Euro Bonds Lose Sway in Blow to Draghi’s Stimulus Plan

Photographer: Krisztian Bocsi/Bloomberg

European Central Bank vice president Vitor Constancio said in Vienna yesterday that the euro's gains had wiped 0.5 percentage point off consumer-price inflation. Close

European Central Bank vice president Vitor Constancio said in Vienna yesterday that the... Read More

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Photographer: Krisztian Bocsi/Bloomberg

European Central Bank vice president Vitor Constancio said in Vienna yesterday that the euro's gains had wiped 0.5 percentage point off consumer-price inflation.

For the first time since 2009, the euro is strengthening even as the region’s benchmark bond yields lose ground to their counterparts in the U.S.

The breakdown in a link that’s existed for most of the euro’s 15-year history is being triggered by a surge in demand for high-yielding assets from the likes of Greece and Spain, a development that makes it harder for policy makers to weaken the currency and ward off deflation through stimulus measures.

“Why would the euro go up when yields drop?” Peter Frank, the London-based global head of Group-of-10 and Asia currency strategy at Banco Bilbao Vizcaya Argentaria SA, said May 8 by phone. “Because credit quality has come up, so euro-denominated assets are more attractive.”

That’s a problem for European Central Bank President Mario Draghi because it’s a source of currency strength that he’s less able to curb by cutting interest rates or purchasing assets. Draghi said at the ECB’s policy meeting in Brussels last week that he’s “comfortable” with the idea of boosting stimulus at the June gathering, and that a strong euro “in the context of low inflation is cause for serious concern.”

The 18-nation euro has been climbing steadily against the dollar for almost two years as the continent recovers from the sovereign-debt crisis that sank the currency union into its worst-ever recession in 2009.

Bundesbank Tumble

The euro has risen 1.7 percent since the end of January and reached a 2 1/2-year high of $1.3993 on May 8. It tumbled to a five-week low of $1.3712 today as the Wall Street Journal reported Germany’s Bundesbank is open to significant ECB stimulus in June, citing a person familiar with the matter.

BBVA predicts the euro will weaken to $1.34 to $1.35 by the end of September, compared with the $1.34 median forecast of 57 strategists surveyed by Bloomberg.

Euro-region inflation remains less than half the ECB’s target of up to 2 percent, while growth lags the U.S. Consumer prices (ECCPEMUY) rose 0.7 percent in the year through April, according to economists surveyed before official data due on May 15.

That’s heaping pressure onto Europe’s policy makers. Draghi pledged April 24 to start asset purchases, known as quantitative easing, if a stronger currency keeps inflation depressed. ECB Vice President Vitor Constancio said in Vienna yesterday that the euro’s gains had wiped 0.5 percentage point off consumer-price inflation.

First Step?

The ECB will need to do more next month than just lower its main refinancing rate from a record-low 0.25 percent, said Ulrich Leuchtmann, the head of currency strategy at Commerzbank AG in Frankfurt. Any cut would be the first since November.

“It’s about whether there’s long-term inflation-outlook concern, and is a rate cut a first step after which potential quantitative easing might follow?” Leuchtmann said in a May 8 interview. “This will be the most important thing next month.”

The relative strength of the euro has wrong-footed investors who were positioned at the end of last year for a decline in the shared currency versus the dollar as the Federal Reserve reduces its own stimulus measures.

The 120-day correlation between the euro and the two-year U.S. Treasury’s yield premium over German notes has risen to 0.2, from minus 0.9 in June, when they were moving in virtually opposite directions from one another. A reading of 1 would mean they were moving in lockstep, while zero would imply there’s no relationship between them.

‘Big Surprise’

The last time the correlation was positive was October 2009, when Greece sparked the euro-region crisis by admitting to misreporting its budget deficit. The euro went on to plunge more than 20 percent by the middle of 2010.

That the euro is no longer moving in line with bonds is a “big surprise” to Brendan Brown, the chief economist at Mitsubishi UFJ Securities International Plc in London.

“One of the most stable correlations has been when yield spreads in favor of the U.S. widen over German government bonds -- then the dollar is strong and the euro” tends to weaken, Brown said in a Bloomberg Radio interview on May 6. “Everyone and their dog is pouring their money into these once-upon-a-time high-yield European products, and that’s what’s pushing the euro up.”

Asset purchases by the ECB could therefore backfire by increasing demand and strengthening the euro, said Valentin Marinov, the head of European G-10 currency strategy at Citigroup Inc., the world’s biggest foreign-exchange trader.

Even with these potential pitfalls, doing nothing isn’t an option, according to John Taylor, the founder of FX Concepts LLC, which was the largest currency hedge fund before it entered bankruptcy in October.

“Draghi has now set everyone up for doing something in June,” Taylor said in a May 9 phone interview from New York. “He has promised it now, and they sort of have to deliver.”

To contact the reporters on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net; Lukanyo Mnyanda in Edinburgh at lmnyanda@bloomberg.net

To contact the editors responsible for this story: Dave Liedtka at dliedtka@bloomberg.net; Paul Dobson at pdobson2@bloomberg.net Paul Armstrong, David Papadopoulos

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