ECB's Draghi Sends Euro on a Wild Ride

The euro ended the European trading day up by nearly 1% Thursday, after the European Central Bank raised its growth forecasts, triggering a volatile ride for a currency that has appreciated rapidly this year.

European government bonds also rallied through the day, with most of the movement coming later in the afternoon.

The ECB kept interest rates and its EUR60 billion ($71.5 billion) monthly bond-buying program unchanged but altered its forecasts for economic growth and inflation. It now says it expects the eurozone economy to grow 2.2% in 2017, up from a previous forecast of 1.9%.

The ECB also cut its inflation forecasts, with price growth of 1.2% next year now expected, down from 1.3%, which ECB President Mario Draghi said was largely due to the recent appreciation of the euro.

The euro already had risen by 0.5% against the dollar before Mr. Draghi's press conference, climbing to as high as $1.2055 while he spoke. The euro ended up 0.9% at around $1.202, only its second close above $1.20 since January 2015.

Mr. Draghi referenced the unexpected strength of the euro as the main reason for the revision to inflation forecasts. The stronger currency reduces import prices, dragging down inflation during the following year.

The prospect of lower inflation would typically weaken the euro. If inflation is expected to stay far below the ECB's target then the central bank is more likely to take its time unwinding the bond-buying that it had started in part to boost prices. The bond buying has helped keep pressure on the euro by pushing down yields and so making the region less attractive for foreign money.

ECB economists had expected a euro-dollar exchange rate of $1.08 this year when they made their last forecasts in June. The currency has appreciated by 14% against the dollar so far this year.

Mr. Draghi stressed that the volatility of the euro was a concern for the ECB's governing council, but the currency's trading hasn't been particularly volatile so far this year, by historical standards.

"It hasn't actually been very volatile at all, that's probably a euphemism for the appreciation," said Patrick O'Donnell, senior investment manager at Aberdeen Standard Investments. "The cyclical recovery in Europe has really become more obvious this year, and with the positive political outcomes that has really released a euro rally."

Investors are still positioned for more euro strength. In the week to Sept. 1, speculators held 86,519 more long contracts -- bullish bets on the value of the euro -- than short contracts.

Eurozone government bond yields fell during the afternoon, many to their lowest levels since the end of June, with most of the reaction coming in the hours after Mr. Draghi's comments.

Germany's 10-year bund yields fell from 0.36% before the meeting began to 0.3% as European markets closed.

Declines in Spanish and Italian yields were steeper, falling from 1.44% to 1.36% and 2.01% to 1.91% respectively.

"It was a strange meeting for markets, because there was something for everyone there," said Lyn Graham-Taylor, senior rates strategist at Rabobank. "In light of them not announcing anything, a bid for bunds makes some sense, you could generally interpret that as dovish."

"But on the currency side of things he took quite a moderate stance with regards to the strength of the euro," he added.

It was unclear how much of the reaction in bond markets was caused by the ECB's decisions. U.S. 10-year Treasury yields also fell to as low as 2.04%, the lowest intraday level of the year so far.

Bond yields often move in tandem with exchange rates, with higher yields in one part of the world attracting global investors and causing the local currency to rally.

This year, that hasn't been the case in Europe. German two-year bund yields are around 2 percentage points below U.S. two-year Treasury yields, which are practically unchanged from the beginning of the year when the euro was at $1.05.

Despite the reduction in inflation forecasts Thursday, many analysts expect the ECB to have to begin reducing bond purchases, as the technical constraints of this quantitative-easing program begin to bite.

The central bank can't hold more than 33% of any country's bonds. At its current pace of purchases, many analysts expect the ECB to hit the limit in the German bund market next year.

"Unless they change the rules of the game, they're all out of juice," said Eoin Murray, head of investment at Hermes Investment Management.

Write to Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

September 07, 2017 12:56 ET (16:56 GMT)