Morgan Stanley Warns Traders Are Underestimating Risk of Sharp Euro Swings

Morgan Stanley warns that traders are underpricing the risk of sharp volatility in the euro, which could lead to sudden swings in the currency. According to David Adams, head of G-10 FX strategy at Morgan Stanley, the market is complacent about tail risks—unusual but potentially high-impact events—that could disrupt major currencies like the euro. The firm emphasizes that these risks are not entirely implausible but are currently overlooked by market participants.

Adams argues that the low volatility in currency markets since April's announcement of aggressive U.S. trade policies has lulled traders into a false sense of security. This complacency is particularly pronounced in the euro-dollar pairing, where Morgan Stanley outlines a wide range of potential price movements. The firm's bear and bull cases for the euro are set at $1.05 and $1.36, suggesting a potential 10% or more swing in either direction from the current level.

Recent geopolitical tensions, including President Donald Trump's rhetoric over Greenland and the independence of the Federal Reserve, have not triggered a significant rise in realized volatility. Despite these developments, the euro-dollar pair has shown relatively muted movements. This suggests that the market is not fully pricing in potential shocks that could arise from these scenarios.

Why Is the Euro Market Complacent?

Market observers note that the euro has touched a multi-month low amid renewed U.S. geopolitical rhetoric and trade policy announcements. The common currency's recent weakness has been offset by the possibility of Federal Reserve rate cuts, which could provide support. However, the underlying uncertainties—such as Trump's Greenland ambitions and the potential for a more aggressive Fed—remain underpriced in current trading behavior.

The J.P. Morgan gauge of emerging-market currency volatility over the next six months is near its lowest level in more than five years. This low volatility environment, while seemingly favorable for stability, may be masking risks that could materialize quickly. Morgan Stanley's analysis suggests that market participants should not assume these tail events are unlikely.

How Might the Market React to Sudden Swings?

If the euro experiences sudden and sharp swings, it could strain liquidity in the foreign exchange market. The $9.5 trillion a day currency market has mechanisms to absorb shocks, but rapid movements—especially in the wake of geopolitical or policy surprises—could overwhelm these systems.

The euro's potential 10% swings, as outlined by Morgan Stanley, could trigger large-scale rebalancing by hedge funds and other institutional investors. This could lead to further volatility as traders adjust their positions in response to changing conditions.

What Are Analysts Watching for in the Coming Weeks?

Analysts are closely watching whether U.S. trade policies, the Federal Reserve's response to inflation and employment data, and geopolitical developments will impact the euro. Trump's statements on Greenland have already raised concerns among European leaders, who are preparing for a range of possible outcomes.

The possibility of a U.S. military or commercial takeover of Greenland could trigger a shift in European monetary and fiscal policies, which in turn could affect the euro's value. European leaders are working to present a united front, emphasizing the importance of NATO and territorial sovereignty.

Morgan Stanley's warning highlights the need for traders to reassess their risk exposure, particularly in the euro-dollar pair. The firm's bear and bull cases suggest that a wide range of outcomes remains possible, and the market's current pricing may not be sufficient to account for these possibilities.