Best Relative Value Trades Athanasios Vamvakidis Erjon Satko MLI (UK) MLI (UK) [email protected] [email protected] Arko Sen Shusuke Yamada, CFA >> MLI (UK) Merrill Lynch (Japan) [email protected] [email protected] Relative value in a macro world ¢ Long EUR/JPY: data and positioning supportive; the Bo) has more tools to address sustainability challenges than the ECB. ¢ Long RUB/KRW: US fiscal expansion suggests more upside for reflation sensitive Russia than interest rate sensitive Korea. ¢ Sell German 2y vs OIS, buy 10y vs OIS: fade the impressive richening of short- maturity German govies. Long EUR/JPY In a recent report we argued that EUR/JPY could appreciate in the months ahead as the Bo) gains credibility and the ECB has to deal with QE constraints. Since then, the EUR/JPY has appreciated by 3%, but we see more upside. Although we expect the ECB to extend QE by a further six months in December, we see more difficulties next year. Extending QE will require difficult decisions, such as relaxing the capital key or buying below the depo rate. QE tapering is therefore a risk and the market could start testing the ECB. Even if Draghi succeeds, the Euro could strengthen in the meantime. In contrast, the Bo)’s new framework should address the sustainability challenges that Kuroda faced this year, and allows more fiscal stimulus by keeping the government’s borrowing costs at zero. The ECB cannot do this, in our view. We have been short EUR/JPY this year, as we were expecting the ECB to extend QE, while the Bo) faced challenges. Data also suggests further EUR/JPY upside. Relative GDP growth would be consistent with a stronger EUR/JPY, as the Eurozone has been gaining momentum, while growth in Japan remains weak (Chart 34). Relative central bank balance sheets give the same signal (Chart 35). Positioning is also in support, as our analysis suggests a short EUR/JPY market position (Chart 36). If the external environment imp