EUR/USD: Is 1.35 Plausible?

by: Evariste Lefeuvre

Futures positioning (long/short IMM speculative positions for noncommercial futures) has little forecasting power for the forthcoming trend of the EUR/USD. It tends to occur in tandem with underlying pair moves.

Risk reversal provides much more information for determining the direction of the pair. Risk reversal is the difference between the volatility of the call price and the put price with the same moneyness level. 25 delta risk reversal is the combination of buying 25 delta out of the money Call and selling 25 delta out of the money Put for the same maturity.

RR25 = 25Δ Call Vol - 25 Δ Put Vol

A negative figure means that put options are more expensive than same moneyness calls. In the FX world, the option strikes are fixed at 25% delta.

A one-year 25 risk reversal for the EUR/USD provides an idea of the degree of faith in the current trend of the pair. A falling RR25 suggests that investors are less confident in the strength of the EUR/USD, thus the cost of hedging on the downside grows.

The charts below highlight the predictability power of 25RR. In Episodes 1 and 2, 25RR on the EUR/USD fell before the EUR/USD, providing a signal for the weaker EUR/USD several months in advance.

Click to enlarge

It happened in late 2009 and mid-2011. As can be seen on the short-run chart (above, right) the EUR/USD 25RR soared this summer. It led the recent appreciation of the EUR/USD. If history is a guide, the EUR/USD should increase to the level implied by the 25RR: 1.35.

Looking at the technical analysis, it makes sense (50% retracement of the fall initiated last spring).

Click to enlarge

This is far from a mainstream scenario. The next strong resistance for the EUR/USD is 1.27 and many investors think that such a level would stop the recent rebound.

Yet, good news from Europe (cap on yields coupled with a non-preferred creditor status of the ECB and a more aggressive than expected QE3) could be enough to make the EUR/USD spike.

As can be seen below, 1.35 is clearly possible if the Fed expands modestly its balance sheet. The usual, QE2-like bull market in equity markets would come along.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.