Buy AUD/USD Call Spread Ahead of ECB and EU Summit

The unwinding of “risk-off” trades ahead of this week’s ECB meeting and EU summit has the potential to support risk assets. We expect a fairly strong response from the ECB and recommend buying upside in cyclical currencies.

Buy 1-week 1.0359-1.0560 AUD/USD call spread at an indicative cost of 0.5%.

Markets could be caught underweight risk and too long the USD

The weakening global growth outlook and high European debt risks have seen investors reduce long positions in risk assets and in cyclical currencies. The equity market is pricing about a 50% global recession probability – according to research done by our equity strategy team – and the latest IMM data shows non-commercial with near record long positions in the dollar. 

We see a case for investors to reduce current stretched “risk-off” positions going into this week’s important euro events (see Research euro area) and hence potential for today’s positive performance on risk markets to run further short term. While EU politicians are at risk of disappointing market expectations, we expect the ECB to cut the policy rate by at least 25 basis points and introduce longer maturity LTROs with full-allotment (e.g. 24-month liquidity). This is likely to support risk sentiment near term, at least temporarily.

A positive reaction on risk markets should support the euro, but if this mainly comes on the back of the ECB easing the result could prove net euro negative. We therefore see a better risk/reward from long positions in non-euro high-beta currency pairs, such as AUD/USD.  In fact, of the main G10 and EM currency crosses, this pair has the highest correlation to global equities (82 percent using a 1Y window of weekly changes) and a beta of 0.58, meaning that long AUD/USD is an effective vehicle for positioning for a positive risk reaction.

A bought AUD/USD 1.0359-1.0560 call spread comes at an indicative cost of 0.5% – leaving a known worst-case loss and a potential 1:3 risk/reward ratio. The key risk to this trade is a disappointing policy response by the ECB or additional negative euro news – as the recent rating warnings.