While Mario Draghi says markets must cope with a little turbulence, he may need a remedy on hand should it prove too much.
With the days of ultra-low U.S. interest rates looking numbered, the European Central Bank president’s advice to investors to weather any volatility gives them notice to prepare for a world without permanent central-bank support. The stance leaves the ECB treading a line between freeing borrowing costs to fluctuate as the euro-area economy heals, and holding them back if they threaten to choke off growth.
The bond market tested the water on Wednesday when Draghi - - after committing again to let the ECB’s 1.1 trillion-euro ($1.2 trillion) asset-buying program run its course -- said “we should get used to periods of higher volatility.” Taking the hint, investors ditched German bunds and pushed yields to a seven-month high.
“There’s a point at which rising real yields translate into an unwarranted monetary tightening,” said Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London. “At that point, the ECB has to act. If talking yields back down doesn’t work, then the ECB has to put its money where its mouth is and buy more bonds.”
Yields continued to rise on Thursday, extending the worst rout in German 10-year debt in the history of the euro. he bonds yielded 0.95 percent, up seven basis points, at 12:12 p.m. Frankfurt time. That builds on an increase of more than 34 basis points in the previous two days, the biggest jump since at least 1999.
Draghi has played this game before. In Amsterdam in April 2014, he helped lay the groundwork for quantitative easing by saying he’d act against an “unwarranted” tightening of monetary conditions. Solutions included cutting interest rates or extending liquidity measures, he said. In the end, he did both -- then went further by unveiling an unprecedented program to buy private and public-sector debt.
The concern about tighter monetary conditions stems from the role that bond markets play in setting benchmarks such as the costs of mortgages, consumer loans, and credit to companies. When yields rise too fast, the real economy suffers.
The ECB’s markets chief, Executive Board member Benoit Coeure, expressed concern last month about the speed of the rise in yields. Draghi made clear on Wednesday, after the Governing Council’s monetary-policy meeting, that the ECB is ready to revise or expand the plan to spend 60 billion euros a month if needed.
“If there were other factors that would, for example, create an unwanted tightening of monetary policy, then we would have to reconsider the size, the timing, the design of the program,” Draghi said.
Investors instead focused on his laissez-faire view on volatility, reading it as a relative lack of concern should market borrowing costs rise.
“Draghi’s verbal intervention failed spectacularly,” said Nick Kounis, head of macro research at ABN Amro NV in Amsterdam. “This is going in the opposite direction. I think further verbal intervention will be necessary.”
Officials may at least need to hammer home the message that the scale of QE is contingent on the economic recovery, and not the other way around.
“The market has to get used to this new situation where you don’t have central banks saving the day all the time,” said Beat Siegenthaler, senior investment adviser at UBS AG in Zurich. “Monetary conditions are kind of a second priority in a way. The prime target is to get inflation expectations and confidence up. If that means tighter monetary conditions, then that’s fine.”