FxWirePro: Take a tour on ECB rhetoric, QE-driven portfolio and bullish hedges

The more conciliatory overtones from G20 on trade resolution are welcome but are unlikely to immediately arrest the slump in global manufacturing. Uncertainty and delayed investment are headwinds.

The ECB will have to ease policy. To maximize effectiveness we expect that this will encompass most unconventional monetary policy tools, like negative interest rates, QE and open-ended forward guidance.

The past week has delivered significant moves in Euro area markets with 10Y bunds rallying 12bp to the uncharted territory of -40bp, the 2s/10s curve flattening and peripheral spreads narrowing especially in Italy. Market expectations of imminent easing of monetary policy and a restart of ECB QE have been boosted by the announcement of Christine Lagarde as the next ECB president, whilst the drop in 5Yx5Y HICP swaps back to the levels seen prior to Draghi’s Sintra speech (1.15% currently vs. pre Sintra low 1.14%) has rekindled fears of Japanisation given a global backdrop where growth risks are still skewed to the downside. 

We refer to the JP Morgan’s baseline call which is for the ECB to deliver a change in language at the July meeting, suggesting that “policy rates will remain at present levels or lower” and a 10bp rate cut in September, while leaving the door open to reinstate net QE purchases but no imminent delivery. 

However, we believe that the combination of low market-based inflation expectations and ECB rhetoric somehow endorsing Sintra speech should support trades that benefit from market pricing increasing chances of a new round of QE. 

In light of the recent moves, we provide an update to our main Euro area trading themes reiterating our QE-driven themes, while holding hedges. 

In summary, our trading portfolio has been focused on seeking carry in an environment of ongoing spread compression whilst holding bullish hedges.

We stick to the same themes but hold hedges against back up in yields given historically rich valuations. Despite the large peripheral rally we still see value in spread compression trades, as the recent momentum can continue given a combination of an ongoing search for carry and markets continuing to price in QE expectations. Although we think a lot of bad news is already priced into the Euro swap curve, the fear of Japanisation can drive intermediate yields lower; we keep bullish hedges, particularly conditional 2s/10s bull flatteners. In intra-EMU, we keep selective narrower and hold 5s/10s Italy-Germany flattener and also a proxy for 10s/30s flattener in Italy as positive convex hedges, which could find support from the QE announcement. 

We continue to hold Bund swap spread widener and Schatz OIS/Bund 6s swap spread curve steepener. 

In Euro cash, we expect the search for yield dynamics to remain dominant driver going into summer months on persistent market pricing of QE along with lower supply pressures and limited systemic Euro area political noise. 

We, therefore, stick with our intra-EMU strategy and hold longs in 10Y Spain vs. France, 9Y Cyprus vs. Portugal, 5Y NRW vs. Germany, 10Y Madrid vs. Spain, 20Y Finland vs. the Netherlands and 10s/30s France flattener vs. Germany. We also add longs in 30Y EFSF/ESM vs. Germany to the portfolio. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly USD spot index was at -25 (mildly bearish), EUR is flashing at 99 (highly bullish), while articulating at (14:06 GMT). 

For more details on the index, please refer below weblink:

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