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The Draghi Effect: Reflation focus boosts the euro, hits bonds

German government bonds dropped and the euro shot higher on Tuesday following comments from Mario Draghi, head of the European Central Bank, that economic recovery in the euro area remained on track, with signs of resurgent reflationary pressures.

The five-year Bund yield rose 4 basis points to minus 0.344 per cent, its highest level in 6 weeks and approaching the high point of the year of -0.29 per cent set in March.

The rebound in yields, which rise as prices fall, signals shifting investor sentiment towards inflation as an indicator of future monetary policy.

The euro gained 0.77 per cent on the day to $1.1263.

Still, Mr Draghi was careful to stress that a cautious approach to normalising monetary policy was warranted, noting:

In the current context where global uncertainties remain elevated, there are strong grounds for prudence in the adjustment of monetary policy parameters, even when accompanying the recovery. Any adjustments to our stance have to be made gradually, and only when the improving dynamics that justify them appear sufficiently secure.

Analyst Ken Wattret at TS Lombard said:

The comments look a bit more balanced than the market reaction would suggest, with the core inflation criteria not yet achieved.

Still, use of the term ‘reflationary’ has probably captured the markets’ attention and rightly shaken out some of the complacency.

That was broadly echoed by currency analysts at HSBC:

Draghi was not unequivocally positive, of course, highlighting ongoing global uncertainty and suggesting the ECB must be cautious in adjusting policy. But the sheer fact the ECB is becoming less concerned about deflationary pressures could suggest to the market that its next step will be to move away from such accommodative policy.

As the market increasingly anticipates a tapering of ECB QE, the euro will garner more support, even if tapering is a long and drawn-out process. This seems to be a slow-motion replay of the Fed in 2013/2014.