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Draghi Changing Course?

28 June 2017 by Mark Holman

Draghi’s speech at the ECB Forum in Portugal certainly caught markets’ attention yesterday. In particular, the words “with reflationary dynamics slowly taking hold…” had us talking here.

No matter how much prudence he poured over this line; we know Draghi chooses his words very carefully and has been a master tactician in coupling ECB strategy with market sentiment. The reaction in markets yesterday was felt predominantly in Euro Government bonds, which saw one of their biggest single day spikes in yield for over a year, and in the euro currency which rallied strongly.

The 10 year Bund for example climbed from a yield of 0.24% to 0.385% as I write, a loss of nearly 1.5% in mark-to-market terms.

Back in March when government bond markets were being driven mainly by President Trump’s future policies, Bund yields also moved higher through their correlation and touched 0.48%, but since then we have had continued strong data from the Eurozone and a reduction in the monthly purchases from the ECB.

Does it therefore really make sense that Europe’s most risk free asset actually has lower yields today than in March?

The answer in our opinion is no. Nor are Bund yields, in our opinion, consistent with the word “reflation” either. The ECB has a primary mandate of achieving price stability and inflation at or close to 2%, and it is acknowledging that it is getting closer to its goal.

From a market perspective, we think Draghi was looking to achieve three things yesterday:-

  1. continued confidence in the Eurozone recovery;
  2. preparing the market for an additional taper in September; and
  3. moving core yields higher, and in a gradual manner.

To be clear, we think this translates into a red light for core European Government bonds.

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