So now we know. Draghi couldn’t have put it more bluntly: “we should get used to a period of higher volatility”. “The Governing Council was unanimous in the need to look through this”. This is significant. It means:
1. The ECB will not be using their QE to smooth out spikes in bond yields. They WILL use it if inflation persistently undershoots expectations. This confirms that QE is a monetary policy tool – pure monetisation of the money stock, to shock inflation expectations higher. It’s not a market stability tool, unlike the QE we came to know and love from the Fed and the BOE. This is because the ECB is attacking a different problem from the market dislocations of the post Lehman era.
2. This explains the dichotomy between the Coeure “frontload QE” comments and the ECB’s actual lower purchases: they DON’T want to distort the market and they’re not playing verbal intervention games such as those favoured by the BOJ in their QE prime.
3. The ECB have likely loosened policy at the most pro-cyclical moment. It took them so long to respond to the deflation risk that they are now doing QE when the world is stabilising. That should mean that European stocks can rally, whatever happens to bonds. If bonds sell off on growth expectations, that’s good for equities. If they rally due to more QE, that’s also good for equities.
4. Draghi is relatively optimistic. The first reasons he gave for the sell off in Bunds? “Higher growth expectations”. The second? “Higher inflation expectations”. Only after that did he go onto technical reasons such as an excess of supply, and lower liquidity.
Adding this up = the ECB just gave the green light for bond yields to continue higher. As Draghi said, “inflation bottomed out at the start of the year”. The deflationary dragon is wounded, if not fully slain. Bund yields duly responded:
Now, if this gets to a point where it tightens monetary conditions such that inflation expectations fall… then the arithmetic shifts. But until then we are in a hiatus with the Euro supported by rising yields, but hurt by ongoing Greek fears and the fact that deposit rates are still negative.
Separately, Draghi’s comments are a watershed for markets more generally.
We have heard countless warnings about the increased market volatility – the ECB have now joined the BOE, BIS, IMF and RBA in pointing out that low interest rates create these risks. But crucially, Draghi today pointed out that higher volatility is a sign of normalisation. A sign of the world getting better. It is not only to be expected, but to be welcomed.
This means that they will not be there to intervene from now on. That might sound strange, with ECB QE continuing, but just look at the market volatility that has caused in the once benign and solid German bond markets. Do not equate asset purchases with sedation for the patient. The patient is up off the operating table, out the hospital, and coming off the drugs. Understandably, the patient will not return to ‘normal life’ without emotional periods where he demands more drugs and then fails to get them. These tantrums will therefore persist.