Macro and Vol Commentary
The ECB implemented another 25bps hike last week, marking the 10th consecutive increase to quell inflation out of the eurozone’s incredibly fragile economy. With the market now pricing in to be the last hike of the tightening cycle, what is the outlook for EURUSD in the near term?
Eurozone economy
- The Eurozone economy has barely avoided a contraction in Q2 2023, growing by 0.3% QoQ, but the outlook remains bleak.
- This was later confirmed by a revised downgrade to 0.1% due to poor trade activity.
- The region's biggest economy, Germany, is largely to blame.
- Germany, which had been expected to grow in 2023, is now facing a decline of 0.4%.
- Spain and France, on the other hand, are set to aid expansion thanks to the continued strength in the consumer segment.
- Weaker growth momentum is expected to extend into the year-end, and the impact of tight monetary policy should continue restraining economic activity.
- As a result, the European Commission has cut its outlook for the euro area once again, predicting it will be dragged down by 0.8% y/y in 2023, vs. an earlier prediction of 1.1%.
- Next year's outlook, despite the YoY improvement, was also lowered by the same amount, to 1.3%.
- We will likely see the Eurozone's GDP underperform its Western counterparts this and next year.
- Inflation in the bloc remains upwardly sticky.
- Headline inflation is expected to come in flat, at 5.1% y/y, in August.
- Even though we see that underlying inflation has already peaked, the path to further inflation softening is likely to be bumpy.
- According to the European Commission, inflation is set to average at 2.9% in 2024, 90bps above the target.
- Despite stickier inflation supporting the narrative of higher-for-longer interest rates, further news of economic weakness in Europe is likely to stall any significant upside momentum for the currency.
- The modest growth in Q1 2023 dispelled fears of a winter recession as the bloc's economies gathered enough natural gas storage to survive through the winter months.
- However, as winter approaches, so will the energy woes in the region, along with whether the union has learnt from last year's crisis.
- The upcoming months will reveal whether Europe's energy strategy can handle the impact of colder winter temperatures.
- Despite the EU reaching its 90% capacity target for natural gas storage, colder winter and energy import disruptions could drain the storage much faster than spring can arrive.
- If the reserves prove insufficient, Europe will again be reliant on fast access to fossil fuels, which could prolong inflation stickiness. This should further price the cuts out down the curve.
The US
- We see that Europe is no alternative to the US market and expect that most of the cash not sitting on the sidelines will remain in American assets.
- The greenback is poised to appreciate further into the year-end as the "last man standing" among major economies despite earlier end of the tightening cycle in comparison to other developed central banks.
- We expect the dollar to edge higher in the near-term, testing the 106 resistance level.
The ECB
- The ECB executed the 10th consecutive hike in its tightening cycle, pushing the interest rate to the new high of 4.0%.
- In the meantime, once the last hike from the ECB has been priced in, we expect the euro's strength to diminish.
- This is due to the fact that all the recent downgrades on hike expectations have translated into weaker performance against the dollar.
- Moreover, we expect that once inflation falls closer to the target, market jitters regarding the cuts will intensify.
- We believe the actual cuts will be in short supply, and a higher-for-longer interest rate environment will prevail over the H1 2024.
We believe that the ECB is more concerned with bringing inflation to the target level in a timely manner than the economy falling into a recession. As a result, a less aggressive hawkish rhetoric is to remain into 2024, especially given the fluctuations that we may see in energy prices over the winter months. We expect policymakers to stick to the data-dependent rhetoric instead of admitting to the last hike of the cycle. That would help prop up the longer-term rates and expectations of a higher-for-longer interest rate environment. The biggest challenge will be offering guidance on cuts in an environment where policymakers provided little to no guidance, referencing the data-driven approach from meeting to meeting. We expect the EURUSD to weaken into the support of 1.06 in the near term.
Sources: S&P Global, European Central Bank, Eurostat
Volatility Comment
The economic outlook has worsened in the eurozone with the standout release being the PMI activity slowing considerably. GDP was revised lower to 0.1% and the weaker momentum is expected to continue into year end. However, after this week’s hike by the ECB, we see both rate paths in the EU and US converge of late with minimal change to current policy priced over the coming months leading us to believe a period of consolidation in the near term.
Although volatility is trending lower this year, looking back to a previous period of stability in rates at the end of 2021 before CB tightened monetary policy to tackle inflation, implied vols are still 1.5% higher and continuing to realise lower.
Therefore, we still see opportunity to sell vol at these levels and remain slightly bearish. Our view is to sell a strangle with a skew to the downside.
EURUSD Trade Idea
- SELL STRANGLE
- 3mth expiry
- SELL EURUSD 1.0450 PUT
- SELL EURUSD 1.0750 CALL
- RCV 1.53% of EUR notional
Positioning Charts
EURUSD Vanilla Positioning Data 31/08/2023 - 07/09/2023
EURUSD option expiry pointed to a reduced appetite for both calls and puts in the week ending September 14th; the range has remained broadly unchanged, suggesting the recent trend might have exhausted itself. Still, the number and size of the notional for put contracts offsets that seen in calls, suggesting continued downside pressures in the near term. With the large number of options pretty much removed from November expiry, it suggests to us that the market has priced out the ECB's interest rate decision then.
EURUSD Vanilla Positioning Data 07/09/2023 - 14/09/2023
USDCNY Vanilla Positioning Data 31/08/2023 - 07/09/2023
USDCNY option expiry shifted to the right during the week ending on September 14th after the pair strengthened. The number of calls grew, suggesting that the market still remains bullish despite the introduction of local currency control. The extended upside cover, mostly constituting bigger-notional calls, confirms this. The expiries suggest that the appetite for further gains is still present and has intensified in the recent week.
USDCNY Vanilla Positioning Data 07/09/2023 - 14/09/2023
Charts and Tables
FX Expiries
Historical Spot FX Volatility (30D Rolling)
FX Matrix (today)
Weekly Change
Key Events & Releases
