Investment Conclusion: Short EUR/USD (FXE)
At today’s meeting, ECB President Draghi left the key interest rates and the asset purchase program (QE) unchanged (as expected) – his big language shift was removing the prospect that interest rates could be cut lower from present levels.
Where did his language not shift? He again underlined that “if needed, we stand ready to increase our asset purchase program in terms of size and/or duration”. Additionally, the ECB updated its economic forecasts (vs March estimates) revising growth slightly higher and inflation slightly lower over the next three years:
- GDP Projections: 1.9% in 2017 [1.8% in March], 1.8% in 2018 [1.7%], 1.7% in 2019 [1.6%]
- CPI Projections: 1.5% in 2017 [1.7% in March], 1.3% in 2018 [1.6%] and 1.6% in 2019 [1.7%]
It’s 1) Draghi’s commitment to QE, 2) our research call that Eurozone growth and inflation will dip in 2H17 – see our Eurozone growth, inflation, policy (GIP) model below, and 3) market consensus and derivatives pricing (see further below) – that are supportive of our short call in the EUR/USD, which we yesterday recommended in Real Time Alerts.
And while Draghi signaled in today’s presser that the ECB is seeing “stronger momentum in the euro area economy”, his commentary is very measured and worried about the inflation outlook:
- “A very substantial degree of accommodation is still needed for underlying inflation pressures to build up and support headline inflation.”
- “Economic expansion has yet to translate into stronger inflation dynamics. Underlying inflation continues to remain subdued.”
We translate this to mean that Draghi prizes “reflation” vs. deflation and will therefore roll out more dovish policy in 2H17 to protect and spur weakening growth and inflation, which translates to EUR/USD weakness.
The Increasingly Consensus Currency
The market gives us some pretty convincing signals with regard to the more positive or bullish consensus expectation on the direction of the Euro from here which we’re of the view to fade.
- Net non-commercial futures and options positioning coming into this week’s ECB announcement was at the highest level since 2007 at net long 73K contracts. Last week marked the fifth consecutive week of marginally more bullish positioning with the Euro +2.8% m/m against the dollar. On a TTM and 3-year Z-Score basis, this level of net positioning is +2.8x and +3.1x extended, respectively.
- Looking to options markets for expectations, forward volatility expectations in the Euro have declined since the French elections, a set-up that mirrors what is observed in speculative positioning. Volatility expectations have compressed relative to the Pound and Dollar. In both the Pound and Dollar, the spread in At-the-Money implied volatility relative to the Euro has widened out to near YTD highs.
- We also show a comparison of 60D implied volatility premiums in the Euro, Dollar, and Pound. Where the market has increasingly required a premium to 60D realized volatility in the Pound and Dollar, implied volatility trades ~10% below 60D realized volatility in the Euro. The market expects volatility to continue declining in the Euro. And for important context, realized volatility isn’t coming from a lower place in the Dollar and Pound, a would be argument to explain the divergence.
- A look at volatility skew paints a similar picture. When comparing strikes 5% below and above the money in the Euro (95-110% skew), the spread is hovering just above its YTD low at ~1 percentage point wide. The spread widens out when downside protection gets more expensive and narrows when the price of calls and puts converges.
