Dovish Draghi Wakes Bund Bears in Classic Case of 'Sell the Fact'

Bulls sidelined as they await better levels to reload positions

Mario Draghi, president of the European Central Bank (ECB)

Alessia Pierdomenico/Bloomberg

It might seem counterintuitive that European Central Bank President Mario Draghi’s forceful reiteration of more easing on Friday buoyed tactical demand for puts in bund options; but it’s a classic case of buy the rumors and sell the facts, Bloomberg strategist Tanvir Sandhu writes.

The move in bund volatility skew, the chart that captures preference for puts or calls, over the past week suggests investors may be switching to outright positioning from mere hedging.

The change in skew has distorted a perfect smile structure seen a week ago, although a period of negative issuance is ahead into the year end.

Staid market reaction to ECB chief’s comments show investors seem to be have priced in the central bank’s expected policy move.

This could also signal investors are on the verge of unwinding long positions across asset classes and the preferred route could be via options.

Investors may await for better levels to reinstate positions, after any unwinding, as second round effects from ECB policy action take hold.

Market’s response to any extension of quantitative easing could be different from what was witnessed earlier this year.

Announcement of QE and the beginning of purchases in the first quarter accelerated a bund rally, which was a case of buy the rumor and buy the news, until the April bond rout took hold.

Market’s response also shows Draghi may fall short of meeting elevated expectations, partly hampered by technical issues such as scarcity of quality assets to purchase.

Plus, as ECB Governing Council member Jens Weidmann says, there’s no reason to talk down euro-area recovery.

Transitory effect of oil prices are expected to fade from headline inflation at the turn of the year.

The fact that most European equities indexes are near key major resistances could warrant buying downside protection.

Eonia is pricing in a 14 basis point cut in the deposit rate by the ECB at its December meeting.

Note: Tanvir Sandhu is a strategist who writes for Bloomberg. The observations he makes are his own.

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