How To Position For ECB Cuts

Room for more ECB cuts in the near term

• We think the ECB will lower the refi rate further.

• A 50bp cut at the December meeting cannot be ruled out.

• An emergency rate cut cannot be ruled out either.

• The ECB refi rate could fall to 0.50%, and the deposit rate is likely to reach its floor at 0.25%.

• Interest rate corridor to narrow substantially, which should bring down the marginal lending rate.

• We think the ECB will be able to support lower Euribor fixings as rate corridor narrows and the easing brings some relief.

• However, big risk is that stress won‟t ease and fixings will remain high.

• The ECB could introduce 24M LTROs and the markets might price in more credit easing (quantitative easing).

What is priced in?

How to position for ECB cuts

• Short three by one ratio call spread on 3M Euribor March ‟12 future

• Short two by one ratio receiver swaptions, 1Y1Y EUR

• Buy Danish „flex‟ bonds (non-callable bullet bonds)

• Still room to price further cuts by the Riksbank – receive SEK FRA JUN12

• Swedish curves flat on a relative basis – ample room for steepening

• Curve steepening and covered bond performance in Sweden next year

Short three by one ratio call spread on 3M Euribor March ’12 future

Buy 1 call option at strike 99.00

• Sell 3 call options at 99.25

• Spot reference: 98.83

• Stop at MtM = -10bp

• No exposure to higher fixings

• The position can be entered at 1.5bp

• Biggest risk would be if 3M Euribor fixing declines below 0.67% by March IMM-date

• Maximum potential downside known, and would materialise if fixings go to zero

• Alternatively – buy condor

• Buy 1 call option at 99.00, sell 1 call option at 99.125, sell 1 call option at 99.250, buy 1 call option at 99.375

• Net price is 3.0bp

Short two by one ratio receiver swaptions, 1Y1Y EUR (3M)

• Buy 1 receiver swaption at 1.20%

• Sell 2 receiver swaptions at 0.95%

• Spot reference: 1.28%

• Stop at MtM = -10bp

• No exposure to higher underlying rates and wide profit-range

• The position can be entered at zero cost

• Biggest risk would be a sharp decline in the underlying rates

• Maximum potential downside known, and would materialise if rates fall to zero

• Alternatively – long receiver ladder

• Buy 1 receiver swaption at 1.25%

• Sell 1 receiver swaption at 1.05%

• Sell 1 receiver swaption at 0.90%

Buy Danish ‘flex’ bonds (non-callable bullet bonds)

• Buy 1Y Danish „flex‟ bonds – for example RD 2% DKK 13 (Jan) SDRO (CC T) at 50bp-55bp against Cita curve

• Potential for performance if 1) Cita curve moves lower or 2) spreads narrow to Cita curve

• Risk: Exposure to stress in Danish money market, which could lead to higher Cita rates and ASW spread widening

• Alternatively – Buy ‘flex’ bonds against Eonia to hedge some of the risk

Still room to price further cuts by the Riksbank – receive SEK FRA JUN12

• Expectations about the Riksbank are quite moderate.

• The large exposure to exports to the euro-zone combined with a weakening domestic sector means that the Riksbank will have to act soon.

• The fact that ECB has started cutting rates is paving the way for the Riksbank to cut in December.

• SEK FRA JUN12 is pricing in slightly less than three 25bp cuts. We think there is a clear risk of more cuts.

Swedish curves flat on a relative basis – ample room for steepening

• In our view the downside in Schatz is limited.

• Even though the spreads in the short end have tightened, SGB1041 still trades high relative to Schatz and should start performing once the Riksbank starts cutting rates.

• In the longer run we expect a near convergence in policy rates.

• Thus, we should see the 2Y-10Y curve box move to only slightly negative levels.