ECB's Draghi Hints at Possible Winding Down of Eurozone QE -- 5th Update

By Tom Fairless Features Dow Jones Newswires

SINTRA, Portugal -- The euro soared to its biggest one-day gain against the dollar in a year and eurozone bond prices slumped after European Central Bank President Mario Draghi hinted the ECB might start winding down its stimulus in response to accelerating growth in Europe.

Continue Reading Below

Any move by the ECB toward reducing bond purchases would put it on a similar policy path as the Federal Reserve, which first signaled an intent to taper its own stimulus program in 2013. But the ECB is likely to remain far behind: The Fed has been raising interest rates gradually since December 2015, while the ECB's key rate has been negative since June 2014.

Mr. Draghi's comments, made Tuesday at the ECB's annual economic policy conference in Portugal, were laced with caution and caveats. But investors interpreted them as a cue to buy euros and sell eurozone bonds, a reversal of a long-term trade that has benefited from the central bank's EUR60 billion ($67.15 billion) of bond purchases each month.

"All the signs now point to a strengthening and broadening recovery in the euro area," Mr. Draghi said.

Following Mr. Draghi's comments, the euro jumped 1.4% against the dollar, the largest daily percentage rise since June 2016, to end U.S. trading at $1.1340. It is the euro's highest level against the greenback since August 2016.

The yield on government debt in countries such as Germany and Italy alsorose sharply. Bond yields rise as prices fall.

Continue Reading Below

The EUR2.3 trillion bond-buying program has had a large impact on financial markets, and Tuesday's moves indicate that investors are girding for the day it ends. The bond purchases helped drive down borrowing costs, which economists say aided growth and investment.

Until now, the ECB's top officials have carefully avoided discussing the future of their bond-buying program, also referred to as quantitative easing, which is due to continue through December. They worry that such a discussion could lead to a repeat of the turmoil in financial markets four years ago, known as the taper tantrum, when the Fed signaled it would wind down its QE. That might upset the region's economic recovery.

On Tuesday, though, Mr. Draghi appeared to shift course. He argued that leaving the ECB's policy unchanged as the euro area's recovery strengthened would amount to increasing its stimulus -- a hint that policy makers will instead start to reduce their bond purchases rather than maintain the status quo.

"Today Draghi moved his first step towards indicating that ECB monetary policy will become less [stimulative] in 2018," said Marco Valli, an economist with UniCredit in Milan.

Pressure has been mounting on the ECB to change course as evidence accumulates that its aggressive stimulus is bearing fruit and as political uncertainty in the region fades following Emmanuel Macron's election as French president.

"Political winds are becoming tailwinds," Mr. Draghi said. "There is newfound confidence in the reform process, and newfound support for European cohesion, which could help unleash pent-up demand and investment."

The eurozone has notched 16 straight quarters of economic growth, creating more than six million jobs, and business- and consumer-confidence indicators have risen to multiyear highs.

The change comes as the Fed signals it will continue to raise interest rates over the coming years. Fed officials indicated earlier this month they are on course to raise borrowing costs once more in 2017, after increasing the bank's benchmark rate twice this year to the current range between 1% and 1.25%. The U.S. central bank also plans to begin reducing the amount of bonds it holds.

Earlier this month, the ECB took a tiny step toward ending its stimulus by signaling it probably wouldn't cut interest rates any further below zero. Many analysts expect the central bank to announce in September or October that it will start early next year to taper, or wind down, its QE program.

Mr. Draghi didn't directly address the question of timing. He instead emphasized the positive developments in the eurozone, including quickening economic growth and reduced political uncertainty.

Michael Schubert, an economist at Commerzbank in Frankfurt, said the latest remarks were "another sign suggesting that the central bank is moving towards an exit" from its stimulus.

Still, the ECB chief stressed that moves to stop bond purchases would "have to be made gradually," and only when the path of growth and inflation was "sufficiently secure."

Some analysts called for caution. "We don't think we should be surprised by" Mr. Draghi's comments, economists at Bank of America Merrill Lynch wrote in a research note. "What he said today is also consistent with a very slow exit."

If so, that would disappoint officials in Northern Europe, who have been pressing for a swift end to the ECB's monetary stimulus. In Germany, Europe's largest economy, officials have called for years for an end to policies they complain hurt savers and pensioners.

The dilemma for ECB officials is that while eurozone growth is accelerating, outpacing the U.S. in the first quarter, the area's inflation rate remains weak. It slid to 1.4% in May, some way below the ECB's target of just under 2%.

Nevertheless, Mr. Draghi said fears of deflation, a destructive cycle of price and wage declines, had passed. These worries played into the ECB's decision to launch QE in the first place.

"Deflationary forces have been replaced by reflationary ones," he said.

Mr. Valli of UniCredit said the ECB might reduce its monthly bond purchases to EUR40 billion in the first half of next year, followed by a further reduction to EUR20 billion a month in the second half of the year. That would be a slower pace of stimulus reduction than many analysts expect.

However, the ECB is expected to face a challenge if it wants to extend QE much beyond the middle of next year. The central bank is soon expected to start running short of bonds to buy, particularly German debt, due to self-imposed constraints in the design of QE.

Write to Tom Fairless at tom.fairless@wsj.com

(END) Dow Jones Newswires

June 27, 2017 22:22 ET (02:22 GMT)