By Paul J. Davies
European monetary policy erupted into a war of words on Tuesday. For now, markets seem to be listening most closely to European Central Bank chief Mario Draghi.
Mr. Draghi's suggestion in a speech of a fresh round of stimulus sent key European government-bond yields to record lows and caused the euro to fall against the dollar.
That drew the ire of President Trump, who tweeted that Mr. Draghi's comments had weakened the euro in a move that was "unfair," making it easier for Europe to compete against the U.S.
German 10-year bond yields dropped to minus 0.321%, while French rates touched zero for the first time ever, sliding from 0.11%. The euro also slipped against the dollar, falling 0.2% to $1.1196.
In a sign of how investors are anticipating monetary policy getting much looser, German government bonds with maturities ranging from three months to nine years now have yields lower than the ECB's main deposit rate of minus 0.4%.
The central bank has a number of weapons in its arsenal to take action if inflation doesn't pick up, according to Draghi. "This applies to all instruments," he said at a forum on the outskirts of Lisbon. "Further cuts in policy interest rates and mitigating measures to contain any side effects remain part of our tool."
Markets are now pricing in a rate cut of 0.10 percentage point by September for the eurozone, according to investors and strategists, effectively bringing forward expectations from some point over the next year. Mr. Draghi may have been prompted to make the comments by concerns that the U.S. Federal Reserve may pare rates at its meeting on Wednesday. Lower relative U.S. rates can cause the dollar to weaken.
Mr. Draghi responded to President Trump's criticism in a later session of the forum, saying that the ECB didn't target the level of the euro with its policies, only inflation. "We have our remit, we have our mandate," Mr. Draghi said. "We are ready to use all instruments that are necessary to fulfill the mandate."
"For Draghi, it is all about maintaining optionality and showing that the ECB is still an effective central bank with tools at its disposal," said Andrew Mulliner, a portfolio manager for global bonds at Janus Henderson. "If the Fed cuts rates in July, or soon after, and the euro rises to $1.15 or so, then it is very likely the ECB will have to cut rates."
Europe has seen inflation expectations plunge in recent weeks, which is another spur for Mr. Draghi to act. The "five year, five year," an interest-rate derivative that measures inflation expectations, has dropped in Germany to 1.23% from 1.39% in late May. U.S. inflation expectations have also fallen to 1.97% from 2.32% in late May.
"From Draghi's perspective, the main risk is a stronger euro weighing on inflation expectations," said Themos Fiotakis, head of FX and rates strategy at UBS. "So whatever the Fed outcome tomorrow, the ECB does need to fend off the notion that there is a lot more space to ease in other economies."
A move to more deeply negative rates would be hugely unpopular with Europe's savers and its banks, which have to pay to post reserves at the ECB. However, the ECB is expected to introduce some pain-relieving measures for banks, such as charging them lower negative rates on some of their reserves, which was why Mr. Draghi referred to "mitigating measures to contain side effects" of rate cuts.
That helps explain why shares of banks in Europe rose even as bond yields tumbled. Deutsche Bank rose 3.6% and a string of smaller Italian and Portuguese banks also benefited.
Riskier credit looks set to benefit most from the softer stance from the ECB, according to Mark Benbow, a fund manager at Kames Capital, who said the most liquid index reflecting investor interest in junk debt, the IHS Markit iTraxx Crossover Index, rallied on the comments. "Both Draghi's comments on the limits of QE and the potential for further rate cuts proved particularly beneficial for high-yield bonds," he said.
"The ECB choosing to respond to economic weakness created by the Trump administration's trade policy cannot sensibly be described as weakening its currencies to gain an economic advantage," Seema Shah, senior global investment strategist at Principal Global Investors, wrote in a note.
Write to Paul J. Davies at firstname.lastname@example.org
(END) Dow Jones Newswires
June 18, 2019 14:44 ET (18:44 GMT)
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