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FxWirePro: Buy 6m European FX/rates combo with commensurate risk/reward ratio

Without prolonged sharp spikes in crude prices or subsequent movements materializing, we do not suppose that recent higher oil prices will have a lasting impact on the euro area inflation outlook and thus will also not pace up the ECB's exit objective from extraordinary monetary policy measures. 

Several ECB members have recently floated the possibility of de-coupling the forward guidance on QE from the requirement of a sustained rise in inflation, which could open up the possibility of the ECB ending the QE programme in 2018, even without a clear pick-up in inflation. 

Supported by the continued strong economic momentum, we expect core inflation to stay above 1.0% in 2018 and 2019 which should be an important argument for the ECB in its decision to end the QE programme in 2018. 

Buy 6m European Dual Digital Call: EURUSD strike 1.2350, USD10y CMS strike ATMF+10bp Indicative offer: 11.3% (USD notional, EURUSD: 1.1846, USD 10y forward: 2.45%).

Thanks to the negative correlation between the EURUSD and USD 10y rates, this hybrid option is cheaper than the product of the individual digital call premiums.

Take advantage of FX/rates correlation EURUSD mostly needs EUR yields. The EURUSD is showing strength despite unhelpful relative yields, and we expect it to break free higher even without their joint support.

Specifically, with more uncertainty surrounding ECB normalization than the Fed’s tightening cycle, implying more room for European yields to grind higher, the next leg of the EURUSD recovery should be driven more by EUR rates than USD rates. With the correlation between the EURUSD and USD 10y rates negative (-30% the past six months), a dual digital payoff requiring both of them to move up should cheapen.

The risk is limited to the extent of premium, the investors buying a hybrid dual digital option cannot lose more than the premium initially paid. However, the FX and rate underlying must both trade above their respective strikes at expiry to get the final payoff. The option would otherwise be worthless at maturity.

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