December Outlook - ECB & Fed

December is being set up as a rather critical month for the markets, with the two biggest central banks expected to diverge policy. First up, and in just under a weeks time from now is the ECB, where currently estimates are for around a 20bps depo cut (to -0.4%), although not fully priced in on the EONIA curve, looking at 2 year german bunds they are currently sat at -42bps.

The issue I have is that I really don't think that the ECB needs to ease more, however we have to position from what we think they will do and not what they should. But looking at what is most important; inflation, then we can see that compared to the beginning of the year when they embarked on QE, its really not so bad.

EUR CPI y/y and 2y inflation swap

CPI has ticked back into positive territory (okay its still awful, but its 0.7% higher than jan) and inflation swaps, which are arguably useless in *predicting* inflation, have tended higher recently and are close to 1% again from the 0% when QE was enacted. Other data from Europe continues to broadly impress, whether it is strong money supply growth or an unemployment rate that has dropped 1% this year... I would be optimistic on the Eurozone outlook. This being said, it seems more than likely that Draghi will cut the deposit rate (with a large amount of exceptions as per Switzerland) given the rhetoric he has put forward over the last few months.

However I still firmly believe that he is playing purely reactively to Oil prices (and the commodity spectrum in general), and propose that if Oil was still sitting quietly above $50 or so, we wouldn't even be talking about any ECB action this December. But we are, and thats just how it is.. One decent tell we've had today is from the SNB, rumours that they've used quiet markets to intervene a tad in the CHF to push it to post peg-break lows on a TW basis.

Whilst not too much of a tell, its worth noting that they acted ahead of ECB QE in January, only they got everything completely wrong that time, they might be pushing up EURCHF in preparation of weaker EUR expectations. Weak analysis at most, but worth considering in my opinion. I dont particularly have any specific trades in the rates space, but at least the combination of improving macroeconomic indicators as well as continually accommodative central bank would lead me to want to take on equity and credit risk. Though I was thinking that taking advantage of differences in vols and skew, funding upside equity calls (3700 on Eurostoxx) by selling payers in itraxx main (90) could work well as a cheap cross asset risk reversal structure.

Soon after the ECB, we have the Non-Farm payrolls teeing us up for the 16th where we see the Fed, as of yet there hasnt been any sort of meaningful mark-up in volatility for this event, with 17th expiry trading at 13% in EURUSD, which against a historical 1m vol of 9 is high, but nothing that really stands out. Some news-y people are probably going to starting saying how this is the "most important NFP ever", but bollocks to that, if a number now was enough to sway the FOMCs mind, then they were never going to hike, at the end of the day 3/6/12 month averages are around 200k, more than enough to maintain a falling unemployment rate, even a print as low as 100k won't be overly damaging to the general trend and would likely see the U/E rate flat at worst (assuming nothing much in labor force participation).

One thing it might lead to is repositioning going into the 16th, washing out the weak 25% of the market in the no hike camp or worrying the 75% but either way you would expect to see any move faded as it won't change anything.

Which then takes us to the announcement, there was a while ago people suspecting they wouldn't go in Dec as its the holiday period and liquidity blah blah, but that hasn't stopped policy decision in the past, the Taper (remember how much of a big deal that was?? lol) and won't stop them this time. But the key market moving news will come from what Yellen chats about in the conference and if we get this "dovish hike", which I personally think we will. I mean, the markets, the curve and sentiment is already in place for a dovish hike, EDZ6 is just a few ticks below 99 with the FF curve implying 3 hikes by next December. So one argument for the USD bull camp / pay rates people is that there is little room to be more dovish, and only room for a hawkish tilt.. which makes sense to a certain degree. But I think that when looking at positional indicators and price action, the market feels stubbornly long, mostly in short EURUSD. It makes sense to be short into ECB but after that? I ceratinly see a high chance of large covering into the Fed.. after all the trade has been the divergence of expectations, we've had that... its now being realised and those that have had the trade can take their profits and pat their backs.

One popular way I've seen to trade further USD upside is with 1x2s, which a few macro managers I talk with have recommended. This does present the risk that if the USD rises sharply these guys will have to increasingly buy USDs as they become short gamma and this could help fuel another leg.. and for these traders, they are zero cost on any downside so arent concerned about a short squeeze in the slightest.

 

On a very very simplistic regression model using rate spreads, the current 2y differential of 1.1% implies a 1.05 level on EURUSD, if the markets just roll as expected along their respective yield curves and there is no change to expectations of monetary policy between now and this time next year we see a 2y 1yf spread of 1.54% which implies via this model a EURUSD exchange rate of 0.97. Firstly, this is incredibly simplistic analysis and assumes things stay as they are with both the historical correlations and the monetary policy, both of which wont happen. The forward curves do however show us more interesting features, namely how in the $ curve and how the actual steepness is far less than it was a year ago looking at price action here there hasn't been anything close to a "huge" shift higher in US rates, if anything it was a bounce of low levels not seen in years, painting a very different picture to spot front end rates.

And looking at the spread against EUR rates, we see the "wides" in monetary policy expectations occured comfortably in March, at 30bps wider than present even with EURUSD at its lows, so possibly this leg lower through 1.08/1.10 has been an overly speculative / positional trade and will be disappointed in a glorious short squeeze...

Or maybe it wont, we will see, should be a good month nonetheless with plenty of opportunities.