At the end of a week when Greece remains teetered precariously on the precipice of bankruptcy and Eurozone expulsion the EUR is poised to end the week higher versus the USD. Gone are the days when the EUR would tumble 300-400 pips on a stalemate between Greece and her creditors, so what is going on and is this the calm before the storm for the single currency?
We think that this time the market is reacting differently to the Greek crisis for a few reasons:
- Greece is considered a political not a financial problem, thus it should not have a long-term impact on EUR-based assets.
- Ireland, Spain and Portugal are in stronger fiscal and economic positions than they were in 2010 and 2012, hence the risk of contagion is much reduced.
- The radical political backdrop in Greece is not replicated across other peripheral nations.
- The private sector only has limited exposure to Greece, thus recent declines in Greek asset prices do not mean that there has been enhanced downward pressure on other peripheral European markets.
This does not mean that the market is oblivious to the Greek risks. Interestingly, the spot market is fairly sanguine, but there has been a lot of activity in the options market suggesting that traders are hedging their bets, putting upward pressure on EURUSD 1 month volatility, as you can see in figure 1. Digging a bit deeper into EURUSD volatility, we used our Bloomberg terminal to measure the spread between 1-month implied volatility and 6-month implied volatility for EURUSD, as you can see in figure 2. The conclusion is interesting, 1 month volatility has been consistently higher than 6-month volatility for most of this year. Usually, one would expect uncertainty about a currency to rise over time, not to fall, after all, none of us can predict the future.
So, what is going on? The rise in short term volatility suggests to us that the market is concerned about a Greek default and expulsion from the Eurozone and the disruption this could cause to risky asset prices. However, if Greece is cut loose, in the longer-term this should not impact the single currency. Cast your mind back to 2012, the last time that Greece teetered on the brink of bankruptcy and Eurozone expulsion, and the ECB chief Mario Draghi said that he would do “what it takes” to save the Eurozone. This calmed Greek fears and caused risky assets to rally. We have reached the moment where someone needs to stand up and say they will do all that it takes to save Greece to keep it in the currency bloc. This would be the only outcome, in our view, that can stem the 18% decline in the Greek stock market over the last week and cap Greek bond yields. But this time though, there is a big difference; saving Greece is not the same thing as saving the Eurozone, hence the market is not pricing in a catastrophe for the EUR, and it appears to be fairly confident that the single currency will continue to exist in the future.
For this reason, we continue to stick with our view that EURUSD will not fall back to this year’s lows at 1.05 in the coming months. Instead, we would expect a knee-jerk reaction lower towards 1.12 and then 1.1050 if we don’t see a breakthrough during Monday’s European leaders summit on Greece. If the sell-off is sharper then we expect then we may even break this level and get back to 1.08, however, in the long-term we are neutral on the EUR. The reasons are two-fold:
- Greece is considered a political not a financial problem, thus should not have a long-term effect on EUR-based asset prices.
- The Fed has stated its sensitivity to dollar strength, which could limit upside in the greenback over the summer months.
Thus, we’re not giving up on the single currency, and any sell-off post Monday’s summit could be a decent buying opportunity.
Although EURUSD has been rising this week, so too has EURUSD volatility…
Longer-term volatility is lower than short-term volatility, which is unusual in the FX market and suggests faith in the existence of the EUR in the long-term.