Markets Insight
June 25, 2013 11:55 am
ECB needs timely response to Fed tapering
Draghi must act so the eurozone is not a major casualty of US policy
This time, you can’t blame the eurozone. The latest turbulence in global bond markets, which has suffered a steep sell-off across emerging and advanced economies, was not triggered by tensions in Europe’s monetary union, unlike most episodes in the past few years. But the region could become one of its casualties.
Investors’ expectations of a European Central Bank response are rising – with justification. Yet, with his options limited, Mario Draghi, ECB president, may simply exacerbate the volatility created by his counterpart at the US Federal Reserve.
What is clear is that the eurozone impact was not at the top of Ben Bernanke’s worry list when he set out plans last week to start “tapering” the Fed’s quantitative easing later this year. As Richard Fisher, president of the Dallas Federal Reserve, told the Financial Times in London this week, even central banks whose influence extends way beyond their shores remain accountable to national constituencies. “It is an oddity in a globalised world,” he admitted.
The market reaction across Europe this week has been severe, however. Yields on 10-year Spanish and Italian government debt, which move inversely with prices, have jumped to levels last seen in February, when inconclusive elections threw Italy into political confusion.
The good news is that spreads between the yield on Italian and Spanish bonds and German Bunds remain well below those seen when the eurozone debt crisis was at its most intense. That confirms that investors are taking a more sanguine view of risks in the eurozone periphery – especially compared with emerging market debt. Street protests in Turkey and Brazil have put social unrest in western Europe into context. More crucially, Mr Draghi’s pledge last July to do “whatever it takes” to preserve the euro’s integrity remains credible. Spanish and Italian debt are performing more like government bonds should – and less like default-prone credit markets.
Limiting the scope for a further sell-off, the most footloose foreign investors have long fled the riskiest bonds. True, crisis-hit Portugal will have more difficulty returning to markets than imagined only a few weeks ago. But we are far from the point where peripheral bond markets dive into the sort of death spiral we saw last year.
The bad news is that actual bond yields have still increased substantially which as well as putting pressure on government finances, amounts to a significant monetary policy tightening. German 10-year Bund yields have risen more than 60 basis points in little more than a month.
Such a tightening could be very damaging for a eurozone economy that – in contrast to the US economy – remains in recession with unemployment rising, including in northern “core” countries such as the Netherlands. The interest rates on longer-terms loans required for job-creating capital investment are determined by market rates, not the central bank. Those rates were rising even before Mr Bernanke started the Fed tapering talk.
With southern Europe undergoing deep restructuring, eurozone deflation is also a bigger danger than in the US. Underlying eurozone inflation measures are hovering around 1 per cent – way below the ECB’s target of an annual rate “below but close” to 2 per cent. It all points to a need for serious policy loosening.
One escape route for the ECB would be a significant weakening in the euro. But that has not happened so far. Instead the unwinding of diversification trades has supported the currency.
Sincé becoming ECB president in November 2011, Mr Draghi has taken a “stop-start” approach towards policy action. At moments of acute crisis, he pushed the ECB’s 23-strong governing council into bold action – the offers of cheap three-year liquidity in 2011 and the “whatever it takes” pledge last year. But then he has shown a more cautious side, anxious to reassure a nervous German audience. This month, for example, he emphasised how higher bond yields were “a very important sign” of normalisation for German savers.
While Mr Draghi has said options for further action are under discussion, he has hesitated so far – hoping an economic pick-up will avert the need to act. The possibilities include fresh offers of three-year liquidity, perhaps on even more favourable terms than in 2011; a negative interest rate on deposits parked by banks at the ECB; or a variety of asset-purchase schemes, some tailored for specific markets, others larger scale. With the eurozone’s complex politics and financial system, all the above have pros as well as cons. But the Fed’s action could soon force a decision.
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Investors’ expectations of a European Central Bank response are rising – with justification. Yet, with his options limited, Mario Draghi, ECB president, may simply exacerbate the volatility created by his counterpart at the US Federal Reserve.
What is clear is that the eurozone impact was not at the top of Ben Bernanke’s worry list when he set out plans last week to start “tapering” the Fed’s quantitative easing later this year. As Richard Fisher, president of the Dallas Federal Reserve, told the Financial Times in London this week, even central banks whose influence extends way beyond their shores remain accountable to national constituencies. “It is an oddity in a globalised world,” he admitted.
The market reaction across Europe this week has been severe, however. Yields on 10-year Spanish and Italian government debt, which move inversely with prices, have jumped to levels last seen in February, when inconclusive elections threw Italy into political confusion.
The good news is that spreads between the yield on Italian and Spanish bonds and German Bunds remain well below those seen when the eurozone debt crisis was at its most intense. That confirms that investors are taking a more sanguine view of risks in the eurozone periphery – especially compared with emerging market debt. Street protests in Turkey and Brazil have put social unrest in western Europe into context. More crucially, Mr Draghi’s pledge last July to do “whatever it takes” to preserve the euro’s integrity remains credible. Spanish and Italian debt are performing more like government bonds should – and less like default-prone credit markets.
Limiting the scope for a further sell-off, the most footloose foreign investors have long fled the riskiest bonds. True, crisis-hit Portugal will have more difficulty returning to markets than imagined only a few weeks ago. But we are far from the point where peripheral bond markets dive into the sort of death spiral we saw last year.
The bad news is that actual bond yields have still increased substantially which as well as putting pressure on government finances, amounts to a significant monetary policy tightening. German 10-year Bund yields have risen more than 60 basis points in little more than a month.
Such a tightening could be very damaging for a eurozone economy that – in contrast to the US economy – remains in recession with unemployment rising, including in northern “core” countries such as the Netherlands. The interest rates on longer-terms loans required for job-creating capital investment are determined by market rates, not the central bank. Those rates were rising even before Mr Bernanke started the Fed tapering talk.
With southern Europe undergoing deep restructuring, eurozone deflation is also a bigger danger than in the US. Underlying eurozone inflation measures are hovering around 1 per cent – way below the ECB’s target of an annual rate “below but close” to 2 per cent. It all points to a need for serious policy loosening.
One escape route for the ECB would be a significant weakening in the euro. But that has not happened so far. Instead the unwinding of diversification trades has supported the currency.
Sincé becoming ECB president in November 2011, Mr Draghi has taken a “stop-start” approach towards policy action. At moments of acute crisis, he pushed the ECB’s 23-strong governing council into bold action – the offers of cheap three-year liquidity in 2011 and the “whatever it takes” pledge last year. But then he has shown a more cautious side, anxious to reassure a nervous German audience. This month, for example, he emphasised how higher bond yields were “a very important sign” of normalisation for German savers.
While Mr Draghi has said options for further action are under discussion, he has hesitated so far – hoping an economic pick-up will avert the need to act. The possibilities include fresh offers of three-year liquidity, perhaps on even more favourable terms than in 2011; a negative interest rate on deposits parked by banks at the ECB; or a variety of asset-purchase schemes, some tailored for specific markets, others larger scale. With the eurozone’s complex politics and financial system, all the above have pros as well as cons. But the Fed’s action could soon force a decision.
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Copyright The Financial Times Limited 2013
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