Bond Markets Have ECB President Draghi in a Vise Over Easing

(Bloomberg) -- Bond investors are pricing in more stimulus from the European Central Bank and still don’t see inflation being revived, making President Mario Draghi’s task of responding to the markets unenviable.

Policy makers will review monetary policy Thursday as yields across the continent breach record lows on global trade and growth fears, with traders looking for more details on the latest round of cheap bank loans, known as TLTROs. Officials may need to signal they are considering stronger action, such as a new round of quantitative easing, if they are to maintain credibility in the eyes of some investors.

Bond Markets Have ECB President Draghi in a Vise Over Easing

“To fight back, the ECB needs to out-dove the market,” Jamie Searle, a fixed-income strategist at Citigroup Inc., said in a note to clients. “That’s unlikely to be achieved via TLTRO pricing or forward guidance changes. It needs to be stronger and unexpected, like a hint that QE can be restarted.”

Traders in money markets are pricing in a 50% chance of a rate cut from the ECB this year, as Draghi plays catch up to easing from global central banks. The Reserve Bank of Australia lowered borrowing costs to a fresh record Tuesday, while the Federal Reserve may need to cut interest rates soon, according to St. Louis Fed President James Bullard. That outlook has driven a rally in global bonds, with German bund yields at the lowest on record.

What’s expected at this week’s meeting:

  • The details of the ECB’s third round of Targeted Longer-Term Refinancing Operations, with traders looking to see what interest rate will be charged. Citigroup forecasts the pricing to be set at the main refinancing rate minus 20 basis points
  • ECB may upgrade its economic growth forecast for 2019, with NatWest Markets expecting a revision to 1.2% from 1.1%
  • Economists predict Draghi will say the balance of risks remain to the downside

The surge in Europe’s bonds in recent weeks has also sent yields on Greek, Spanish and Portuguese securities to the lowest levels ever, while the euro is hovering near the weakest since 2017. Five-year forward five-year inflation swaps, a gauge of the market’s inflation expectations, are close to touching the lowest on record at 1.28%.

Here’s what bank strategists said about the ECB:

BofAML (Don’t doubt Draghi)

  • “We remain bullish duration, despite current levels,” write strategists Sphia Salim and Ruairi Hourihane
    • “We could therefore easily envisage bunds at -25 basis points, even without further rally in the front end”
  • “TLTROs unlikely to be designed in a way that is particularly bullish peripherals”
    • The ECB will “aim to significantly reduce the incentive for fresh carry trades, be that through a rate above the Refi or otherwise (for e.g. much stricter measures of compliance with the lending goals vs benchmarks”

Nordea Bank ABP (Risk of stronger euro)

  • We see risk/reward tilted towards a market reaction with a slightly stronger euro and higher euro rates, says Jan von Gerich, chief strategist at Nordea
  • While Draghi has proved many times that he can be more dovish than market expectation “this time it will be harder”
    • Markets expect a rate cut, very negative outlook for the euro area already priced in and TLTRO-III terms to be less appealing than TLTRO-II terms
  • Draghi unlikely to open the door more to rate cuts compared to what he did in April

Credit Agricole (Underwhelming ‘bazooka’)

  • Given market positioning and FX valuation, positives from the unwinding of EUR-funded carry trades to prevail and euro could thus extend its recent recovery, strategist Valentin Marinov says
  • “With the ECB governing council apparently less supportive of an over-generous TLTRO and still divided on the idea of a tiered deposit rate, we think the markets may find Draghi’s new policy ‘bazooka’ underwhelming,” says Valentin Marinov, the head of G-10 currency strategy at Credit Agricole

Rabobank (Not dovish enough)

  • “There is a risk the ECB could appear ‘not dovish enough’ and we could see a short move higher in the euro,” says Jane Foley, the head of currency
    • “The fact is the market is expecting too much from them”

©2019 Bloomberg L.P.

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