Draghi’s Worst Nightmare

So yeah. Good luck trading this. I’m not sure I’ve ever seen a setup that’s more conducive to algo madness.

That’s from our week ahead preview and it should serve as a warning to anyone feeling brave about trading the euro around Thursday’s ECB meeting.

There’s both upside and downside risk for the single currency this week, and parsing things is made immeasurably more complicated by the fact that not only will FX markets need to try and divine something about the timing of the ECB’s exit strategy, but will also need to listen for any indication that the central bank is prepared to try and put a lid on FX strength.

As Deutsche Bank recently wrote, it seems unlikely that short of explicitly saying a taper is on hold indefinitely, Draghi’s going to have a hard time getting a handle on the FX situation.

And indeed, as markets struggled to price in the latest provocation from North Korea overnight, traders were adding EURUSD long exposure. One-week 25d risk reversals rose above par (again) to trade at 4bps in favor of EUR calls – they closed in favor of EUR puts on August 31 and September 1.

Here’s the big picture, for those who need a reminder:

Of course part and parcel of this is the fact that what started the year as a policy divergence theme (Fed tightening, U.S. yields rising on assumed reflationary momentum from Trump’s agenda set against a patient ECB that’s starting from behind anyway), has morphed into a policy convergence theme (Trump agenda priced out, Treasury yields at or near YTD lows, Fed hamstrung by fiscal gridlock while incoming data in Europe firms up, etc.).

If the convergence theme continues, Draghi is in an impossible spot. He’ll either have to feign pessimism with regard to the European economy in order to justify delaying normalization to keep a lid on FX strength, or risk moving ahead and seeing the common currency soar.