Last week’s pledge from the ECB to “remove the tail risk for Europe” has triggered a series of hedge unwinds across financial markets. FX vols have fallen to a five-year low, while EURCHF has rallied sharply, EURUSD skews are flattening, European sovereign credit default swaps are approaching their tightest level of the year and the USD is selling off aggressively.
John Normand, head of FX research at JPMorgan, says it is a stretch to call the ECB’s strategy a game-changer for the EUR, however, when Spain and Italy remain too proud to ask for assistance – neither country, he believes, wants to solicit a funding programme that would lock-in their bond market rallies.
“Still, the bank’s tail-risk emphasis is a short-term boon for carry trades, which rely on vol suppression to deliver returns,” says Normand. “Whether to fund in euros or dollars depends on how much further EURUSD can rally.”
JPMorgan suspects that EURUSD cannot rally much more, given Spanish and Italian aversion to requesting a bailout and the likelihood of interest-rate cuts from the ECB next month. The bank, therefore, keeps its EURUSD target unchanged at $1.24.
Thus JPMorgan believes if EURUSD is nearing a top and the ECB’s management of tail risk revives carry trades, then this summer’s rally in the euro versus commodity FX, Asian and LatAm currencies has also probably run its course.
According to Normand, the ECB’s July rate cut sent the EUR to levels that were at least 5% too cheap against commodity, Asian and LatAm currencies, almost all of which have since been reversed.
At the same time, positioning in the EUR has shifted from near-record short to flat.
| EUR positions have shifted from near-record short to neutral |
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| Source: JPMorgan |
Normand says if the ECB fulfils its new mandate to contain tail risks, then volatility spikes generated by Europe will be more muted and vol curves will flatten from quite step levels. That would allow the euro to fall against commodity, Asian and LatAm currencies.
“The decline in these crosses may be no more than 3%, since a trend requires an acceleration in the
Chinese economy and US resilience to the fiscal cliff,” Normand adds.