US inflation is ECB's risk as bonds show end of decoupling

President Mario Draghi and his colleagues spent years insulating the single-currency area from global financial markets as it recuperated from a double-dip recession, debt crisis and brush with deflation.

Now yields on German bonds - the closest thing to a regional benchmark - are rising largely in tandem with US. Treasuries as the world undergoes a synchronised expansion, suggesting that decoupling is coming to an end.

Higher US yields spilling over to Europe could force the ECB to prolong asset purchases even further after the current phase ends in September. Unlike the Federal Reserve, which is predicted to raise interest rates at least three times this year to keep consumer prices under control, the Frankfurt-based institution is still well short of its inflation goal.

Draghi has repeatedly urged persistence in providing stimulus, and has an opportunity to renew his call on Thursday, when the Governing Council meets to set policy.

Borrowing costs in the eurozone’s financial sector, according to calculations by Bloomberg Economics, have already risen and are set for more increases.

“The shadow policy rate, which distills borrowing costs at important maturities across the whole yield curve into a single figure, has jumped of late,” said Bloomberg economist Jamie Murray. “In time, that can be expected to feed through to the actual rates paid by borrowers.”

Martin van Vliet, a senior interest-rate strategist at ING Bank, sees a “high degree of curve movement” between the U.S. and German bond markets, and says that while rates are bearable for now, they could become a worry for the ECB.

“Obviously if Treasury yields would quickly move to say 3.3% and bund yields at 1%, then we’re getting into an area where the ECB would get a bit concerned,” he said.

Yields on the German 5-year note were up one basis point to 0.05% as of 11:50. The 10-year was at 0.66%.

Conscious uncoupling

Any push to extend the bond-buying programme could spark dissent within the decision-making Governing Council, where some members argue that rising yields are simply a consequence of the eurozone's own economic growth, the most broad-based in its near two-decade history.

Just two days after quantitative easing started in March 2015, Governing Council member Ewald Nowotny said yields would eventually rise and that would be a sign of the programme’s success. Asset purchases are set to total at least €2.55trn.

“Decoupling was desirable for the ECB while the recovery in Europe was still in its earliest stages while the Federal Reserve was already starting normalization,” said Marco Valli, an economist at UniCredit in Milan. “Today things are different: the increase in yields is partly a consequence of Europe’s robust expansion and it shouldn’t be an issue as long as it is contained.”

Yet the central bank has frequently warned that it’ll guard against any “unwarranted” tightening that may scupper what progress has been achieved.

That was precisely the concern in 2013, after the Fed sparked a global spike in bond yields by announcing it would consider reducing its debt-buying programme. In the two years following that “taper tantrum,” ECB policy makers added forward guidance, negative interest rates, long-term loans and asset purchases to their arsenal of monetary weaponry.

In response, eurozone bond yields slid to record lows while they traded largely in a range in the US.

Eurozone yields have been edging higher since mid-2016 but generally shrugged off political shocks such as the UK’s Brexit vote. They remained low even as US yields jumped following Donald Trump’s election as president, when investors bet that the new administration would step up spending.

But with rates still well below pre-crisis levels, the upward trend has room to continue. That could require an ECB response, though one that Richard Barwell, an economist at BNP Paribas Asset Management, says it’s fully capable of delivering.

“Putting the spotlight on decoupling in policy rates was a neat rhetorical device,” he said. “But in the end it’s financial conditions that matter. The ECB is still the master of its own destiny in the eurozone and, if necessary, could act fast to set markets straight.”