Draghi remarks are honey for euro bears
Frankfurt (Sept 4) Considering the euro's recent declines against the dollar, European Central Bank President Mario Draghi just fed the euro bears a big dollop of honey.
Draghi on Thursday announced a 0.1-percentage-point cut in all three main ECB interest rates alongside purchases of asset-backed securities and covered bonds.
Although the size of the purchasing program is only due to be determined on October 2, Draghi's statement represents a key move toward boosting anemic euro-zone inflation and lowering real interest rates in the monetary bloc. Downward pressure on the euro will be a crucial side-effect. This will not only be a boost for exports from the euro zone to the rest of the world, with goods priced in euros becoming cheaper and more attractive to international buyers, but also food for dollar bulls and euro bears.
As Draghi loosens monetary policy and announces a round of asset purchases in the euro zone, Federal Reserve Chair Janet Yellen is tapering loose policy and asset purchases in the US. Compared with declining rates in the euro zone, U.S. rates are becoming increasingly attractive for depositors and investors.
European Central Bank and U.S. Federal Reserve policy were already diverging before the announcement. The Fed has been tapering its asset-purchasing program since December and is now close to ending it. Meanwhile, Draghi warned over the strength of the euro earlier this year and subsequently introduced a negative deposit rate at the ECB's June meeting. Draghi's announcement Thursday has only reinforced this dynamic.
The divergence between Fed and ECB policy also reflects a yawning chasm between the health of the U.S. and euro zone economies – another headwind for the euro against the U.S. dollar. U.S. inflation was 2 percent on an annualized basis in July, compared with an almost disinflationary 0.4 percent in the euro zone, undershooting the ECB's target of just below 2 percent. The U.S. unemployment rate was 6.2 percent, a little more than half the euro-zone figure of 11.5 percent. And while U.S. GDP grew at an annual rate of 4.2 percent in the second quarter, euro-zone growth stalled.
Draghi has clearly reacted to the loss in economic momentum in the euro zone, highlighting ongoing downside risks and expanding the ECB balance sheet to purchase loan packages and collateralized debt. Although he left the size of the purchasing program open, he said "the aim is to steer the size of the balance sheet of the ECB towards where it was in 2012." The size of the ECB's balance sheet peaked in June 2012 at 3.1 trillion euros. Seeing as it is currently 2.04 trillion euros, this would imply the ECB might buy up to 1 trillion euros of assets.
One might ask what good ECB asset purchases and rate cuts can do, seeing as euro-zone bond yields are already so low and government action is clearly also needed to help restore economic health. The answer is that while euro-zone yields may look low in nominal terms, falling inflation means that inflation-adjusted interest rates – real rates – have risen in recent months.
To be clear, we expect nominal government bond yields to rise over the coming six months, as growth and inflation eventually begin to rise. But the ECB seems determined to tackle the real rate problem head on. Rate cuts may also boost participation in the ECB's upcoming targeted longer-term refinancing operations, the first of which is slated for this month. Draghi's announcement not only opens a new chapter in ECB policy, but also increases the effectiveness of existing measures.
For euro bears, this is not just a spoon of honey, but more like a whole jar! Draghi promised much earlier in the year by talking down the euro, but it has taken a while for that vision to run its full course. With the negative deposit rate announcement in June and his dramatic follow-up Thursday, the ECB president has delivered. Having waited patiently for the single currency to weaken in the early part of this year, euro bears and dollar bulls that clung to their positions are finally savoring the rewards.