Friday's EUR Trade Recommendation‏

Receive 3Y1Y EUR swaps (6M basis).

Scale in with ½ position at 1.195% and next ½ position at 1.40%.

Stop at 1.55% and target at 0.85%, indicative roll-down: 11bp in 3M, 21bp in 6M.

Re-Enter Short-End Roll-Down Position After Sell-Off
The front end of the EUR swap curve continues to offer attractive roll-down opportunities in the two-to-five-year forward segment. Over the past couple of weeks, the levels for receiving outright in this part of the curve have improved, as fixed income markets have sold off following the fiscal cliff deal in the U.S.

Today the sell-off continued during the ECB meeting, as President Mario Draghi revealed that today’s decision (to keep rates unchanged) was unanimous. Contrary to the December meeting, there were no indications that a deposit rate cut was discussed at this meeting.

As financial conditions have improved and signs of growth stabilisation continue to mature, the governing council now seems to have put discussion of a rate cut on hold. However, Draghi also emphasised that there is a long way before a policy exit becomes a relevant discussion.

Before Christmas, we felt more cautious about entering roll-down trades on the EUR curve. Because of the low level of rates, we were not comfortable about receiving outright and we opened a ½ position receiving 3Y1Y EUR vs paying 2Y1Y EUR. This trade is now 5bp in the money including roll down.

However, after today’s sell-off we believe that risk reward has become attractive for receiving outright on the curve. Even though leading data is improving, the euro area will probably not see positive growth before mid-2013. With a big negative output gap and moderating inflationary pressures, the ECB will be mostly concerned with downside growth risks for the near future. Today, Draghi indicated that any talk of exit was very premature.

We therefore recommend receiving 3Y1Y with an indicative roll down of 21bp over the first six months. As the momentum is currently against the trade, we prefer to scale into the position by receiving ½ position at 1.195% and the next half position if the 3Y1Y rate reaches 1.40%.

The Risk Is A Growth Outburst And Tighter Liquidity
The risk to the trade is that economic data improves faster than we expect and that the ECB moves away more quickly from its easing bias in a scenario where commodity prices start to climb fast. Another risk is that a big chunk of liquidity is drained when banks are allowed to return LTRO money starting from February. This could push shortend rates higher and hit the trade.

The Full Outlook Follows: