Risk reverals in the EUR/USD have hit an extreme level. The 25 delta 3 month risk reversals are at the highest level since June 2007. Whenever risk reversals hits critical levels, it indicates that everyone who wants to be long euros are already long and as a result, sentiment has hit an extreme.

The last time EUR/USD risk reversals came near current levels was in June and September 2007. Both times, we saw a relief rally in the US dollar that lasted for approximately 250 to 300 pips. This time around, risk reversals are once again telling us that the US dollar has become oversold and is due for a further rally. But like in June and September, the long term downtrend in the dollar is intact.

Source: Bloomberg

Will the Fed Intervene to Prop Up the Dollar?

The dollar is also rallying because this morning, Bernanke said that forex intervention should be done rarely and that USD intervention may be justified in disorderly times. Most of us would argue that current conditions can be described as “disorderly.”

But intervention would not accomplish much as this point. The main reason for intervention in the dollar would be curb inflationary pressures and inflation expectations. Even though CPI hit the highest level in 17 years on an annualized basis, oil prices have fallen $13. A steeper decline would naturally curb inflation expectations. The only other reason for intervention would be to restore investor confidence in the US equity markets.

Risk reversals measure the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta.