Europe Rates Markets Radiate ECB Heat as FX Stays Cool: Analysis

December meeting disappointment still fresh in mind.

It’s a study in contrast. Europe’s rates volatility mirrors the elevated levels that prevailed before European Central Bank’s December meeting when investors expected President Mario Draghi to aggressively ease the policy. But the euro is showing no such nerves, Bloomberg strategist Tanvir Sandhu writes.

This divergence potentially exposes currency markets to greater swings if Draghi manages to surprise. On the obverse side, a lukewarm ECB outcome could affect rates market more.

Short expiries of short tails have led the richening of EUR rates volatility, as ECB uncertainty gets expressed there.

The normalized implied volatility for options expiring in one-month on one-year EUR interest rate swaps, known as 1m1y swaptions, is an annualized 36 basis points, 17 basis points higher than year-to-date low of 19 basis points. 1m2y swaption volatility is at 42 basis points, approaching 49 basis points touched ahead of the December meeting.

Short-tail gamma has rallied after sliding following disappointment over December meeting. Very long expiries remain little changed.

Going against the grain

While EUR rates short-tail gamma has outperformed, the volatility on the common currency is subdued.

A measure of expectations for swings in euro against the dollar in a month is at 11.5 percent, compared with 13.4 percent the day before the December 3 ECB meeting. The difference between the implied volatility on calls and puts of 25-delta options, known as risk reversal, is at -0.04 vs -0.5.

The depressed volatility in the euro against the dollar runs against the deterioration in the region’s economic environment since the December meeting.

Inflation curve pricing shows ECB’s target of close to 2 percent won’t be met even in 20 years.

Relatively low volatilities reflect investors’ reluctance to short the currency as the sharp squeeze in December is still fresh in their mind. This is also a reflection of global risk off leading to unwinding of carry trades. 21-day correlation of the euro against the U.S. dollar and the euro-zone’s blue chip index, comprising 50 stocks, is at -0.5, compared with -0.8 during the August stock rout, as euro takes the role of a funding currency as rates go more negative.

EUR short-tenor rates face increased uncertainty as investors try to speculate on the mix of stimulus ECB may deploy to beat tightening of domestic financial conditions as euro trade-weighted index has risen more than 3 percent and stocks have slid since the December meeting.

The euro overnight index average, or Eonia, is currently pricing 100 percent probability of ECB cutting deposit rate by about 12.5 basis points and close to 24 basis points by December 2016. 43 of 59 economists in a Bloomberg survey expect the ECB to expand quantitative easing purchases above 60 billion euros per month.

Note: Tanvir Sandhu is a cross-asset derivatives market strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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