France were celebrated by those favoring the guiding principle of an ‘ever closer union’.

Whatever one thinks of Brexit, the prospects for deeper European integration and the legitimacy of the various national independence movements, the currency markets’ view is unambiguous: they strongly favor deeper political integration:

  • When exit polls mistakenly called the Brexit referendum for the ‘Remain’ voters, the British pound (‘GBP’) rallied from 1.45 to 1.50 versus the US dollar (‘USD’) before crashing, first to 1.32 and later to as low as 1.18 versus the USD when the ‘Leave’ victory became apparent. The euro fell 3% versus the USD on the day of the Brexit referendum and fell nearly 10% versus the USD within six months.
  • Euro rallied 2% versus the USD in the week after Dutch voters dashed the hopes of the Geert Wilder’s Eurosceptic Party of Freedom.
  • Euro soared more than 10% to a two-and-a-half-year high in the weeks after Macron won the French presidential election on a platform advocating domestic economic reform and deeper European integration.
  • September’s German election results halted this advance after it became apparent that not only did AfD enter the Bundestag, as expected, but that Angela Merkel underperformed the polls by about 5-6% and would have to create an unwieldy coalition with the enthusiastically pro-European Greens and the Free Democrats, who oppose deeper economic integration.
  • Catalonia’s independence referendum led to a 1% one-day decline in the euro, further offsetting gains from the Macron victory. Ninety percent of Catalans voted to leave Spain in the referendum on Oct 1 that the Spanish state considers illegal and attempted to repress with force, leading to nearly 900 injuries.

In each case, a victory for the forces of integration sent European currencies higher, while a victory for the forces advocating less unity, whether within or among nations, led to weaker currencies.

In addition to the political concerns there are, of course, many other factors that determine the direction of the euro-dollar (‘EURUSD’) and pound-dollar (‘GBPUSD’) exchange rates, including the relative economic strength of the eurozone, the UK and the US and the relative direction of monetary policy. Solidifying recoveries in the eurozone and the UK combined with the seeming inability of the US Congress to pass anticipated economic reforms boosted European currencies and weighed on the dollar for much of 2017.

What is remarkable, given both political concerns and trans-Atlantic monetary policy divergence, is the lack of concern by options traders. So far this decade, implied volatility on 90-day options on EURUSD futures has traded between 5% and 18%. Recently, it has been trading at around 7%, close to the lower end of the range. Likewise, since January 1, 2011, implied volatility on 90-day GBPUSD options has traded between 5% and 19%, and recently has been hovering at around 8% (Fig.1).

Given the unsettled nature of US, UK and continental European politics, it strikes us that options markets are unusually sanguine. Of course, EURUSD and GBPUSD options markets are hardly alone in assigning low prices to put and call protection. Other currency pairs like the Australia dollar-US dollar (‘AUDUSD’), Canadian dollar-US dollar (‘CADUSD’) and Japanese yen-US dollar (‘JPYUSD’) are also trading near historic lows. Moreover, options on equity index futures, government bonds and precious metals are also priced near historic lows.

The common denominator that may explain the low level of implied volatility on options across four asset classes is the massive monetary expansion undertaken by the Federal Reserve (‘Fed’), European Central Bank (ECB), Bank of Japan and other central banks. Easy monetary policy has generated enormous amounts of cash and may be making it exceptionally easy for buyers and sellers of various currencies, bonds, stocks and metals to transact with one another without prices moving significantly.

The major risk to this state of affairs is central bank tightening. The Fed has already hiked rates four times in its current cycle and this month will begin reducing the size of its massive balance sheet. Moreover, it put markets on notice for a highly-anticipated rate hike in December and more next year. Fed expectations, in particular, remain a key driver of the EURUSD exchange rate (Fig.2). Meanwhile, the Bank of England is considering raising rates for the first time since 2006 while the ECB contemplates further tapering the pace of its asset purchases. None of these factors will necessarily create a short-term explosion in volatility. That said, issues that the markets have been poo-pooing, such as the progress (or lack thereof) in Brexit negotiations, the Catalonian independence movement, Merkel’s attempt to build a coalition, the situation on the Korean peninsula and the state of affairs in the US Congress have the potential to generate increasingly stronger market reactions.

In the past, equity-market volatility has lagged movements in Fed rates by 12-24 months. Given the tendency of volatility to follow monetary policy tightening with a 1 to 2-year lag, it’s not much of a surprise currency and other markets have shown such a muted response to recent developments in Europe and elsewhere, thus far. After all, the Fed has only been tightening in earnest for the past nine months. Presumably, the strongest impacts of it draining liquidity from the system won’t be felt until 2018, at the earliest. Even in the short-term, however, there are still reasons to be concerned that European currency options markets are too complacent:

  • The progress of Brexit negotiations remains a major question mark given the fragility of Prime Minister Theresa May’s governing majority. A ‘soft Brexit’ could send GBP soaring. A ‘hard Brexit’ or UK political turmoil could send GBP plunging back towards post-referendum lows.
  • The Catalonian situation could become increasingly volatile with the possibility of Catalonia’s government declaring independence against the wishes of Spain’s Prime Minister, and the King.
  • A CDU/CSU/FDP/Green coalition in Germany could prove unwieldy and unstable and could hamstring Merkel and Macron’s efforts towards deeper European integration.
  • Italy could hold elections soon that could throw another spanner in the works in Europe.
  • Macron’s popularity has dropped below 40% as he attempts to enact key reforms and push for deeper European integration.
  • The ECB’s eventual tapering of its asset purchase program could also send markets on a wild ride, especially if the central bank is no longer seen as being willing or able to backstop Spain and Italy’s debts.
  • Transitions from Fed Chair Janet Yellen and ECB President Mario Draghi to new leaders could also create volatility exceeding what options markets have priced.

Bottom line

  • Although Europe and US are well into their economic expansion, political tensions unleashed by the 2008 financial crisis remain an influence on exchange rates and other markets.
  • Forces pitting deeper integration against political disintegration continue to buffet currency markets.
  • Monetary policy divergences are more extreme than ever.
  • Options traders may have been lulled into complacency by years of easy monetary policy.
  • Tighter monetary policy might create a bull market in implied volatility.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.