Draghi’s Worst Nightmare

So yeah. Good luck trading this. I’m not sure I’ve ever seen a setup that’s more conducive to algo madness.

That’s from our week ahead preview and it should serve as a warning to anyone feeling brave about trading the euro around Thursday’s ECB meeting.

There’s both upside and downside risk for the single currency this week, and parsing things is made immeasurably more complicated by the fact that not only will FX markets need to try and divine something about the timing of the ECB’s exit strategy, but will also need to listen for any indication that the central bank is prepared to try and put a lid on FX strength.

As Deutsche Bank recently wrote, it seems unlikely that short of explicitly saying a taper is on hold indefinitely, Draghi’s going to have a hard time getting a handle on the FX situation.

And indeed, as markets struggled to price in the latest provocation from North Korea overnight, traders were adding EURUSD long exposure. One-week 25d risk reversals rose above par (again) to trade at 4bps in favor of EUR calls – they closed in favor of EUR puts on August 31 and September 1.

Here’s the big picture, for those who need a reminder:

Of course part and parcel of this is the fact that what started the year as a policy divergence theme (Fed tightening, U.S. yields rising on assumed reflationary momentum from Trump’s agenda set against a patient ECB that’s starting from behind anyway), has morphed into a policy convergence theme (Trump agenda priced out, Treasury yields at or near YTD lows, Fed hamstrung by fiscal gridlock while incoming data in Europe firms up, etc.).

If the convergence theme continues, Draghi is in an impossible spot. He’ll either have to feign pessimism with regard to the European economy in order to justify delaying normalization to keep a lid on FX strength, or risk moving ahead and seeing the common currency soar.

And all of this as the euro is increasingly trading like a haven in a market that’s prone to episodic bouts of risk-off flows.

So what options does he have? Well, jawboning. And as Bloomberg’s Vassilis Karamanis notes in a good missive out Monday, he’s going to have to utilize that tool. After all, just failing to mention euro strength during his Jackson Hole speech was enough to spark a euro rally and he wasn’t even expected to say anything about FX. Omitting references to the recent euro overshoot on Thursday could be a disaster. More below…

Via Bloomberg

Price action in the euro suggests that traders look at the $1.20 handle as the European Central Bank’s tolerance level for now. That doesn’t mean further gains aren’t on the cards in the longer-term.

• Trading has never been a straight line. Even for bitcoin, the cryptocurrency with an ever-impressive performance this year, the ups and downs in the short-term have surely created havoc for investors on a mark-to-market basis
• The same applies for the euro, or any currency for that matter. The upside is here to stay, yet bulls need to exercise patience. Policy makers’ jawboning is bound to keep a temporary lid on gains
• It is true that central banks are not here to determine currency exchange rates. Yet, they do — or think they are entitled to — have a say as to the pace in which their currency reaches a certain level. The ECB acknowledges the strong fundamentals pushing the common currency higher but cannot stay sidelined
• Imagine a muted response to the euro’s rally. The result could be Mario Draghi’s worst nightmare. Just because he refrained from mentioning currency strength at Jackson Hole, the euro rallied to its strongest level since January 2015. One dare not imagine the extent of gains if the Governing Council stood unfazed on the currency’s performance
• Euro bulls have more than charts and option gauges to take comfort from. On the one hand, it’s the currency’s growing appeal as a haven. In contrast to 2015, its gains are not on the back of an unwinding of carry trades amid risk-off flows
• It’s genuine interest by investors as they increasingly see the euro as a reliable and stable store of value. Korean tensions might be another burden on Draghi’s checklist
• On top of that, political divergence versus the U.S. could help drive the euro forward in the long term. And while traders may be quick in responding to Washington turmoil, they are bound to take more time before responding to Merkel and Macron attempts toward a more united euro area
• A strong currency might trouble exporters and do little to help inflation reach the ECB’s desired level. Yet should gains come at a decelerated pace, Draghi et al may have little verbal ammunition to use, giving euro bulls the upper hand