The euro has faced bearish bets amid rising stock prices as traders anticipate further monetary loosening from the European Central Bank (ECB). In a recent speech, its President, Mario Draghi, indicated that downside risks to demand and inflation may prompt an even more accommodative policy stance. The comments have buoyed government bond and equity markets and led to declines in the value of the common currency.
Draghi delivered his comments at a gathering of central bank officials in Jackson Hole, Wyoming. During his speech, the ECB chief drifted from prepared remarks to say that ‘inflation expectations [in the euro area] exhibited significant declines at all horizons‘. He pointed out the negative impact this may have on economic output, noting that ‘real rates on the short and medium term have gone up‘. In assessing the factors that have led to lower inflation, he concluded that many are ‘temporary in nature – though not all of them’.
The off-key remarks underscored concern on the part of policymakers about the outlook for prices. Low rates of inflation are associated with a range of negative outcomes, including elevated unemployment, stagnant demand and more difficult debt dynamics. Some market participants therefore believe that the ECB will take action to counteract these risks. In June, the Governing Council reduced both its deposit and refinancing rate by 10 basis points to -0.10% and 0.15%, respectively. These could fall even further.
Some have not ruled out a full-blown quantitative easing program. A Reuters poll conducted prior to Draghi’s speech found that money market traders were evenly split as to whether a European QE program would be unveiled in the next twelve months. The odds of such an occurrence have surely risen since he made his dovish comments. The scale and scope of any such intervention may be different from those seen in the U.K. and U.S. Traders envisage a proportionally smaller program, focused on private sector assets. However, as always, German reticence complicates matters.
Quantitative easing or not, the outlook for monetary policy in euro area is on a divergent path from that in the U.S. Across the Atlantic, Federal Reserve officials have begun to debate steps towards policy tightening, with mid-2015 the consensus expectation for a first hike in interest rates. It is a similar story in the U.K. By contrast, rate setters in Frankfurt have recently loosened policy and may take further steps in that direction. Against a backdrop of austerity, high unemployment and disinflation, it is almost certain that euro area policy will be extremely accommodative for some time yet.
This renewed expectation for loose monetary policy has helped to lift European bond and equity markets. The yield on a benchmark ten-year bund has drifted further below 1%, and at the time of writing was 0.92%. It has declined by over 100 basis points so far this year. But this is not a ‘safe-haven’ story; its Spanish equivalent has declined – by almost 200 basis points in 2014, and is on track to fall below 2%. Elsewhere, the yield on two-year government bonds has turned negative for several member states. Meanwhile, the headline Euro Stoxx equity index has jumped by more than 3% since Draghi uttered his words.
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If European bonds and stocks are the winners, the euro may be the big loser. Indeed, the divergent outlook for economic activity and monetary policy has re-focused attention on currency markets. In theory, the euro should suffer in the current environment for reasons that Draghi himself has laid out. These include the divergent outlook for monetary policy, as well as reduced capital inflows and purchases from other central banks. There are signs of this already. The euro has fallen by over 4% this year and crossed below the benchmark of 1.32. Should policymakers in Frankfurt reveal a further policy loosening, the common currency may decline even further.
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