Friday, 1 November 2013

Market update - ECB in view

If you've followed me for a while on twitter or my daily webinars, it will be no surprise that the ECB could cut rates soon, In fact I've been calling for it since the end of the Summer. But all of a sudden the market finally woke up to the fact the ECB need to do something. Even though 25 bps won't do much to inflation / expectations / growth / unemployment, it will show that the ECB are ready and willing to act to prop up the EZ.

In terms of the options market this drop in the EURUSD was seen by the sharp widening of the 25 delta risk reversal from -0.15 to -0.4 in a short time. The EUR them precedded to drop and the 25d RR stand at -0.788 now.

EUR1MRR (white), EURUSD (purple), EUR 1 week vol - 1 month vol (green)

furthermore a term structure view suggests the market is positioning itself for volatility ahead of the ECB meeting on Nov 7th, and now 1 week vol is 1.6 points higher than 1 month.

These ideas can all be shown together in the Vol surface below

We can see the higher implied volatility in the 1 week than up to 6 months, but in the very short term the 25d risk reversal is small, only getting bigger with time

Today, the expectations of intervention from the ECB grew as credit risk and premiums tightened somwhat across Club Med credit markets.

Here we can see Italian, Spanish and then Portuguese 5y CDS mid spreads today, all down around 10-15 bps on the day.

This came at the same time as Spanish 10 Yrs have dropped to 4%, testing their post crisis lows, and Greek 10 years down to ~8%. Now up 403% in price (ex. coupons) since the Q2 2012 low.

Overall, it would have to seem like the credit markets now expect to see some sort of dovishness from the ECB next week. This comes at a time that the CitiFX economic surprise index for the EZ drops to negative territory

As Barclays FX puts it

"Any month end demand for EURUSD was obliterated by a wall of EURxxx supply as the deflationary issues rear their head and people start to think more seriously about ECB action later on this year or at the start of 2014. Nowotny kicked things off in Asia talking about liquidity provision and EURUSD was lower as stops were triggered down to 1.3688. Swathes of EURGBP and EURCAD supply from spec names kept the headline pair very much under pressure "

The idea that a lot of the move came through the Crosses is seen here through a heatmap of FX volume as seen on the Reuters dealing platform (2nd largest by volume in the world)

All in all, I'd put the chance of a 25bps cut next week at about 30%, with a 50% chance in Dec and then 20% not at all (as per Goldman)

But even though the EUR has dropped, there is still a long way to go to meet 2 year yield differentials

EUR (blue) vs. US/DE 2 year yield spread (green)
- UBS: Now expect 25bp refi rate cut and a 50bp marginal lending rate cut at Nov meeting.
- BAML: Believe ECB will cut refi rate by 25bp next week, but will refrain from cutting the deposit rate. Inflation likely to remain at low levels, therefore no need for ECB to move after next week's cut.
- BNP: Now expect a refi rate cut of 25bp before year-end.
- JPM: Now expect 25bp refi rate cut in December. - RBC: Do not look for ECB to lower rates in the near term.
- Barclays: ECB to remain on hold. Wait for inflation forecasts at Dec meeting.
- CS: Should leave door open for possible rate cut in Dec when 2014/15 inflation forecasts are announced.
- RBS: Now expect 25bp refi rate cut in November, with a 50bp cut in marginal lending rate, while deposit rate remains unchanged.

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