Trading the ECB: limited EUR weakness and bund rally likely but risks

My accompanying post details how the return of EA deflation, EA inflation expectations are in the process of de-achoring plus deteriorating EA and foreign activity mean that the 10 March ECB meeting is shaping up to be make or break for EA prospects and ECB credibility. I argued that the likely downward revisions to the ECB’s inflation forecasts (to around 1.4%-1.6% in 2018) should theoretically drive a strong risk-management driven policy easing (20bp deposit rate cut, tiered interest rates, LTRO extension, €10-20bn increase in monthly QE purchases plus technical adjustments).But there’s also a distinct possibility of disappointment given apparent ECB divisions, worries about adverse side effects and ECB staff being sanguine about second round effects (2018 inflation then around 1.7%-1.8%). Here I detail likely market impacts in the different scenarios. The main points are:
• Elevated two-week EUR implied volatilities indicate that markets are not expecting the 10 March ECB meeting to be boring.
• But risk reversals illustrate that markets are not pricing general EUR weakness to result (either immediately, or in the coming months).
• The recent EUR retracement reflects ECB policy easing expectations, both via the impact on lower bund yields and recovering EA equity prices (market risk appetite).
• ECB over-delivery would likely be generate further bond rallies, especially bunds   unless the capital key rule is amended.  Equity prices would also be supported.
• The EUR’s continued funding currency nature means that it’s only likely to fall a little, not sharply, on ECB over-delivery unless market risk appetite is substantially supported (which seems a stretch given global worries see here).
EURJPY and EURSEK short positions seem attractive given the BoJ’s and Riksbank’s likely difficulty in matching the extent of ECB easing, Sweden’s stronger prospects and the fact that both JPY and SEK look undervalued.
• While my bias is also for further grinding EURUSD downside on ECB over-delivery, especially given recent improving US activity and inflation data, this is likely more a H2 development given that the Fed will likely also be dovish on 16 March.
• Conversely, fresh ECB disappointment (e.g. only a 10bp deposit rate cut) would likely see EA bonds sell off (especially periphery), EA equities retrace and the EUR re-strengthen. EA inflation breakevens would also likely plunge.
•  This tightening of financial conditions would be very dangerous for the EA.
• But short EURJPY positions could also benefit with ECB disappointment, given the likely JPY support from falling risk appetite. I wouldn’t rule out short EURSEK positions also doing OK if markets focus on economic fundamentals after an ECB disappointment.

Markets anticipating action next week

The first thing to note is that markets are anticipating the ECB having a substantial impact one way or another.  Specifically, EUR 2-week implied volatilities have spiked notably, with the EURUSD ones approaching their early-December levels (in advance of the ECB and Fed meetings).  But markets are far from convinced that further EUR weakness is in prospect immediately after the – while EURJPY 2-week risk reversals have been grinding more negative as EURJPY spot has hit fresh lows, the equivalents for other EUR pairs like EURUSD, EURGBP and EURSEK point to limited EUR upsides.  This is unsurprising for EURGBP, given the Brexit risks I anticipated  here and here. The pattern are similar, but generally more pronounced, at longer maturities.

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EUR retracement driven by ECB anticipation

Several findings indicate that the recent EUR retracement (TWI down 2% in recent weeks) reflects the anticipation of ECB action: (i) the stalling of EURUSD’s ascent coincided with Draghi’s dovish European Parliament testimony; (ii) EURUSD movements have continued to be closely correlated with 10-year Bund-Treasury yield differentials, with Bund yields approaching April 2015 lows in anticipation of ECB action; (iii) the EUR TWI has continued to trade closely, inversely, with equity prices – consistent with the EUR’s role as a funding currency and hence “risk off” nature the wake of the ECB’s move to negative rates.  The EA’s large current account surplus also supports that role in the market’s eyes, although strictly speaking the surplus is fundamentally a sign of failure (insufficient EA investment to absorb domestic (precautionary) savings and the EA lacks Japan’s substantial stock of foreign assets (to be repatriated in times of stress supporting the currency). Anecdotally spillover effects from heightened Brexit risks (see here) have also contributed to recent EUR weakness, given that Brexit could well cause substantial financial and economic turbulence in the EA as well as in the UK.

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The continued bund rally, in expectation of further ECB action, is of course notable in it’s own right.  Indeed, bund yields out to 9 years now lie below the current ECB deposit rate, forcing future purchases to longer maturities and hence flattening the yield curve unless the depo rate is cut or the rule are changed (I expect both, see my companion post). But French yields have also fallen in parallel.  The EA equity support is also notable, with the panic about the EA banks subsiding, although they continue to underperform their US and UK equivalents but move more in in-line with Japanese equities which also sufer from negative rate concerns.

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Trading a positive ECB surprise

The ECB exceesing market expectations e.g. via both a 20bp rate cut (with tiered rates) and an €10-15bn  increase in monthly QE purchases would likely see an extension of the recent EA government bond rally. Given the capital key, bunds would be expected to especially benefit, along with OATs to a slightly lesser extent. And that should give EA equities a boost, although the impact on bank stocks will depend on how credible the market thinks measures to protect banks margins are.

The EUR’s continued funding currency nature means that it’s only likely to fall a little, not sharply, on ECB over-delivery unless market risk appetite is substantially supported.  And that seems a stretch given the extent of global worries, see here.  Moreover, the EUR’s recent inverse relationship with the Dax features a relatively low-elastitcity: a 1% EUR fall has been associated with a 3-4% Dax rise. That said, the bond yield effect looks a bit a stronger – the recent 3% EURUSD fall was “only” associated with a 20bp fall in 10-year Bund-Treasury spreads.  And the recent clear out of EUR short positions may make any ECB positive surprise more impactful.

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So which EUR bilateral to establish short positions against?  My bias is also for further grinding EURUSD downside on ECB over-delivery, especially given recent improving US activity and inflation data.  Yesterday’s better than expected manufacturing ISM with improved price balances follows the recent upside core PCE deflator news and wage growth showing greater signs of life. But more substantial EURUSD downside seems more likely to be a H2 development given continued doubts about whether and when the Fed will raise again in 2016.  And the Fed will also likely also be dovish on 16 March, with the market likely focusing most on a probable cut to the dot plot. I eventually I expect market and Fed expectations (dots) to converge at two rate hikes in  2016, but it will likely take a few months before the market grudgingly accepts that.

But a short EURJPY position looks attractive going into the ECB meeting from several angles (and I note that my mid-October short EURJPY recommendation, see here, has performed well):
• The BoJ is looking increasingly boxed in about implementing further aggressive easing, and so will likely struggle to match a decisive ECB move.  The recent move to negative rates (-0.1%) was only narrowly passed (5-4), while imposing them on such a narrow category of deposits indicates concerns about the banking sector.  Indeed, Japanese bank stocks has suffered about as much as those in the EA.  Concerns about QQE’s high holdings of government bonds, and the adverse impact on market functioning, also continue.
• Public concern about the impacts of JPY depreciation persist.
JPY looks undervalued from a long-term perspective, so attempts to further weaken it could get them into hot water with G20 members given the renewed pledge not to pursue competitive devaluations.
• The counterveiling argument is that JPY could lose some of its recent bid if the ECB easing substantially supports market risk appetite, but that seems unlikely.  But JPY long positioning is already quite stretched (see above) and there’s continues to be an active debate about whether Japanese investors will increasingly send money abroad.  But at least in the near term monetary policy seems likelty to dominate. And short EURJPY is a useful hedge should the ECB disappoint and risk aversion consequently spike.

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There are several motivations for a short EURSEK position running into the ECB meeting.
• The Riksbank will also likely struggle to match an aggressive ECB easing, although some easing is to be expected if the ECB acts decisively. Swedish rates are already at -0.5%, so they could be approaching levels where further cuts have a counterproductive impact on the banking sector. Expanding or extending QE (due to stop mid-2016) faces constraints from the already-high owndership of the stock of bonds (around a third) even if it’s a relatively-low share of GDP.
• But there also looks to be less need ease aggressively given that both growth and inflation have picked up more than the Riksbank expected. Q4 GDP growth of 1.3% qoq beat market expectations of 0.7%, with the 4.5% yoy figure exceeding Riksbank expectations of 3.6%. The strength was broad-based, with consumption rising 3.0% yoy while capex and exports are both up more than 7% yoy. Survey indicators have also been strong and the labour market is tight (with part of the 7.o% unemployment reflecting students). The recent rise in CPIF inflation to 1.6%, again higher than the Riksbank expected, may change their view that the “upturn in inflation is still not on a firm footing“.
Four of the six Riksbank board have doubts about easing.  Two members Riskbank minutes entered reservations about the 15bp February rate cut, while the minutes revealed that nascent strength of activity caused dounts for a further two.
• The Riskbank has recently motivated rate cuts by the need to constrain nascent SEK strength, given their inflation worries. But that seems more like a constraint on sharp EURSEK falls rather than a gradual movement: they’ve been clear that potential FX intervention aims to slow SEK rapid gains rather than to affect SEK in the long-run.  Previous Riksbank actions suggest that they likely won’t get serious about intervention until EURSEK falls to around 9.1.
•  Riksbank forecasts anticipate a gradual SEK TWI appreciation going forward.
• Like JPY, SEK looks undervalued from a long-term perspective.
EURSEK also looks expensive relative to 10 year rate differentials, which suggest rates of around 9.25 rather than the current 9.35, so there’s room for that gap to close and for rate differentials to shift further towards EURSEK weakness.
• Unlike EURJPY, implied volatilities are not particularly elevated and EURSEK risk reversals are not pricing downside (the trade looks less crowded).

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Trading ECB disappointment (not central case but a definite risk)

Conversely, fresh ECB disappointment (e.g. only a 10bp deposit rate cut) would likely see EA bonds sell off (especially periphery), EA equities retrace and the EUR generally re-strengthen. EA inflation breakevens would also likely plunge. Given the seriously adverse impact of such developments on EA prospects and ECB credibility, the ECB should hopefully strive hard to avoid them.

But short EURJPY positions could also benefit with ECB disappointment, given the likely JPY support from falling risk appetite. I wouldn’t rule out short EURSEK positions also doing OK if markets focus on Sweden’s inherently-better economic fundamentals and the bleak EA prospects after an ECB disappointment.

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