3 Reasons Why ECB's Mario Draghi Could Be More Dovish Than Expected

 | Jul 13, 2017 | 8:00 AM EDT
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This time next week, European Central Bank (ECB) President Mario Draghi will be preparing for his habitual press conference after the monetary policy meeting in Frankfurt. He most likely will need to deliver a double dose of dovishness to bring market expectations about monetary tightening back to levels closer to the ECB's intentions.

After Draghi's June 27 speech in Sintra, in Portugal, yields on government bonds increased everywhere, but especially in Europe, on worries that the central bank is on track to scale down the asset purchases that are part of its quantitative easing program.

The offending part of the speech was this:

"... monetary policy is working to build up reflationary pressures, but this process is being slowed by a combination of external price shocks, more slack in the labour market and a changing relationship between slack and inflation. The past period of low inflation is also perpetuating these dynamics.

These effects, however, are on the whole temporary and should not cause inflation to deviate from its trend over the medium term, so long as monetary policy continues to maintain the solid anchoring of inflation expectations."

Investors were spooked because they took this statement to mean that Draghi was turning more hawkish, as he now believes slow inflation is just a temporary phenomenon. Looking at German 10-year Bund yields shows quite a dramatic rise. The yield is around 0.5% currently, up from 0.26% one month ago. If we compare it with the year-ago level, the rise looks even more dramatic, as 10-year Bunds had a negative yield of -0.09% then.

Investors' fears were amplified by the accounts of the ECB meeting of June 7-8, which showed the members of the Governing Council did discuss, however obliquely, the need to scale down the purchases of bonds by the central bank.

"While there were valid reasons at this juncture to retain the APP [asset purchases program] easing bias, it was noted that, as the economic expansion proceeded and if confidence in the inflation outlook improved further, the case for retaining this bias could be reviewed," the accounts show.

Taking these two remarks in isolation, investors would be right to conclude that the ECB is becoming more hawkish. Step back, though, and the overall picture shows that the central bank is very likely to remain dovish.

First, there is the political angle. The elections in Germany in September are the next hurdle for the eurozone economy, and it is well-known the prudent Germans would like interest rates to go higher. Therefore, a handy push up to the Bund yield a little before these elections is timely (central banks are political animals too, after all; don't believe the total independence hype).

Second, there is the still-fragile eurozone recovery. Yes, the economy has been growing nicely compared with those of the U.S. and U.K. But the euro area is at an earlier stage of the business cycle than these other two economies, so that's normal. And if we take a closer look, household debt in the single currency area is still high, so consumers could do with low interest rates for a while still.

The fall in debt has been very gradual since the eurozone crisis, according to research compiled by economists at London-based think tank Capital Economics. Household debt to disposable income for the eurozone as a whole was 95% last year, compared with a peak of 99% in 2010.

When we look at country-by-country data, it is clear why interest rate increases are still far away. Irish households have debt of 148% of their incomes and the Dutch have even more (but that's partly because of tax advantages for getting into debt in that country), while the Spanish and the Portuguese have household debt ratios of 104% and 108% of disposable income, respectively.

Third, liquidity in the government bond markets is far worse than a few years ago, mainly because of regulatory reasons. Prominent banks have left primary dealer roles in European government debt markets because of changes in regulation that force them to hold more capital for such roles, while revenues from these bonds fell because of record-low interest rates.

This is a problem that the ECB's bond purchasing program is masking for now, because the central bank is the biggest buyer out there. But if the ECB were to suddenly stop buying bonds, liquidity on the market would dry up substantially.

Next week's ECB meeting will be watched with increased worry about the central bank's plans for what is being dubbed "quantitative tightening" -- an exit from the quantitative easing program. However, any such "QT," when it takes place, will be so gradual as to almost pass unnoticed. At least, that seems to be the ECB's plan.

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