By Julie Haviv
NEW YORK, Oct 10 (Reuters) - Foreign exchange options
investors remained cautious on Thursday curbing bets that would
profit from a stronger dollar as Washington showed some signs of
reaching a temporary deal to reopen the government and avoid a
disastrous U.S. default.
The greenback, which had weakened since the U.S. government
partially closed on Oct. 1, gained ground on Thursday on signs
of progress toward ending the U.S. budget deadlock and debt
limit deadline in Washington.
But if politicians fail to be forge an agreement, the U.S.
currency, which hit an eight-month low versus the euro last
week, should continue to weaken.
A reflection of the heightened market uncertainty is evident
in one-week euro/dollar risk reversals, a broad
gauge of currency market sentiment, which show options investors
on Wednesday and Thursday seeking the smallest protection
against the euro's depreciation versus the dollar in eight
Adding momentum, one-year risk reversals showed
demand for euro puts, the right to sell the euro versus the
dollar at a future date, not far from Wednesday's level when it
reached its smallest since July.
This indicates that bullish dollar sentiment has waned in
the hedge fund sector that largely drives demand for short-term
risk reversals and has broadened to long-term investors.
Options investors are "no longer pricing in a premium for
dollar calls, which indicates investors have been buying
protection against a weaker dollar," said John Hopkinson,
foreign exchange and derivatives strategist at BoA Merrill Lynch
in New York.
"It is reasonable to assume that a (U.S. debt) default is a
scenario that they are concerned about," he said.
A partial U.S. government shutdown is in its second week and
there are only seven days left for Congress to raise the U.S.
debt ceiling. Congress must strike a deal by Oct. 17, when the
government will run out of money to pay its bills, according to
Treasury Secretary Jack Lew.
Indeed, December $1.39 euro calls were actively traded
early on Wednesday, according to Matthew Schilling, a
commodities broker at RJO Futures in Chicago.
Investors who buy these calls expect the euro to rise above
that level before they expire in December, far above where the
euro last traded at $1.3528.
Moreover, on Thursday, there were 2.7 euro calls for every
put, above a ratio of 2.4 earlier this week.
"The dollar has got two headwinds going on, one is the debt
ceiling and the other is the nomination of Janet Yellen as the
next Federal Reserve chief," Schilling said.
U.S. President Barack Obama nominated Fed No. 2 Yellen on
Wednesday. Investors expect her to tread carefully in winding
down economic stimulus.
The Fed's $85 billion per month bond buying program, called
quantitative easing, is negative for the dollar as it is
tantamount to printing money.
Should the U.S. default on its debt the "dollar should
initially fall precipitously, but would rebound sharply as the
safe-haven flows spark a rush back into dollar denominated
assets," said Brad Bechtel, managing director at Faros Trading,
in Stamford, Connecticut.
"First, there will be a large outflow from the U.S. as other
markets around the world start to falter, but safe-haven bids
will return to the dollar," he said.
In the latest Reuters poll of foreign exchange strategists
the overwhelming majority forecasted the dollar to rebound over
Ken Dickson, investment director of currencies at Standard
Life Investments in Edinburgh, Scotland, who helps oversee
$271.2 billion in assets, expects the dollar's "outperformance
to re-assert itself" towards the end of the year and through
"The dollar was already attractive on valuation grounds and
recent trading suggests that shorter term players have built up
short dollar positions," he said. "We expect the U.S. economy to
outperform developed economies over the next few quarters, so
incoming data now holds the key," to the dollar's direction.
Nevertheless, implied volatility, or "vol", a measure of the
options market's expectations of price movements, on one-month
euro/dollar implied volatility rose as high as 7.50
percent on Wednesday, its highest since early September. On
Thursday it dipped to around 7 percent.
"However the tail risk is large and as we move closer to
mid-October, vol is likely to increase," making it more
expensive to hedge currency positions, said Camilla Sutton,
chief currency strategist at Scotiabank in Toronto.