The dollar is taking a beating from the euro on the foreign exchange markets Thursday, in what appears to be a side-effect of some tough love for fund managers from European Central Bank President Mario Draghi.
In an otherwise drab press conference that desperately needed brightening up by someone jumping on the podium and showering glitter, Draghi managed to send the Eurozone’s €14 trillion ($16 trillion) bond markets into a spin by warning them that he really didn’t care about how hard their lives had got due to new regulation introduced since the financial crisis.
The message was enough to drive yields on Bunds, the German 10-year bonds that are the benchmark for the rest of Eurozone debt, up by an eye-watering 17 basis points. Bond prices move inversely to yields, implying a correspondingly sharp fall in their value.
That wrenching move pulled the euro higher against the dollar, as higher interest rates improved the relative attractiveness of holding euros.
The most eye-catching part about the incident is how it revolved around an almost throwaway remark on an arcane debate among financial market professionals. Draghi didn’t change at all his message on monetary policy–large-scale bond-buying until next September, although he did for the first time allow for the possibility of ending the program early if the threat of deflation is convincingly banished. He didn’t present any radically different new outlook for the economy, nor did he signal any shift in policy on Greece.
The Italian had been asked about last month’s “Bund tantrum”, when the market had sold off violently after a hard, five-month rally. He answered that his colleagues on the ECB’s governing council were unanimous in thinking the ECB should “look through” such episodes–in other words, do nothing to stop them.
By late afternoon in Europe, the 10-year Bund yield had shot up to 0.86%, having traded as low as 0.07% in April. As a result, fund managers have now lost in six weeks all the profits they’d made on those bonds in the previous six months. The euro, meanwhile, was up a cent against the dollar at $1.1263.
“We should get used to periods of higher volatility,” Draghi said, arguing that when interest rates are near zero, bonds inevitably get more volatile.
In addition to the absolute level of interest rates, most observers agree that a number of other factors have sharply reduced liquidity (that is, the degree to which you can buy and sell without making the market move against you) since 2010. New capital requirements on banks have led them to shed vast amounts of bond “inventory” previously held for trading purposes; asset managers are increasingly relying on program-driven and ‘passive’ investment strategies that increase ‘herd’ behavior; and Draghi Thursday pointed to new regulations on the insurance sector (the biggest investor in European bonds) that make it harder for them to diversify or hedge their risk.
In finance, being in favor of ‘liquid markets’ is a bit like being in favor of motherhood and apple pie. And liquidity does matter: if investors expect greater volatility, they will ask for higher returns, driving up the cost of capital for the economy at large.
But some argue that much of the complaining is just special pleading by the ‘buy’ side (for an excellent summary, read this post by Frontline Analysts’ Dan Davies) which had gotten used to the luxury not paying for the provision of liquidity by intermediaries.
Draghi, it would appear, seems to agree.