Draghi Breaks New Ground, Euro Breaks A Cent

The ECB took an unprecedented step today. Part of its mantra has been that it does not pre-commit. Today it did. It indicated interest rates will be the same or lower for an extended period of time. Draghi, when pressed, chose not to define extended period, except to note that it does not mean six or twelve months.

Sometimes ECB officials are surprised by the market's reaction, but not today. Interest rates fell. The implied yield on next year's Euribor futures contracts fell 8-11 bp, while the yield on the 2015 contracts fell 12-13 bp. Even further out, the 2-year yields fell 5-7 bp in Germany and France and 14-16 bp in Italy and Spain. As one might expect,the reaction was more muted at the long end of the curve. Benchmark 10-year yields were off only slightly in the core, and 5-8 bp lower in Italy and Spain. Portuguese bonds continue to recover from the dramatic losses as more appear to be coming around to our view that an early election is not the most likely scenario.

The euro fell to new lows since late May near $1.2880. Reactive bounces have been limited to the $1.2915 area, thus far. With the US markets on holiday conditions, of course, are thinner than normal, and there is scope for a technical bounce toward $1.2940-50, but dealers will likely sell into it. The direction and near magnitude of the move we anticipated and continue to look for a test on and eventual break of the trend line drawn off the early April and mid-May lows that comes in near $1.2850 now.

It seems quite clear that both Draghi and Carney were motivated by the backing up in rates in recent weeks. While tapering talk by Fed officials obviously played an important role, we have also noted two other forces at work in recent weeks: 1) the selling of foreign bonds by Japanese investors--and the MOF data out earlier today showed this continued and 2) the liquidity squeeze in China, which continued to ebb today, but which may have also encouraged a sense of the end of so-called easy money and the unwinding of structural positions.

The source of easy money is shifting. While many observers expect the Fed to begin tapering in Sept/Oct and it appears that the Fed funds futures are pricing in the risk of the first rate hike at the end of next year, the BOE and ECB signaled no intention on joining it. In fact, their respective guidance today has eased monetary conditions (rates fell, equities rallied and both sterling and the euro fell). At the same time, the BOJ remains committed to its QE, which has only been in effect three months as of today.

This divergence in policy should underpin the dollar on a trend basis. The US-German 2-year spread, which often closely tracks the exchange rate should move move into the US favor.

Draghi did what he had to; forced by circumstances. He had to lean against the increase in market rates. He had to indicate that the 50 bp refi rate is not a lower boundary. He kept open the possibility of a negative deposit rate. Draghi also reaffirmed that the ECB expects the region economy to recover later this year and next, recognizing that the survey data supports this view.

On balance, this was one of Draghi's more successful press conferences. It should, but probably won't, put to rest claims of central bank impotence. The ECB is being forced to innovate by circumstances. It borrows from the Fed's language guide the market.