The 2020 Outlook for Euro Interest Rate Volatility

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(Bloomberg) -- The average implied volatility in Euro rates has ended up higher overall this year following the collapse in yields.

Buying volatility at the long-end would have returned well in 2019 as the high level of policy uncertainty and weak growth led to a sharp bull-flattening of the yield curve. The first half of next year may see short-volatility strategies in favor at the long-end, if rates remain in a broad range in the case of no material shift in the outlook. The ECB’s review of monetary policy instruments may be a source of volatility.

The 2020 Outlook for Euro Interest Rate Volatility
  • Gamma on long-tenors has been outperforming on the swaption grid this year given the higher realized volatility as the yield curve sharply bull-flattened over summer.
  • The yield curve may continue to exhibit either bull-flattening or bear-steepening behavior with the front-end anchored, leading to higher long-tail gamma relative to shorter tails whenever implieds move higher.
  • A new ECB president and strategic policy review risks seeing higher volatility in front-end rates.
  • The ECB won’t urgently change its forward guidance and appears likely to remain on hold for the foreseeable future while debating the strategic policy review and with immediate geopolitical risks having diminished.
  • The curve ball is if ECB exits negative interest rate policy early, as arguments grow over the side effects of such monetary easing. The volatility curve may flatten if the money markets increase the pricing of the chance of an ECB rate hike as vol would move inwards. This will also weigh on receiver skews. The Riksbank hiked rates to 0% this month given it’s concerns about negative yields, while strengthening forward guidance to keep the curve flat.
  • Long-dated hedging of the change to ECB’s reaction function may gain importance in 2020 and be a source of volatility (see more: European Rates 2020 Outlook).
The 2020 Outlook for Euro Interest Rate Volatility
  • 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.

©2019 Bloomberg L.P.

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