EUR: Receive 1Y Swaps, 2Y Forward‏

Time to fade the sell-off in the belly of the EUR swap curve

Receive 1Y EUR swaps, 2Y forward (versus 6M Euribor)

Enter ½ position @ 0.925%, with an option to enter next ½ position above 1.05%

Average entry 0.99%, target @ 0.60%, stop @ 1.21%, roll-down +10bp in 3M

EUR rates pushed higher during May
The front-end of the EUR curve sold off during May despite ECB’s decision to cut the refi rate to 0.50%, and despite Draghi not ruling out the possibility of the ECB introducing negative deposit rates.

A key driver for the selloff has been the ongoing decline in excess liquidity, which steepened the EONIA forward curve and squeezed low-for-long positions. Another factor has been the US led long-end sell-off, which pulled up the belly of the EUR curve.

Time to fade the sell-off
We believe it is time to fade the sell-off. Firstly, the EONIA forward curve steepened to an extent where the market is now pricing in not only full normalisation of the liquidity position by mid-2015, but also some probability of refi rate hikes during H2 15. This is in our view too aggressive and the ECB will probably try to accommodate this through dovish speak at Thursday’s policy meeting. We do not believe that Draghi will introduce any new measures now but he is likely to repeat his message from early May, which would be perceived as dovish by the markets given the current pricing. Secondly, we believe the US led sell-off could take a breather on the back of the weak ISM report (released yesterday). So far the market reaction in the Treasury markets has been rather limited, but we believe risks are skewed for a move below 2.0% in the 10Y yields.

Implementation and risks
A continued decline in excess liquidity, which is not accommodated by the ECB, would be a risk factor – especially if economic data improves at the same time. This is an argument in favour of doing the trade 2Y forward instead of 3Y or 4Y forward, where the roll-down is a little better. Further, the sensitivity to a U.S. led sell-off is less compared with 3Y and 4Y forwards. Alternatively the trade could be done against OIS instead of 6M Euribor. An OIS-based swap would probably benefit more from a potential deposit rate cut than a Euribor-based swap would. However, as we do not expect a cut in the deposit rate, we prefer rolling down the FRA/OIS curve instead of gaining exposure towards a deposit rate cut.

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