Draghi under pressure to jolt eurozone into life

Mario Draghi is once again testing whether words can replace action. 

Since the European Central Bank president said last week that policy makers will use “all the available instruments needed to ensure price stability” and are “ready to adjust the policy stance further,” the euro has weakened and the region’s bond yields have dropped to record lows.

Draghi’s comments rekindled memories of his 2012 statement that he’ll do “whatever it takes” to save the single currency and a subsequent pledge to buy the debt of stressed countries if needed.

The promise in the midst of a financial crisis sent yields tumbling, easing pressure on government budgets and ensuring that the purchase plan has never been implemented.

Investors inferred that his speech at the Federal Reserve Bank of Kansas City’s annual economic symposium in Jackson Hole, Wyoming, last Friday, pushes the ECB closer to the quantitative easing programme it has long avoided for political, legal, and logistical reasons.

“The market won’t wait to see if the ECB will in fact do QE,” Andy Laperriere and Roberto Perli, partners at Cornerstone Macro, said.

“The higher odds of QE should be reflected soon in asset prices.”

The yield on Spanish 10-year government debt dropped to a record low of 2.175%. That’s less than the equivalent US bond, which yields about 2.37%. The euro traded at the lowest against the dollar in 11 months.

Draghi, in a deviation from his prepared text, cited the broad decline in eurozone inflation expectations that took hold among investors this month. The reference suggests he is spooked by the increased risk of a self-perpetuating fall in prices, or deflation.

The question now is whether he gets enough of a positive response from financial markets to his new rhetoric that he doesn’t need to fire the bond-buying bazooka. The scope for improvement may be more limited — when he spoke two years ago, Spain’s 10-year debt yielded about 8%.

Still, Cornerstone predicts that the gap between the yields of Germany, the risk-free benchmark debt for the eurozone, and the so-called peripheral economies should compress further, provided that the risk of recession does not increase. That is in part because they reckon any downward pressure on German yields from the quantitative easing signal will be offset by an increase in inflation expectations, leaving them largely unchanged.

On the other hand, Spanish, Italian, and other peripheral yields have room to fall, said Washington- based Laperriere and Perli.

“Increased confidence that the ECB would do QE should attract more foreign investors and thus push those spreads down further,” they said.