LONDON (Reuters) - Currency derivatives tied to the outlook for the euro fell to their lowest level in more than a year on Tuesday, pointing to further weakness for the single currency as a sharp selloff in Italian debt spilled into foreign exchange markets.
Risk reversals on the euro, a gauge of demand for options on a currency rising or falling, fell to their lowest levels since late April 2017, indicating that demand for euro puts has surged to protect downside risks.
Markets are concerned that snap elections that could take place in Italy as soon as August, might serve as a quasi-referendum on the country’s role in the European Union and euro zone and strengthen its eurosceptic parties even further.
Risk reversals for one-month and three-month tenors EUR1MRR= EUR3MRR= are now at levels last seen just after French presidential elections in 2017.
The sharp drop in risk reversals in recent weeks indicate that sentiment towards the euro has flipped considerably since the single currency’s rally in the opening weeks of 2018.
Weakness in the single currency since February has wrong-footed market participants who had bought derivative structures betting on further currency strength through purchasing euro calls and funding them by selling euro puts.
But that left them exposed to big losses if the currency weakened sharply. The euro has fallen more than 7 percent since hitting $1.2556 in mid-February with most of its losses coming in the last two weeks.
JP Morgan strategists said hedge funds are short the euro.
“A decent euro short base by hedge funds is consistent with what our FX trading desks are seeing,” Nikolaos Panigirtzoglou, a strategist at JP Morgan said in a note.
To view a graphic on Euro risk reversals and positions, click: reut.rs/2LDYil2
“Rather than taking any directional calls on the euro, markets are gearing up for more volatility in the currency,” said a derivatives trader at a U.S. bank.
The euro EUR=EBS dropped below $1.16 for the first time in 6-1/2 months on Tuesday, down 0.3 percent on the day. Against the Swiss franc, it fell by a similar margin to 1.1528 francs EURCHF=EBS. [FRX/]
Despite the selloff in the single currency in recent days, down more than 3 percent in the last two weeks, fund managers said that longer term institutional funds were still holding on to their euro positions.
“We haven’t seen clients wanting to change their euro positions based on the Italian news in the last few days,” said James Binny, global head of currency at State Street Global Advisors.
Implied volatility EUR1MO=, a gauge of expected price swings in the euro currency for one-month and three-month tenors have jumped this week to their highest levels in nearly four months as investors brace for more market volatility.
Editing by Matthew Mpoke Bigg