Commerzbank Sees EUR/USD Volatility Mispriced vs Energy

Key Moments

Options Market Seen Discounting EUR/USD Risk

Commerzbank strategist Thu Lan Nguyen questions why implied volatility in EUR/USD remains subdued even as the situation is characterized as the greatest threat to energy security in history. She observes that pricing in the options market does not appear to reflect the scale of the current shock.

Nguyen points out that the 3-month implied volatility for EUR/USD is trading at levels well below those seen at the onset of crisis episodes in 2020 and 2022, and even below levels observed shortly after Liberation Day last year.

She frames the current market configuration with the following assessment:

“… the implied exchange rate volatilities currently priced into the options market are almost shockingly low. The 3-month implied volatility for EUR/USD is trading significantly lower than it was at the start of the crises in 2020 and 2022, or even shortly after Liberation Day last year. How can this be explained, and is it justified?”

Monetary Policy Expectations as the Core Volatility Driver

Nguyen attributes the main source of expected foreign exchange volatility to shifts in interest rate expectations. In her view, anticipated changes in monetary policy – and the resulting impact on carry between currencies – are central to how exchange rates are repriced.

She explains the mechanism as follows:

“The source of (expected) volatility can generally be found in expectations regarding monetary policy. If a strong monetary policy response – i.e., significant interest rate cuts or hikes – is expected – meaning that a significant change in the carry differential between currencies must be anticipated – then a corresponding revaluation of the exchange rate must also occur. The greater the expected change in the interest rate differential, the greater the exchange rate change.”

Parallel Rate Repricing in US and Eurozone

According to Nguyen, the outbreak of the Iran war has prompted a notable adjustment in interest rate expectations in both the US and the Eurozone. However, she underlines that the scale of this repricing has been similar across the two regions.

As she notes:

“Interest rate expectations for the US and the eurozone have also changed significantly with the outbreak of the Iran war. However, at the moment, the magnitude of interest rate changes in the two currency areas is quite similar (just over 50 basis points). A significant change in the interest rate differential is therefore not expected.”

This parallel move in anticipated rate paths helps explain why implied EUR/USD volatility has not risen more sharply, given that the projected interest rate differential between the two currencies has not materially shifted.

ECB Reaction Function and Potential Market Repricing

Nguyen considers the possibility that the European Central Bank may react earlier than in prior episodes, but she remains more cautious than prevailing market pricing suggests.

She comments on the ECB’s potential stance:

“It may be that this time the ECB will not wait until inflation is already approaching double digits before raising interest rates. However, the hurdle for interest rate hikes is likely to be higher than the market currently assumes.”

On this basis, she warns that markets may need to reassess their expectations, which could in turn trigger larger FX moves:

“In this respect, there is potential for a correction and thus also room for stronger exchange rate movements.”

Implied Volatility Context

While the article does not provide explicit numerical levels for implied volatility, it emphasizes the relative position of current 3-month implied EUR/USD volatility compared with previous crisis periods and last year’s Liberation Day.