Draghi Secret Roadmap Coveted as Yields Jump: Euro Credit
Mario Draghi may need to give investors a better peek at his policy roadmap as bond yields in Europe rise once again.
With Portugal’s 10-year yield yesterday climbing above 8 percent for the first time since November and the Federal Reserve signaling it may remove monetary stimulus, investors are now seeking assurance from the European Central Bank president that it has no plans to end its current accommodative stance. Some economists are suggesting Draghi will go a step further and offer commitments on the path of interest rates.
“Forward guidance is probably the most powerful tool the ECB has left,” said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam. “It’s certainly something they need to consider because financial markets are pricing in higher short-term interest rates.”
Almost a year after Draghi halted an increase in borrowing costs by saying he’ll do “whatever it takes” to save the euro, bond investors are signaling that more is needed, in words if not in deeds. The ECB head used a form of forward guidance in March when he said for the first time that monetary policy “will remain accommodative for as long as needed.” With some economic indicators showing an improvement, his challenge now is to pledge that the central bank will keep rates low without compromising its inflation goal or boxing itself into a corner.
The Frankfurt-based ECB will keep its benchmark interest rate unchanged at a record low of 0.5 percent today, according to 61 of 62 forecasts in a Bloomberg News survey of economists. Morgan Stanley is the only institution predicting a reduction, by a quarter point.
The decision is due at 1:45 p.m. in Frankfurt and Draghi will hold a press conference 45 minutes later. The Bank of England, at its first rate decision under new governor Mark Carney, will keep its bond-purchase target at 375 billion pounds ($573 billion) and maintain its key rate at 0.5 percent, separate surveys show. That decision is due at noon in London.
Additional forward guidance may help the ECB keep market interest rates in the 17-nation euro area from rising to levels that threaten to prevent the currency bloc emerging from its longest-ever recession.
On July 2, banks charged each other 8.2 basis points, or 0.082 percent, for overnight lending, compared with as little as 5.6 basis points in February. Bond yields in Portugal have spiraled since the resignation of two of the nation’s ministers sparked concern austerity fatigue will derail fiscal reforms.
Italy’s 10-year bond yield rose six basis points yesterday to 4.5 percent while the 10-year bond yield for Spain jumped more than 14 basis points to 4.768 percent. Germany’s bunds advanced, with the 10-year yield dropping 4 basis points to 1.660 percent.
“Draghi will use the press conference to reassure banks and markets that there is a consensus in favor of an accommodative policy,” said Christian Schulz, an economist at Berenberg Bank in London. “He will provide everything short of Fed-style forward guidance to signal that the ECB will keep rates very low, liquidity provision generous and the OMT commitment credible as long as necessary.”
OMT, or Outright Monetary Transactions, is the ECB’s as-yet-unused pledge to buy the bonds of crisis-hit countries in the euro area that sign up to reform conditions. Judges at the German Constitutional Court in Karlsruhe are considering whether the program contravenes the nation’s Basic Law.
The theory behind forward guidance is that it boosts weaker economies by lowering the anticipated path of interest rates while signaling the bank will tolerate higher inflation. The Fed has gone the furthest among major central banks by tying changes in its benchmark rate directly to indicators for employment and inflation, setting thresholds that dictate the lifespan of easy money.
The ECB is looking “carefully” at the U.S. experience, Executive Board member Benoit Coeure said in an interview with The Times last week.
Still, the Fed’s example shows that forward guidance comes with risks. Financial markets slumped after Fed chairman Ben S. Bernanke said June 19 that the central bank could stop purchasing assets around the middle of next year when joblessness “would likely be in the vicinity of 7 percent.”
Central bankers including Draghi, the then Bank of England Governor Mervyn King and ECB Governing Council members said a week later that an exit to current monetary policy is “distant.” Richard Fisher, president of the Federal Reserve Bank of Dallas, said that officials are talking about a “dialing back” rather than an exit, and Minneapolis Fed President Narayana Kocherlakota said the Fed must emphasize that policy will remain accommodative “for a considerable time.”
For the ECB, “forward guidance linked to real economic benchmarks - à la the Fed - is less likely, as highlighted by the problems of forward guidance in the U.S.,” Michala Marcussen, global head of economics at Societe Generale SA in London, said in a note this week. It also risks “possibly diluting the ECB’s primary objective of price stability,” she said.
ECB policy makers have said that the central bank’s primary goal of price stability won’t change and that inflation rates above two percent won’t be tolerated in the medium term. At the same time, Draghi has several options to choose from when extending forward guidance.
He could tell investors how long low interest rates will last, mirroring an existing commitment to supply unlimited liquidity to euro-area banks against collateral until mid-2014. If new Bank of England Governor Mark Carney’s policy at his former job at the Bank of Canada is an inspiration, the ECB might commit to keep rates low for a set period of time, unless inflation spirals above a target.
Fixing the rate charged on longer-term refinancing operations would be a more indirect commitment to keep rates unchanged. At the moment, the interest banks pay is linked to the average of the ECB’s benchmark over the life of the loan.
“The most likely form of guidance is a statement that exit is ‘very distant’,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “But it is possible that the Council will go the whole hog and commit to time-contingent Delphic guidance to coincide with what is already being done on the liquidity operations.”
Draghi said on June 26 in Paris that he has an “open mind” about all possible instruments. Last month, he said options include charging banks for depositing money with the ECB, easing collateral rules, reviving the market for asset-backed securities and providing investors with greater guidance on how long borrowing costs will stay low.
“The general attitude of the ECB is, ‘we have an open mind, we can do more if needed,’’ said Ken Wattret, an economist at BNP Paribas SA in London. ‘‘But the appetite to do more is rather limited at the moment.’’
While unemployment rose to a record 12.2 percent in May, other indicators have signaled the economy may recover under current monetary policy. Confidence in the currency bloc jumped to the highest level in more than a year in June, a gauge of manufacturing and services output improved for third month and industrial output rose for a third month in April.
‘‘Draghi will probably address the latest increase in bond yields,’’ said Carsten Brzeski, senior economist at ING in Brussels. ‘‘He will not use traditional policy tools but rather central bankers’ other powerful tool: words.’’
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