Trading the EURUSD With Zero Cost and Plenty of Appeal

Even before Draghi fueled speculation of an another leg to negative ECB deposit rates, latest capital flows data have shown an extraordinary $1trillion gap between US net fixed income inflows and EUR area net bond outflows over the 12 months through August.

Small unorthodox policy changes, notably negative rates, have huge capital flow implications.

While the market may have read too much into Draghi’s comments on the possibility of a ECB depo rate cut, the speculation will add to the main G3 capital flow thematic of unusually large net Euro bond outflows and net US bond inflows.

Even a small Fed rate hike in coming quarters could add substantially to such flows, as capital is attracted to both the front-end, and the US back-end does just fine, as long as the Fed is seen acting ‘ahead of the curve’.

While the rough rule of thumb that 10bps of 2yr US-EUR spread widening in favor of the USD is worth some 1% lower on EUR/USD is a useful guide, we would expect a substantially bigger response were the ECB to eventually deliver on a cut in the depo rate. One way to look at the Draghi comments is

that he has effectively capped the EUR’s upside, now that they seem to have shown they are willing to employ a tool that is very effective in influencing the exchange rate.

With spot at 1.1130, selling a one year EUR/USD 1.18 digital call and buying a one year 1.10 EUR/USD put is indicated at close to zero cost and has plenty of appeal.