Euriborderline insane?

What BTP sell-off?   Although the protest party (or, if you're a member of the European political elite, the looney-bin party) vote was quite strong in much of Europe (viz. UKIP and le Front National), the Renzi government scored a convincing victory in the European elections, sending BTP futures up a full point and a half.

Euribor followed suit because hey, the new trading rule in that market is that you are only supposed to buy on days ending in 'Y' that do not begin with 'S'.  The whites are now pricing a terminal rate as low as 0.18%; while it is true that spot euribor has settled there in the past, it's equally the case that it didn't enjoy it there very much.  Moreover, the familiar bugbear of excess liquidity continues to be an issue, with the current level of excess (88 billion) insufficient to keep EONIA pinned to the deposit rate.

The easiest way to solve this is via specifically targeting the quantity of excess reserves (i.e., QE!), though more LTROs may be somewhat problematic given that Eurozone banks are still trying to shrink their balance sheets and shore up their capital bases for the AQR.  Asset purchases therefore remain the obvious alternative, except for the fact that large scale sovereign bond buys will give the German "monetary financing hawks" a conniption and buying ABS remains like scheduling a holiday in El Dorado: attractive in principle but imaginary in practice.

It therefore seems probable that next week will see a reduction in the key ECB interest rates, including a move to a negative deposit rate.  Fortunately, we have something of a precedent in this regard, as Denmark ran a negative CD (e.g., deposit) rate from mid-2012 until this April.  And how did the market react?   Did CIBOR crash towards zero when the CD rate went to - 20 bps?  Err....not exactly.


Now, part of the reason for this is that Danish banks showed a marked aversion to paying for the privilege of depositing money, so the actual overnight OIS fixing was only negative on Thursdays, the one day of the week when banks were legally mandated to keep money with Danmarksbank.  On all other days it tended to trade slightly positive (1-3 bps.)  Macro Man would not be surprised to see a similar outcome in Europe.

Now, maybe this is what happens and spot euribor drifts down to the high teens.   Whoopee....that's exactly what is priced from September onwards.   However, if the excess liquidity issue is not resolved the risk must be that EONIA and euribor trickle higher, just as CIBOR failed to match the CD rate cut beep for beep.

There are some moderately interesting option spreads that one can look at to play for disappointment, particularly if selling the 99.875 call is something that doesn't frighten the socks off of you.   Funding a 99.75/99.625 put spread with that call will probably cost you half a tick in September, price flat in December, and may even earn you half a tick in March.

In fairness, although Macro Man expects eventual disappointment in the euro front end, it would probably be foolish to do anything like your full size before the announcement.   Assuming that the deposit rate is cut, as seems as close to certain as things ever get with the ECB, it seems reasonable to posit that there will be a (possibly short-lived) knee jerk rally in the whites, possibly to the mid-high 80's.   THAT is the rally to properly lean against in size, at least in your author's option.

And hey- there's even a "cheap" hedge you can put on.  White euribor-euroswiss spreads look very cheap, even with the latter pricing negative rates.  Indeed, the generic 4th contract spread is in the 1st percentile in the SNB-peg era, and in the 0th percentile over longer time frames.   Moreover, it has basically never traded below 20 ticks, only 4 away from the current price of 24.



One could conceivably "hedge" the aforementioned euribor spreads with longs in euroswiss- the implicit stop is at 99.98, the general level of Swiss LIBOR.  If you don't like selling euribor calls (perhaps understandable), the spread makes an attractive alternative way of fading ECB euphoria. 

Remember: when Draghi has brought the hammer down, it has been reflected in peripheral rates, not front end cash.  In the grand scheme of things, it really is irrelevant whether EONIA fixes at 3 bps at 18: either banks are willing to lend or they aren't.  Indeed, while the ECB has consistently over-delivered on driving peripheral yields lower since August 2012, a survey of the market's cumulative euribor P/L over the same period would suggest that they have massively under-delivered in that department, largely because they don't care about the same types of moves that a holder of 150,000 call spreads does.

It's a cliche that the definition of insanity is doing the same thing over and over and expecting a different result....and yet here we are yet again, with the market pricing and positioned for a a big drop in euribor with low levels of excess liquidity.   It might not mean punters are insane...but it does suggest that they may be (euri)borderline.
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Anonymous
admin
May 27, 2014 at 12:07 PM ×

Hello MM. Interesting post as usual. In order to ease monetary policy, what if ECB opts for large scale FX intervention? That could resemble to some sort of QE, while making everybody happy within ECB and think that Fed wouldn't mind too much ..... totally silly?

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Macro Man
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May 27, 2014 at 12:24 PM ×

The Fed might not mind but I am sure the US Treasury would be up in arms, as would Japan. Remember, the EZ runs a current account surplus, so on that basis there is little evidence that the EUR is overvalued. As always, the real exchange rate misalignments in Europe are internal.....

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amplitudeinthehouse
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May 27, 2014 at 1:28 PM ×

Nice challenge word for the day , Macro Man. The internal misalignment
is an obvious one, and there's smarter people than me that know how to trade it. It's been awesome working around the clock creating the last Butterfly spread trade I'd just put on. You like those wings?
Who needs the ECB crap.

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Nico G
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May 27, 2014 at 10:34 PM ×

can we please go back to 1996?

you know, when a central banker would condemn markets irrational etc etc and the markets would tank 5%

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Anonymous
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May 28, 2014 at 8:33 AM ×

partially wrong read of Italian elections mate. PD got 40% but anti euro parties got approx 30% - let me explain:

Grillo M5s 21%
Lega Nord 6%
Lista tsipras 4%
Fratelli d'Italia 3.5%

these are different parties swinging from extreme left to extreme right that all have one thing in common: Auti Euro.

you add the # up and you get more than 30% i.e. one voter out of three wants to get rid of EUR.

this is quite worrying

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Anonymous
admin
May 28, 2014 at 10:08 AM ×

what if ECB opts for large scale FX intervention?

ECB is not responsible for FX policy, finance ministers are. ECB simply acts on their behalf.

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Anonymous
admin
May 28, 2014 at 12:38 PM ×

I agree that market is pricing a lot in terms of Euribor reaction and could be disapointed on that part. But it is clearly pricing some sort of liquidity injection and not only a rate cut. Also, when the ECB first cut the depo to 0 in July12, we've observed a decent FRA/OIS compression (even though it was obvioulsy not from the same levels).
I also doubt euribor contracts will go to mid 80's on a rate cut announcement which is already widely priced in.

I also think the Euroswiss is the worst hedge against this strategy, as the SNB would go negative only on secondary effect (floor under pressure, which is not obvious in case of negative depo) and EuroSwiss are pricing too much.

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Macro Man
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May 28, 2014 at 12:54 PM ×

@ anon 8.33: The share of the anti-euro parties' vote in Italy was largely unchanged from last year's general election, while the ruling coalition saw big gains. How is that not a positive stabilizer?

@ 12.38, I don;t think bor will stay in the mid 80's very long, but I would be surprised if there isn't a knee jerk move that only lasts a few minutes...especially as a cut would be announced at 12.45 London without any commentary, allowing the market to do whatever it wants.

I will concede that as an outright trade the Euroswiss is not particularly attractive, however these contracts have gone quite a bit higher in the past during periods of -ve rate euphoria in Europe, and the spread versus bor does look quite enticing to me. Frankly, on the charts being short just about any core euro rate versus virtually anything else is looking good on the charts...

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Anonymous
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May 29, 2014 at 1:39 PM ×

@ anon 8.33: The share of the anti-euro parties' vote in Italy was largely unchanged from last year's general election, while the ruling coalition saw big gains. How is that not a positive stabilizer?

except M5S, Lega Nord, Fratelli d'italia and SEL/Lista Tsipras were not openly anti-EUR...

Lega for instance was criticising it but only in 2014 they introduced the "NO EURO" sign in their logo and got a sh1tloads of votes.

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