EUR: Positive Roll Down, High Volatility

Sell EUR 6M 5Y payer swaption, Strike ATM fwd (1.53%), Spot ref. 1.32%.

Receive a premium of 119 ticks.

Break-even at expiry is 1.78% or below.

Take advantage of the positive roll down and high volatility
The sell-off has pushed volatility higher as positioning in ‘low-for-long’ trades has been poor. Furthermore, it pushed short-end EUR swap rates to levels where ECB members are beginning to intervene verbally. Christian Noyer stated on Friday that ‘the market reaction [to the FOMC meeting] has been excessive’ and he further indicated that an ECB exit was not around the corner. Benoit Coeure followed up today and said that ‘there should be no doubts that our exit is distant and our monetary policy is and will remain accommodative’. In addition, Mario Draghi said this afternoon that ‘economic outlook still warrants an accommodative stance’. Not that any of these comments provide much new information, but still they serve the purpose of calming down the markets.

The short end of the EUR curve is pricing in full normalisation of liquidity by end-2014, and more than one 25bp refi rate hike is priced in by end-2015. Given the large negative output gap and the above comments, this seems excessive, in our view. Hence, we do not believe the money market curve can steepen much further. The belly of the curve could, however, still move higher if the US long-end sell-off continues. We, however, believe that US markets are seeing some tentative signs of stabilisation after the comments by the two Fed members yesterday. The most remarkable comment was given by Minneapolis Fed President Narayana Kockerlakota (non-voter), who issued a very dovish statement in an attempt to clarify the communication from the FOMC.

This position will have a negative P/L at expiry if the underlying rate is above 1.78%. One way to judge how elevated this is would be to look at the spread against 6M Euribor. If the 5Y swap rate moves to 1.78% and the 6M Euribor fixing is around 35-40bp, then the spread is around 140bp. The last time the spread was this wide was in early 2011, when the ECB had initiated a rate hiking cycle.

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