Monday, November 30, 2015

Trade Idea: Positioning For ECB

The expectation for the next ECB is running high. Many from ECB, including Mr. Draghi, has already talked up further measures. There are already talks of telescopic monetary policy taxation in the air. And a lot of speculations to follow.

The ECB announced QE at the end of Jan this year. Then the market priced in QE aggressively as well, and yet ECB over-delivered. The continuation of the movement past the announcement and well past the start date is a proof of that. This time as well the market has priced in possibilities of further measures aggressively. The question is this time, will they deliver, or over-deliver?

The recent moves in the market in many way resembles the time period before the last QE announcement. And at the same time differs in some crucial details. The major similarities: 1) selling off in Euro, 2) rally in the front-end and major differences are 1) remarkable steadiness of the long-end and 2) steepening of the curve. In the figure below we show the excess moves in rates and slopes (relative to the US). The Blue columns are the move in the last QE. Red one current moves and the green columns shows what the current move should be if we adjust for the move in Euro (that is we assume the euro move correctly prices expectation and compare rates move based on that). As we can see the move in the front end much stronger than before, and reverse for the long end. In fact corrected for euro, the move in 10y is about fair. While 8th euro futures rallied most and 30y did much less than expected.

The bone of contention here is of course what exactly will the ECB do. As clear from the picture above, the market is fully or to a large extent pricing in an action in the front end, that is, a significant depo cut. And with all the stories of -20/-50 tiers or -35 flat or all other possible combination, it is hard to say what happens if ECB does a significant deposit cut. There is no reason to believe they cannot exceed expectation. So perhaps short end move is justified.

But here is the key. Whatever be the depo cut, it is in itself not important. It is plausibly true that the point of this depo cut is simply to make the QE program more tenable. With 15% of euro area govies trading below current depo, the ECB has a strong incentive. The question is if they do deliver, what does that mean for long end. It does not mean we have an increased supply, nor it means depo is reflationary. All it does it to save the QE program by making more bonds eligible. I have not checked for euro area, but based on Germany distribution of yields and amount outstanding, roughly a move from -20 to -35bps makes 84b more available. With a capital key of 18% that is ball-park 470b more papers to buy for ECB, approx. 8 months worth of QE. This is significant. But we also have to count in the feed-back response, as the market may potentially push the curve further down, and thus neutralizing a part of the impact the ECB hoped to create. So if this depo rate comes with any significant expansion of QE in terms of time or size, the long end should be biased for rally. And if the depo rate cut does not match market expectation, the short end will sell off back to previous levels.

And while we have all these, another point to note is the levels of vols. The implieds are way to high compared to delivered. But if we adjust for the Fed hike expectation (by computing implied/realized premiums in EUR over USD), the front ends are still cheaper compared to long end on a realized basis, with 5y around fair.

I believe whatever ECB does, it will hardly be a lasting change. Europe needs fiscal stimulus now. Monetary policy is just a tool to avoid falling behind, but can hardly give a large push ahead. Whatever the move follow the momentum, and then position for a fall back. ECB claims the QE has "clearly" worked, but the real rates in euro area were back at the 2014 levels at end of August, before the new QE expectation kicked in.

The trade here: A convex flattening position in 5s30s or 5s10s. If not through spread options, given the vol richness and underlying directionality, buying the belly payer vs. long end looks better than the alternative in a risk-reward consideration.  Otherwise a Nothing. Wait till the announcement and no point trying to fade the market from here.

EDIT (3-Dec-2015:08:55 UTC): The hidden risk to this view is the ECB doing away with the yield-floor limit for QE eligibility. That may lead to a large upward correction in long term yield and a significant steepening.

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