ECB Gets Tantrum Response from Market

European Central Bank President Mario Draghi last week got a taste of the market’s addiction to his ultra-loose monetary policy.

After saying at a speech in Portugal on Jun. 27 that deflationary forces in the Eurozone have been replaced by reflationary ones, and that the central bank will need to “accompany” the region’s burgeoning economy, investors interpreted it as sign that the existing monetary stimulus is nearing the beginning of its end.

Government bonds fell, with the yield on 10-year German bunds spiking 22 basis points to 0.47%. Investors also sold corporate bonds, which have benefitted from the ECB’s buying hand. The STOXX EURO STOXX 50 Corporate Bond Index dropped 0.7% between Jun. 27 and Jun. 30, the biggest four-day retreat since November 2016 (Chart 1).

The euro also reacted, rising from $1.12 to over $1.14 in two days. ECB Vice President Vitor Constancio said the market’s response was misplaced.1

Challenge in managing market expectations

To many, it felt like a departure from Draghi’s usually dovish rhetoric. It also coincided with newly hawkish comments last week from the heads of the Bank of Canada and the Bank of England.

While Draghi was far from suggesting policy tightening is near – in fact he reiterated that “a considerable degree of monetary accommodation is still needed” – the market move nonetheless highlights the sensitivity that asset prices have to stimulus after years of extraordinarily loose policy. It therefore underscores the challenge that the central bank will face in coming months as it pulls back the support.

In 2013, US Treasury yields jumped sharply in what market analysts called a “taper tantrum” following suggestions by the Federal Reserve that it would taper its asset purchases.

“Draghi sparked a veritable mini-taper tantrum,” Elwin de Groot, head of macro strategy at Rabobank, wrote in a note. “We believe Draghi’s speech wasn’t an immediate change of heart, but it does again illustrate our view that the ECB is changing its narrative.”

The Eurozone’s economy expanded in the first quarter more than economists had forecast, while the manufacturing and services industries are growing at the fastest pace in years. Still, inflation has remained below the ECB’s target.

“We continue to hold the view that the ECB will remain very cautious as it eyes the exit of its policy of monetary accommodation,” said Mark Dowding, co-head of investment-grade debt at BlueBay Asset Management in London. “Whilst the economic backdrop continues to remain very upbeat, low inflation and a large output gap mean that Mario Draghi can bide his time. We believe that 10-year bund yields can remain in a range between 0.25% and 0.50% for another few months to come.”

1 “Draghi Tried to Be Cautious But Spooked the Market Anyway,” Bloomberg, Jun. 28, 2016.

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