Draghi Hands Masterclass in Volatility Control Over to Lagarde

(Bloomberg) -- Looking through the lens of rates market volatility, Mario Draghi has performed a masterclass in the art of keeping it very low. Incoming European Central Bank President Christine Lagarde will have a challenge to achieve the same effect as monetary policy nears its limits.

A successful central bank will aim to keep market volatility controlled by the predictability of its policy. Draghi has been in the business of keeping euro rates volatility suppressed, by communicating policy shifts effectively and deploying large-scale monetary easing.

Lagarde may find it harder to achieve a consensus on easing, inheriting a divided Governing Council. Policy makers disagree on whether more monetary stimulus is needed, and have voiced louder calls for fiscal policy to do more.

• Systematic gamma selling strategies have performed well during Draghi’s tenure and yield starvation has resulted in selling volatility to enhance returns
• Draghi mastered the art of selling a hawkish step with a dovish spin, impressed markets with easing packages and dovish rhetoric, giving the green light to carry trades that are implicitly short volatility
• Draghi’s ‘whatever it takes’ approach has given investors a return of about 50% for euro-area government debt in aggregate, according to a Bloomberg Barclays index; that is a hard act for Lagarde to follow, and would require a depressing view of the future
• As Draghi heads for the exit door, the economic picture looks weak, with 5y5y inflation swaps settling in a new range close to record lows and PMIs continuing to signal the risk of a recession in the euro-area
• Bund volatility is at subdued levels, with German 10-year bunds trading close to fair value at around -0.40% when modeled against macro fundamentals
• For now, the deflation premium has been successfully removed from markets with 0% floor options (a leveraged play on deflation) costing only a few basis points
• But sustained convergence toward the ECB’s goal is still very much unconvincing and as Draghi’s last press conference provides no further guidance, Lagarde’s big challenge will be how to re-anchor inflation expectations

• NOTE: Tanvir Sandhu is a global fixed income and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net

To contact the editors responsible for this story: Paul Dobson at pdobson2@bloomberg.net, Neil Chatterjee, Michael Hunter

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