Draghi and the bond market

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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.

Bond yields were (and still are) at low levels, which did not fit in with macro fundamentals. Nick Kounis Nick Kounis Head of Macro Research

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?

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 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, this week, Mr Draghi seemed to lose his magic touch.

Draghi unable to prevent bond yields and euro rising

During and after Wednesday’s ECB press conference, government bond yields and the euro rose in tandem, while equity markets fell in their slip stream. The sell-off in bonds and euro strength occurred despite ECB President Draghi stepping up his dovish tone on QE, which seems to have been designed to calm the markets. He mentioned that if necessary the ECB could step up QE and that an unwarranted tightening of financial conditions could be a trigger for that. However, investors focused more on his subsequent comments that volatility in the bond market was here to stay, which gave the impression that the ECB was happy to stand aside.

Tightening of financial conditions

Following the upward trend in bond yields and the euro of the last few days, financial conditions have tightened somewhat more than the ECB assumed in its projections for this year. Given current market prices, weighted average eurozone bond yields are above the levels assumed for this year.

The ECB’s projections show inflation just about reaching the target in 2017, at 1.8% compared to the its price stability goal of close to but below 2%. This means that the sell-off in the bond market and euro strength could eventually threaten the ECB achieving its goal.

Graph: Draghi unable to stem rise in yields

The ECB’s options

So what can the ECB do next given that Mario Draghi’s dovish commentary fell on death ears earlier in the week? The ECB’s next step could be to step up verbal intervention by various degrees. The central bank could say that it saw an ‘unwarranted tightening of financial conditions’ making explicit its displeasure at recent market developments. The next step could be to mention ‘tighter financial conditions’ as being a downside risk to economic growth. If words do not work, it may have no choice but step up QE, though that is not our base case scenario.

Deconstructing the bond market correction

Government bond markets have been extremely volatile over the last few weeks, though the trend for yields has been clearly upwards. What explains the correction? Bond yields were (and still are) at low levels, which did not fit in with macro fundamentals. The ECB’s large bond purchases against the background of weak net supply of bonds had been keeping 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.

Tug of war for bond yields

The big question is what happens next? As discussed above, the ECB is likely to step up its attempts to calm the markets. In addition, the core government bond market will likely return to a situation of scarcity as bond issuance will soon dry up again, while ECB bond buys will continue. We therefore think that the rise in yields will at least pause or even reverse somewhat in the months ahead. In the medium term bond yields are set to rise significantly as the economic recovery strengthens and markets start pricing in a normalisation of monetary policy.

Upside risks

The risks are tilted to the upside. Recent market developments suggest that the sharp upward correction in yields that we expected to materialise at the turn of next year, may have started earlier. Indeed, the recent rise in yields has been extremely abrupt and has taken us by surprise. We are currently reviewing our near term forecasts.

Greece buys more time

The Greek government deferred its payments to the IMF. The first payment was due today, while three more payments were scheduled during the course the month. All these payments – totalling EUR 1.5 bn will now be bundled towards the end of the months. The action is allowed under IMF rules, but has been very rarely used. Somewhat comically, a European Commission spokesperson said that the decision ‘does not call into question the ability of a member state to honour its financial obligations’.

Near term pressure to agree is less

The move gives the government more time to reach a deal, but also reduces the incentives to compromise and reach an agreement in the near-term as liquidity pressures will be less. Eurogroup head Jeroen Dijsselbloem said that Greece had yet to respond to a proposed text for a deal from eurozone finance ministers. He said he hoped to receive it today. There is a possibility that the Greek government will make a counter proposal.

New Greek elections?

In addition, there are rumours that new elections may be necessary to give the government the mandate for any agreement. This could be the case if it judges that the measures it needs to adopt are not consistent with the manifesto it was voted on, or if the left wingers leave in protest, meaning Syriza loses its parliamentary majority. An often mentioned possible date for new elections in 28 June. Given the bundled IMF payments, the Greek government might be able to make it through to then, assuming that it can roll-over upcoming bond payments. We expect a deal eventually, though the situation looks set to drag on.

Graph: US labour market in rude health

Eurozone recovery on track

Reports coming out of the eurozone economy over the last few days have been encouraging. Retail sales were up by 0.7% mom in April. Although that came after a 0.6% decline in March, that followed five successive monthly gains. Meanwhile, German factory orders rose by 1.4% in April after a 1.1% gain in March. There was more positive news in the shape of the ECB’s bi-annual Survey of the Access to Finance of Enterprises in the eurozone. It showed that SMEs reported a marked improvement in the availability of bank loans. Given that SMEs account for 70% of all eurozone employment this is a key development for the economic outlook. Indeed, the labour market continues to improve. Unemployment fell to 11.1% in April from 11.2% in March.

Eurozone inflation returns to positive territory

Eurozone inflation turned positive in May, rising to 0.3% yoy from 0% in April. The period of negative inflation looks to be behind us, having lasted only four months. So much for Japan scenarios. There was an upward effect from food and energy prices, but the really big story in the report was the rise in underlying inflation. Core inflation jumped to 0.9% yoy from 0.6% in April. The rise may well prove a blip, but it does emphasise that deflation fears were exaggerated.

US labour market remains buoyant

US economic data were also generally positive this week. Both the ISM manufacturing index and the Markit manufacturing PMI rose in May. The equivalent surveys for the services sector slipped but are still at high levels. Crucially, the labour market remains in rude health. Nonfarm payrolls jumped by 280K in May after the 221K rise in April, which was well above expectations. Average hourly earnings firmed to 0.3% mom. While the unemployment rate edged up, this reflected a rise in the participation rate. The report signals that the US economy is likely to regain momentum after a weak Q1 and confirms the outlook for a September Fed rate hike.

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