Macro Weekly Draghi and the bond market
Group Economics
Nick Kounis +31 20 343 5616
5 June 2015 ECB President Draghi has shown the magic touch on a number of occasions, managing to shape market expectations with a well-coined phrase. However, this week his signal that the central bank was prepared to step up QE if necessary fell on deaf ears, with Bund yields surging further, the euro strengthening and equity markets falling in the slip stream. We think the ECB will make further efforts to stem ongoing tightening in financial conditions, with further verbal intervention the next step. Meanwhile, Greece looks to have bought itself some more time by deferring IMF payments. Economic data this week was generally positive on both sides of the Atlantic. The strong US jobs data confirms the outlook for a September Fed rate hike. Losing the magic touch?
Draghi unable to stem rise in yields
ECB President Mario Draghi has a record of being able to turn investor sentiment with the power of words. His pledge to ‘do whatever it takes’ to save the euro was a watershed moment in the euro crisis. More recently, his signals that the ECB would
German 10-y government bond yield, %
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again do whatever it takes to revive inflation had a big impact in easing financial conditions even before the announcement of QE. Super Mario came to the rescue once again. However,
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this week, Mr Draghi seemed to lose his magic touch. 0.2
Draghi unable to prevent bond yields and euro rising During and after Wednesday’s ECB press conference,
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government bond yields and the euro rose in tandem, while equity markets fell in their slip stream. The sell-off in bonds
Source: Bloomberg
and euro strength occurred despite ECB President Draghi stepping up his dovish tone on QE, which seems to have been
The ECB’s options
designed to calm the markets. He mentioned that if necessary
So what can the ECB do next given that Mario Draghi’s dovish
the ECB could step up QE and that an unwarranted tightening
commentary fell on death ears earlier in the week? The ECB’s
of financial conditions could be a trigger for that. However,
next step could be to step up verbal intervention by various
investors focused more on his subsequent comments that
degrees. The central bank could say that it saw an
volatility in the bond market was here to stay, which gave the
‘unwarranted tightening of financial conditions’ making explicit
impression that the ECB was happy to stand aside.
its displeasure at recent market developments. The next step could be to mention ‘tighter financial conditions’ as being a
Tightening of financial conditions
downside risk to economic growth. If words do not work, it may
Following the upward trend in bond yields and the euro of the
have no choice but step up QE, though that is not our base
last few days, financial conditions have tightened somewhat
case scenario.
more than the ECB assumed in its projections for this year. Given current market prices, weighted average eurozone bond
Deconstructing the bond market correction
yields are above the levels assumed for this year.
Government bond markets have been extremely volatile over the last few weeks, though the trend for yields has been clearly
The ECB’s projections show inflation just about reaching the
upwards. What explains the correction? Bond yields were
target in 2017, at 1.8% compared to the its price stability goal
(and still are) at low levels, which did not fit in with macro
of close to but below 2%. This means that the sell-off in the
fundamentals. The ECB’s large bond purchases against the
bond market and euro strength could eventually threaten the
background of weak net supply of bonds had been keeping
ECB achieving its goal.
prices elevated. However, over the last few weeks net supply all of sudden rose. In addition, economic data has dispelled fears of a deflationary spiral. Finally, the market is illiquid, which may exaggerate moves.