As Europe Wobbles, FX Options Signal Distress

Europe's never-ending debt saga has investors girding for volatile, unsteady currency markets for years to come.

This debt crisis has also boosted bullish bets on the world's safe havens -- the U.S. dollar and yen -- well into the next 24 months in the options market, reflecting fears that problems in the euro zone could linger for years.

There's enough uncertainty surrounding Europe and the global economic picture that higher volatility will likely become a feature of this market for some time. And it's more or less across the board, said Aroop Chatterjee, senior currency strategist at Barclays Capital in New York.

This is the second time in four years that the options market has signaled such a high level of anxiety. Right after U.S. investment bank Lehman Brothers collapsed in September 2008, currency option prices options spiked as investors paid a high premium for protection against the market's big moves.

Now the same scenario is playing out. And it's anyone's guess as to when it ends.

Implied volatility on one-month euro/dollar options surged to 18.35 percent on Monday -- the highest in at least 2-1/2 years. That 18 percent figure is equivalent to expectations for a roughly 5.2 percent move in the euro over the next 30 days, options strategists said.

Implied volatility, or vol, is a measure of the options market's expectations of price movements.

Tuesday's speculation about plans to boost the euro-zone bailout fund did little to ease fears that the fiscal crisis could drag on, especially after Germany and Spain poured cold water on the idea.

Euro vols did retreat on Tuesday, but have generally traded above the 50-day moving average since early September.

One- to two-year euro/dollar vols were also elevated at nearly 17 percent, generally an indication of stress.

Heightened volatility in the one- to two-year time frame is unusual, analysts said. Normally, investors tend to sell long-term volatility even as short-term volatility spikes.

The fact that volatility is heightened down the road suggests worry that markets will remain unsettled.

You have basically entered a period where front-end vols have really gone up and the long end has sort of tracked the front end, which is a function of risk aversion, said Aditya Bagaria, FX options strategist at Credit Suisse in London.

EMERGING MARKETS ALSO SEE WORRY

In a clear sign that European contagion is spooking investors, option hedges against some of the best-performing emerging market currencies have soared as well.

The rise in volatility there underscores the vulnerability of these assets in times of stress despite their strong economic fundamentals. Already, these markets are experiencing capital outflows, similar to 2008.

Vols on one-month U.S. dollar/Mexican peso pair exploded to 28.4 percent on Friday, a roughly 2-1/2 year high from as low as 8 percent in July. Traders said one-week Mexican vols had traded as high as 45 percent.

The peso's one-month vols, though, slipped to 24.8 percent on Tuesday, but the increase in volatility is consistent with the peso's 8 percent drop against the dollar this year.

Vols in the Brazilian real, the Turkish lira and the South African rand have also surged, just as they did three years ago.

Investors have realized that, if more than half of the world is to have (stalling) growth, emerging markets will not likely have an easy time, said Stephen Jen, managing partner at hedge fund SLJ Macro Partners in London.

I think (emerging market weakness) will continue, even if large interventions slow down the pace of the prospective dollar rally. Too many long-term real money investors are still in these long-EM trades for the dollar rally to be over.

RISK REVERSAL SKEWS

Further signs of stress are evident in risk reversals, a key indicator of risk sentiment in the options market. Risk reversals in major currencies are all showing a strong bias to hold U.S. dollars -- still considered a bet on safety.

One-month Australian dollar/U.S. dollar risk reversals, for instance, showed a put bias of -7.60 vols on Monday, the most extreme skew since at least 2007, but slipped on Tuesday. In general, put options suggest more investors are betting on a decline in the Aussie than a rise. The higher the number, the more bearish investors are on the currency.

Risk reversal skews favoring the greenback are further supported by positioning among hedge funds, such as Quaesta Capital in Zurich, Switzerland, which has increased long U.S. dollar positions in the last week in its $3 billion currency fund of funds.

Extreme long positioning in the Australian dollar also contributed to the negative bias. Real money accounts, Japanese retail investors and speculators are still clinging to Aussie net longs, though short-term investors are paring positions.