MADRID – Christine Lagarde’s nomination to lead the European Central Bank sent investors scrambling to buy more government debt Wednesday in a bet that she will oversee an easing of monetary policy to support the economy and markets.
German 10-year bond yields hit record lows on Wednesday and Thursday, reaching minus 0.408 percent, below eurozone interest-rate levels. French government bonds did the same, touching minus 0.136 percent Thursday, according to TradeWeb.
Italian rates saw the steepest fall and closed on Wednesday at their lowest level since early November 2016, long before the current populist government was formed. Italian 10-year yields were trading at 1.651 percent on Thursday, down 0.241 percentage points from Tuesday’s close.
The euro slipped slightly against the dollar and European equity markets rallied with the Stoxx 600 up 1 percent and Italian stocks more than 3 percent higher over the two days.
Lagarde’s previous support for ultraloose monetary policy, including bond-buying programs, put her squarely behind her predecessor’s efforts to kick-start inflation, analysts and investors said. She inherits a central bank struggling to hit its medium-term target for price growth of just under 2 percent. Outgoing President Mario Draghi recently signaled that interest rates could be cut further and there could be a second quantitative easing program, or QE2.
“Lagarde has always been supportive of ECB’s unconventional policies, which is essential for the credibility of future decisions,” said Frederik Ducrozet, a strategist at Pictet Wealth Management. “She could very well be the one implementing a QE2 program in her first year as President.”
Eurozone inflation fell to 1.2 percent on an annualized basis in May and the central bank currently forecasts a rate of just 1.3 percent for 2019, rising to 1.4 percent next year.
However, Europe faces challenges that rate cuts and bond buying alone will struggle to solve, according to Draghi, so investors may be hoping too much for quick monetary-policy action.
Lagarde herself has expressed concerns in the past about the potential damage to financial stability from too much loose monetary policy. There are also questions among investors and strategists about how much firepower the ECB really has, given that interest rates are already deeply negative and further cuts would likely do more harm than good to eurozone banks.
That raises the possibility that Wednesday’s bond-market moves might already be overdone. Investors had been pricing in a rate cut of 0.1 percentage points in September, according to analysts. Jurgen Odenius, fixed-income economic counselor at US-based PGIM, expects a go-slow approach to further loosening.
“[The ECB has] felt the heat so many times that no matter who takes over, they don’t want to walk into that [monetary policy] press conference and say: We’ve shot all our bullets,” Odenius said.
Lagarde will be the first non-economist to lead the ECB, which some see as a question mark over her credibility, but she has dealt with numerous economic and banking crises in her previous roles as chair of the International Monetary Fund and France’s finance minister during the global financial crisis.
“Bringing someone in with deep experience of European politics rather than monetary policy theory or practice is potentially an asset for the ECB,” said Tomas Hirst, an analyst at CreditSights.
Her political skills may be particularly important in efforts to get eurozone governments to loosen their purse strings and boost economies directly.
“She will tack firmly behind Draghi’s message that the central bank stands ready to respond to shocks but that any action would be significantly augmented by supportive fiscal policy,” Hirst said. “If anything, she may even be better placed to make progress on that argument given her career history.”
One of Europe’s big problems is that its weakness is driven by factors beyond the ECB’s control, including a drop in demand for European exports, driven by the US’s trade disputes and a weakening Chinese economy.
Market expectations for eurozone inflation also fall whenever the euro strengthens against the dollar because this cuts the prices of many imports. That means the ECB has to follow looser policy from the US Federal Reserve because that tends to weaken the dollar.
The yield on the benchmark US Treasury 10-year note has fallen to multi-year lows as investors have priced in Fed rate cuts. The yield settled at 1.952 percent Wednesday, down from 2.684 percent at the end of last year.
These factors combined mean the ECB may end up running hard to stand still and make it more likely that monetary policy alone won’t be able to stimulate demand within the eurozone economy. Draghi has called many times for more government spending or other fiscal measures to support monetary policy – and that is where Lagarde’s background may give her an edge.
“The hope is that she can contribute, in her own way, to a shift toward a more proactive fiscal policy in Berlin,” Ducrozet said. “It won’t be easy, but it may have been more difficult with other candidates.”
One leading contender for the role had been Jens Weidmann, current head of the Bundesbank. While many market watchers expected him to be a more conservative influence on ECB policy, others had become increasingly convinced that Weidmann wouldn’t only have pursued looser policy, but would also have won over Germany.
“What’s overlooked with Weidmann is that should we need a new QE program, the best person to sell that, especially in Germany, is Weidmann,” said Odenius.
The market’s reaction Wednesday, though, suggests that Lagarde’s nomination is a welcome move.
“She will be seen as supporting the continuation of Draghi’s policy framework,” said Salman Ahmed, chief investment strategist at Lombard Odier IM. “We think QE is coming and appointment of Lagarde implies that additional QE-focused policy easing is now a certainty.”