An exit sign is pictured at the Frankfurt stock exchange, on Jan. 15, 2015, as global markets were thrown into turmoil by a shock move by Switzerland to abandon its three-year cap on the franc. (Reuters Photo/Kai Pfaffenbach)

European Central Bank’s New QE Move Seen as a ‘Done Deal’


JANUARY 16, 2015

London. Investors are now so confident the European Central Bank will unveil a government bond-buying stimulus next week that some contrarian traders are betting on a broad market shock if it doesn’t.

Failure of the ECB to unveil a quantitative easing program at its next policy meeting on Thursday could pummel European stocks by lifting the euro exchange rate and government bond yields that have sunk on the stimulus speculation.

Large-scale purchases of government bonds are seen as a key part in the ECB’s fight against deflation and attempts to revive the 19-nation bloc’s sluggish economy. Markets expect QE to come; only the timing remains uncertain.

“In the short term we are cautious. We bought [a] hedging position on all our risk exposure,” said Monica Defend, global head of asset allocation at Pioneer Investments. “We like equities but we are completely hedged.”

Some analysts, such as those at JPMorgan, reckon the recent plunge in oil, has led to a collapse of bond yields and the euro that indicate markets are virtually fully discounting the ECB pulling the trigger next week. Economists at Citigroup said on Thursday it was “done deal.”

In dropping its cap against the euro on Thursday, the Swiss National Bank may also have been recoiling from having to defend the franc against an ECB euro-printing onslaught.

But there are reasons to believe the ECB may wait a bit longer. Policymakers are far from united behind QE, and Greece holds a general election on Jan. 25 — the outcome of which could determine Greece’s future in the single currency.

Paul Gleeson, chief executive at Arcanum Asset Management, has been buying “puts” due to expire in March on the Euro STOXX 50 and FTSE 100 at 2,800 and 5,560 points, respectively.

These represent bets on the market falling to those levels by March.

The put/call ratio, which measures the amount of negative “put” option bets on the market versus “calls” on the market rising, rose to around 1 for options maturing in February from around 0.6 earlier this week, according to Eurex exchange data.

This reflects how many investors are still banking on QE next week, as they look to hedge against a stock market pullback in the aftermath of the ECB meeting.

Derivatives that bet on future dividends from European companies, meanwhile, have fallen since the start of 2015. This points to falling inflation expectations or rising skepticism that the ECB will act as soon as next week.

Euro falls below launch rate

There has also been a notable increase in demand for protection from a shock via short-dated currency options that guard against disappointment on Thursday.

One-week risk reversals measuring investors’ demand for “put” options expiring on the ECB’s decision show that traders’ extremely bearish stance on the single currency has actually softened.

They have almost fallen by a third in the last 10 days, to -0.8 point in favor of the euro weakening from -1.2 points.

And the gap in euro option prices expiring before Thursday and those expiring just after is unusually high, at around 2 vols, traders said.

“That shows there is an element of surprise and investors are wary. So they are seeking to hedge against any disappointment from the ECB,” said one trader.

The euro has tumbled 15 percent since last summer to a nine-year low, falling below its 1999 launch rate of $1.1747 .

Currency analysts have consistently lowered their euro forecasts. Goldman Sachs and Deutsche Bank both now predict a fall to parity against the dollar next year. Market bets on further weakness have rarely been bigger.

The euro zone bond market has been no less quick to price in QE as soon as this month, with yields and spreads being crushed.

All German borrowing costs out to five years maturity are negative, and the 10-year yield this week hit a record low 0.40 percent.

The yields of “peripheral” countries such as Italy and Spain have also plumbed new lows because if the ECB does do QE, it will likely buy the bonds of these countries as well as “core” countries.

One gauge of QE expectations is the performance of peripheral sovereign bond yields against yields on corporate debt with a similar credit rating.

The gap between the two widened during most of 2014 as government bond yields plunged in anticipation of QE, but has largely stabilized in recent weeks. This suggests at least there’s little fresh impetus for this trade and even a growing sense of skepticism around it.