FX Trading Portfolio Short EURUSD: ECB risks skew dovish – FXWW Chatroom

We recommend reinitiating short EURUSD positions, either through spot or risk reversals, ahead of next week’s ECB meeting where we expect the discussion, and possibly actions, to skew to the dovish side. China-related market volatility stopped out our previous short EURUSD recommendation earlier this week (see Market volatility triggers stops in short EURUSD and long USDCHF trades, 24 August 2015). Yet, we reaffirmed our strategic expectation for EURUSD to resume its downtrend once the position squeeze abated. Stabilization across asset markets and the prospects of more-dovish-than-expected forward guidance from the ECB next week – and possibly even an outright extension of its QE program – suggest to us that the time for reinitiating structural EURUSD shorts already is upon us. 
We continue to see numerous reasons for material EURUSD depreciation from current levels. While the US is not immune from international volatility and we recently revised our Fed rate hike call to March 2016 (see Federal Reserve: First rate hike in March 2016 as financial volatility amid uncertainty in EM pushes out our call, 24 August 2015), the US economy remains the global growth outperformer whose central bank is the nearest to policy normalization as one of the few countries able to generate inflation. Conversely, the euro area recovery remains fragile and the risks to growth and, especially, inflation remain skewed to the downside. 
We now expect the ECB to nod in the direction of further policy easing at next week’s Governing Council meeting, with risks skewed towards more forward leaning guidance and possibly even action (see ECB Preview: more easing before year end, 28 August 2015). Since the last policy meeting in July, effective appreciation of the EUR, falling commodity prices and an elevation of the risks to foreign growth have reduced the near- and medium-term inflation outlook and tighten overall financial conditions as breakevens have fallen anew. The ECB staff macroeconomic projections are likely to show a downward revision in inflation forecasts for both 2015 and 2016. Thus, we expect the ECB, at a minimum, to signal its ability and willingness to ease further if monetary and financial conditions tighten further. By year end, we expect that the ECB will announce an extension of the minimum period for its asset purchase program – an announcement that may even come next week – and possibly in the future extend the size and scope of the purchase program or a cut in the deposit rate further into negative territory. We believe that the last of these measures – although highly unlikely at next week’s meeting – would be most effective in generating greater downward pressure on the EUR, but all should lead to some measure of additional depreciation. 
That said, we acknowledge that the ECB also retains the ability to disappoint ill-defined market expectations at next week’s meeting by failing to give guidance towards further action, and in that event EURUSD likely would trade higher. However, we see the risks as skewed toward more forward-leaning guidance and also believe that EURUSD remains in a structural downtrend. As a result, we see a good risk reward in re-initiating short EURUSD positions from current levels. 

Specifically, we recommend selling EURUSD spot (reference: 1.1278), targeting 1.0460 (year-to-date low), with a stop at 1.1562 (the 26 August, post-position squeeze high). Alternatively, clients able to use options may find even better value in a risk reversal (short a 25-delta call, long 25-delta put) given the sharply narrower skew implied by risk reversals. 

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