Euro Traders Face Risk of Complacency Ahead of German Elections
Key Takeaways:
* Euro options market suggests traders anticipate gains, but risk of political uncertainty remains.
* Stock markets are also pricing in a positive outcome, with the DAX at record highs.
* Coalition negotiations could create volatility if the center-right CDU/CSU fails to form a stable government.
* Some analysts recommend buying protection against a potential euro drop.
* The market is undervaluing the risk of the far-right AfD blocking budget reforms.
Analysis:
Despite the upcoming German elections this weekend, the derivatives markets remain unusually calm. The majority of euro options expiring after Sunday's vote are positioned for currency gains, indicating a fading bearish sentiment. Stock markets have also rallied, with Germany's DAX benchmark hitting record highs.
However, this complacency could prove costly if the center-right CDU/CSU alliance struggles to form a coalition after the elections. Such an outcome could drive the euro towards parity with the U.S. dollar, as uncertainty and political horse trading ensue.
Societe Generale SA and Commerzbank AG are both warning investors of the potential risks. Michael Brown of Pepperstone Ltd. suggests that the market is assuming a non-event, which could lead to significant volatility. Prolonged coalition negotiations could create a "worst-of-all-worlds scenario," potentially pushing the euro below $1.03.
Despite these risks, options traders remain optimistic. Data shows that 60% of options expiring Monday target a stronger euro. This suggests a belief that the currency will trade towards the higher end of its recent $1.02-$1.05 range after the elections.
Market expectations for post-election volatility are also muted. The premium for hedging against euro swings is below average, indicating limited anticipation of a sell-off.
However, some analysts caution that the market is undervaluing the risk of a surprise outcome. Mizuho Bank Ltd.'s Jordan Rochester believes that the market is underestimating the possibility of the AfD uniting with other parties to block budget reforms and government spending.
Credit Agricole SA strategists warn that a strong showing by the AfD could complicate coalition negotiations and push the euro-dollar pair back toward recent lows around $1.03.
The delay in forming a government could also prevent Germany from implementing necessary budget reforms and military spending increases amidst geopolitical tensions.
BNP Paribas' Sam Lynton-Brown highlights that coalition negotiations in Germany typically take more than two months, highlighting the potential for delays in addressing urgent issues.