Draghi’s Virtuous Bond Circle Vicious for CurrencyAnchalee Worrachate
When the Federal Reserve and Bank of England raised the prospect of buying bonds to support the economy, the dollar and the pound tumbled. As the European Central Bank makes similar suggestions, the euro is rising.
That’s the perverse predicament facing ECB President Mario Draghi, who is trying to avert the risk of deflation that a stronger currency would exacerbate. Working against him is the wave of cash flooding into euro-region bonds as investors, including the world’s largest money manager BlackRock Inc., snap up the securities in anticipation of quantitative easing that may lower yields and push prices higher.
“There is a virtuous circle at play here for peripheral nations but a vicious one for the ECB,” Richard McGuire, head of rates strategy at Rabobank International in London, said in a phone interview on April 25. “Speculation of QE further underlines the appeal of peripheral debt, which in turn attracts more money from non-euro based investors, which strengthens the euro, which raises concern of disinflation, which underpins speculation of QE. The circle goes on.”
The euro’s 6.1 percent gain versus the dollar in the past 12 months and record-low borrowing costs from Ireland to Italy are signs of Draghi’s success in calming the euro region’s sovereign-debt crisis. The irony is that the currency’s strength also risks weighing on a recovery hampered by inflation that’s less than half the ECB’s goal of just under 2 percent.
All but two of 51 economists in a Bloomberg News survey say officials will keep the benchmark rate at a record-low 0.25 percent when the central bank makes its next policy announcement on May 8. One analyst predicts a cut to 0.15 percent and another forecasts a reduction to 0.1 percent.
The ECB will probably take some sort of action within two months against the threat of falling prices, according to a separate survey of economists in April. Twenty-two percent of respondents to Bloomberg News questions expected the central bank to extend a program of long-term loans. Sixteen percent said the ECB would start buying assets.
Draghi said on April 12 that “further monetary stimulus” is required as the euro appreciates to keep the ECB’s policy stance “equally accommodative.”
“In the last year, year and a half, it was the exchange rate that had an impact on price stability,” Draghi said. “I’ve always said that the exchange rate is not a policy target, but it’s important for price stability and growth. And now, what has happened over the last few months, it’s become more and more important for price stability.”
Since then, 10-year rates on Italy’s and Ireland’s bonds have dropped to records of 3.05 percent, and 2.81 percent, respectively. Securities from the region’s most-indebted nations gained 0.8 percent in the period, compared with a 0.3 return from German securities, according to Bank of America Merrill Lynch indexes. Treasuries earned 0.2 percent.
Portugal’s two-year yields have fallen to less than 1.2 percent from as high as 2.6 percent in February, based on closing-market rates, vindicating a call that month by BlackRock’s head of investment strategy for international fixed income, Stephen Cohen, that ECB easing speculation would send the price of the notes higher.
Draghi reiterated on April 24 that the ECB might start broad-based asset purchases if the inflation outlook worsens. The euro strengthened against the dollar that day, and added 0.2 percent since then to reach $1.3861 at 11:53 a.m. London time today.
The dollar weakened more than 10 percent during the Fed’s first round of quantitative easing from November 2008 through March 2010, according to Bloomberg Correlation-Weighted Indexes, which track a basket of 10 developed-nation currencies. Sterling dropped about 4 percent from the beginning of a similar program by the Bank of England in March 2009 through the end of that year.
“This puts Draghi in a difficult spot because the ECB thought that by using verbal intervention, they will be able to put pressure on the euro,” said Salman Ahmed, a London-based global strategist at Lombard Odier Investment Managers, which oversees $46 billion. “Communication has an important role in monetary policy, but it has a limited shelf-life if it’s not followed by action. The danger is that if the market isn’t convinced the ECB is going to do it, we may see a spike in the euro.”
Net portfolio investment flows into euro-region assets rose to 24.3 billion euros in February from 19.3 billion euros in January, according to ECB data. The data show positive flows for four consecutive months, the longest streak since the six months to January 2013 that followed a pledge from Draghi to do “whatever it takes” to preserve the currency bloc.
As he seeks policy tools to stimulate the economy, Draghi is also facing skepticism from the region’s biggest money managers over his plan to buy asset-backed securities. The ECB’s president is promoting the market for bonds backed by loans to small- and medium-sized enterprises in a bid to increase funding to the businesses that employ about 70 percent of the European Union’s private-sector workers.
“It would be nice for banks as they could fund very cheaply, but would they pass on the cheap funding to customers or will they keep the higher profit margin themselves?” said Frank Erik Meijer, The Hague-based head of ABS at Aegon Asset Management, which oversees 250 billion euros of assets. “I don’t see SMEs benefiting a lot because banks will probably try to keep the additional profit margin to increase their capital base.”
There are signs that the euro-area economy is recovering from a prolonged slump that followed the global financial crisis. The region’s services and manufacturing expanded at the fastest pace in almost three years in April, according to data from London-based Markit Economics.
That’s not translating into faster inflation as the region remains blighted by unemployment. The headline price-growth rate fell short of economist forecasts last month, when it climbed to 0.7 percent from 0.5 percent in March. It was the seventh straight reading below 1 percent. Euro-area unemployment was unchanged at 11.8 percent in March, a level reached in December and just short of a record 12 percent set last year, according to data from the EU’s statistics office in Luxembourg today.
Price-growth expectations in the euro area, as measured by inflation swaps, were at 1.67 percent today, having fallen to 1.62 percent on March 28, the least on a closing-market basis since 2008. The 10-year average is 2.14 percent.
Bond investors may win either way, as slower inflation preserves the value of fixed payments on the securities. Spanish government debt led returns this year among the 50 biggest issuers in the Bank of America Merrill Lynch broad index, with average gains of 7.4 percent, followed by 6.6 percent for Italian debt and 5.7 percent for Irish securities.
“Investors continue to buy peripheral bonds, which is a positive thing for the region, but the strength of the euro will make it a bit more challenging for the ECB to navigate,” said Soeren Moerch, head of fixed-income trading at Danske Bank A/S in Copenhagen. “It’s not easy to be Mr. Draghi.”