With the BOJ having stolen the limelight in the past week with its unprecedented, and unexpected, QE expansion it is easy to forget that following the Fed's halt to QE3, there is still a substantial gap of flow that must be filled to keep the markets comfortably levitating (as Citi explained recently [4]). Enter the ECB, which tomorrow will conduct its November meeting together with the traditional post-meeting press conference. But while all eyes will be on Draghi to see just how bad the mood in the room is surrounding the text-messaging central banker, who as Reuters reported yesterday, [5]is now facing a full blown mutiny from anywhere between 7 and 10 regional central bank peers, the bigger question is what will the ECB do and how to trade it.
Not unexpectedly, in the aftermath of the BOJ's Banzainomic, the consensus is for a major dovish announcement from Draghi. A case in point comes from the bank that first, one year ago, floated the idea of European QE: BNP (see "Next From The ECB: Here Comes QE, According To BNP [6]" from November, 2013). The same BNP now says:
We maintain a short EURUSD recommendation (target 1.18) and on Monday published a near-term bearish FX option recommendation covering the ECB event. Like the JPY, there is a strong probability that the EUR weakens sharply following the meeting as we do not believe the market is sufficiently positioned for a dovish ECB. EUR positioning is at -14 vs JPY at -28 (on our scale of -50 to +50). Below we discuss five possible scenarios for tomorrow’s ECB meeting from an FX perspective.
And here is the full matrix of possible actions that the ECB can undertake, from adjusting the TLTRO, to shifting the deflation inflation message, to revising its balance sheet target, and finally, to launching a broader QE, and how these could impact the EURUSD based on how Draghi frames them.
[7]
But is the EURUSD the only trade? Not at all. In the table below, Deutsche Bank compares the developments in some key variables since the last ECB meeting on 2-October to determine the best risk-reward trades ahead of the ECB. Here are its preferred trades based on whether the ECB will "disappoint" or "deliver"
Disappointment trades
- On this simplistic risk-reward perspective iTraxx Main spread wideners, long euro/usd and Bund ASW wideners offer the best risk-reward for ECB disappointment trades.
Delivery trades
- The conclusion regarding ECB delivery is a bit more complicated. If we ignore 10Y Bunds which could rally if the ECB announces a broad based QE including government bonds we are left with 2Y Euribor-OIS spread tighteners, long 2Y1Y inflation swaps (which might remain under pressure due to the decline in oil prices) and paid positions on the long-end of the EUR curve.
[8]
