Draghi Impotent as Fed Trumps ECB on Yield Curve

The widest gap between two- and 10-year German yields in more than a year suggests the European Central Bank is struggling to protect the region’s economy from a U.S.-led surge in borrowing costs.

ECB President Mario Draghi pledged last week to keep interest rates low for an “extended period of time,” capping yields on bonds with maturities of three years or less. Longer-dated borrowing costs tracked Treasury yields higher after the U.S. Federal Reserve signaled it may scale back its bond-buying program. Borrowing costs for companies in the euro region rose to the most in eight months in June.

“The steeper yield curve in the euro area effectively means an increase in funding costs for both sovereign and corporate borrowers without an associated change in inflation or growth,” said Lyn Graham-Taylor, a fixed-income strategist at Rabobank International in London. “What Draghi did will influence shorter-dated rates. They don’t have an efficient tool at the moment to deal with long-term yields which are being driven by the Fed.”

The difference between German two- and 10-year yields rose to 161 basis points on July 5, the widest since April 2012 on a closing basis, while in Spain the gap is within 10 basis points of its highest in a year. Italy’s 30-year borrowing cost has climbed almost 50 basis points since Fed Chairman Ben S. Bernanke told lawmakers on May 22 that the central bank may begin tapering bond purchases “in the next few meetings,” as long as the local economy continues to grow.

Corporate Bonds

The yield on euro-region corporate bonds reached 2.38 percent on June 24, the highest since Oct. 11 and up from a euro-era low of 1.72 percent as recently as May, according to Bank of America Merrill Lynch’s Euro Corporate Index.

“We are now seeing a wholesale rise in bond yields,” said Michael Leister, a fixed-income strategist at Commerzbank AG in London. “It’s clear the ECB is capable of protecting the front end of the euro market. It’s more difficult further down the curve because of the influence of U.S. Treasuries on the global bond market.”

While U.S. data suggest the recovery there is gaining traction, Europe is struggling to emerge from the longest recession since the introduction of the single currency in 1999. Economists in a Bloomberg News survey predict the euro-area economy stagnated in the second quarter.

Unemployment Forecast

Looking ahead, gross domestic product will rise just 0.1 percent in the three months through September and 0.2 percent in the subsequent two quarters, according to the median forecast in the survey. At the same time, unemployment is forecast to rise to a record 12.4 percent this year.

In pledging to keep rates low on July 4, the ECB departed from a tradition of never “pre-committing” on monetary policy. While the ECB’s version of forward guidance differs from that of other central banks, which have tied interest-rate moves to particular economic indicators or a timeframe, analysts said it signifies a major change in European central banking.

More than three-quarters of respondents in the Bloomberg monthly survey of 50 economists said that Draghi’s definition of an extended period is likely to exceed 12 months, while 10 said it may be anywhere between six months and a year. The Frankfurt-based central bank will keep its benchmark rates unchanged until at least 2015, the median of 34 economists shows.

Bond Losses

German bonds due in 10 years or longer handed investors a 5.43 percent loss in May and June, compared with a 0.62 percent decline in notes that mature within five years, according to Bank of America Merrill Lynch indexes.

Italian two-year notes yielded 1.71 percent at 3:56 p.m. London time, up from 1.37 percent at the start of May. The 10-year yield climbed more than 50 basis points in the same period to 4.47 percent.

The ECB may have to consider a new approach to curb long-term borrowing costs, said Jack Kelly, who helps oversee $250 billion at Standard Life Investments in Edinburgh. The central bank pledged in September to buy unlimited notes from troubled countries, under a program called Outright Monetary Transactions, if officially asked.

German newspaper Sueddeutsche Zeitung reported last month that ECB officials are considering a policy of quantitative easing in the euro region. ECB Executive Board member Joerg Asmussen later played down the report, saying that discussion wasn’t “policy-relevant.”

Legitimate Debate

“There will be a more legitimized debate and argument about QE now than there was before because the justification will be about keeping borrowing costs low across the board and not about supporting individual sovereigns,” Kelly said. “The ECB may not need to use it, but including QE in its lexicon might be sufficient to keep a lid on yields.”

In the meantime, Kelly said he remains wary of longer-dated government securities in the euro region.

“The recent backup in yields at the front end of the core market offered an opportunity to buy because there is no risk of early tightening by the ECB,” Kelly said. “There is little the ECB can do with its current tools to mitigate the impact of the Fed’s policy on longer-term rates.”

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