(Bloomberg) --
Traders betting volatility in the euro will pick up once central banks turn hawkish are about to be put to the test.
Hedge funds are rushing to add topside exposure in the common currency by the biggest volumes since the summer of 2020, according to a Europe-based trader familiar with the transactions who asked not to be identified because they aren't authorized to speak publicly.
The surge comes after European Central Bank President Christine Lagarde signaled that the Governing Council is taking a hawkish turn, joining peers like the Bank of England and Federal Reserve as they look to scale back the extraordinary stimulus unleashed during the pandemic.
The setup is perfect for traders who want to capture the shift. An ECB hiking cycle is a game changer that will affect asset allocation for months, yet one-year implied volatility is still trading well below its longer-term averages.
Signs of a shakeup in the market are already visible. The euro had its best day against the dollar in 16 months on Thursday and is adding to those gains before the week comes to a close. It climbed as much as 0.4% to $1.1484 on Friday, the strongest level in almost three months.
Demand for long gamma -- long volatility in other words -- is also picking up. One-week implied volatility rose to the strongest level since mid-December while three-month hedging costs are now at their highest since December 2020.
The euro's volatility skew, meanwhile, has moved in favor of euro calls in the front-end. While the inversion may be challenged heading into the ECB meeting in March, for now the currency is taking cues from the money market, where traders are betting the ECB key rate will rise to zero by year-end.
Higher interest rates in the euro-area mean the common currency is also losing its allure as funding currency for carry trades, which for years has been drag on performance.
Elevated realized volatility should pull implied metrics higher as well, especially as long-dollar exposure comes to the test given that Fed rate-hike pricing may have peaked.
- NOTE: Vassilis Karamanis is an FX and rates strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice
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