Euro Swaptions Aligned With Peripheral Spreads Offer Protection

Options on European swap rates are trading at the cheapest in a year even as political risks on the continent are growing, Bloomberg strategist Tanvir Sandhu writes.

The normalized implied volatility for options expiring in three-months on ten-year euro interest rate swaps, known as 3m10y swaptions, has slid to an annualized 56 basis points from 67 basis points level on the day before the March 10 ECB meeting. It’s now hovering near levels seen immediately prior to last year’s aggressive Bund selloff.

Intermediate- to long-tail EUR rates gamma have historically been bid when peripheral spreads widen suggesting they may be used as potential hedge following the post ECB cheapening.

EUR rates short-tail gamma outperformed into ECB’s March meeting, reflecting the increased policy-outcome uncertainty and then extended post-ECB slide beyond typical event-risk unwind as Draghi shifted focus away from rate cuts.

Volatility may also increase concurrently with shift in Eonia curve, as market is now pricing in a 100 percent probability of a 10 basis points ECB deposit-rate cut in December, compared with 52 percent immediately after the reserve-maintenance period lapsed. Shift in Eonia curve came about after ECB March accounts and speeches by officials signaled that further rate cuts are still possible.

Upcoming peripheral risks include Spain’s parliament being dissolved if no government is formed by May 2, Italy municipal elections expected in June, Portugal’s sovereign rating by DBRS being reviewed on April 29 and the U.K. votes on EU membership on June 23.

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.