- Bond yields and the euro have already edged above the levels assumed by the ECB in its forecasts
- The ECB could strengthen verbal intervention, or in case of a sharper rise, step up QE
- Most data point to a solid US labour market report for May
ECB unable to prevent bond yields and euro rising
During and after Wednesday’s ECB press conference, government bond yields and the euro rose in tandem. This trend continued with a vengeance on Thursday morning, though the moves more than reversed by the end of the day. The sell-off in bonds and euro strength occurred despite ECB President Draghi stepping up his dovish tone on QE, which seems to have been designed to calm the markets. He mentioned that if necessary the ECB could step up QE and that an unwarranted tightening of financial conditions could be a trigger for that. However, investors focused more on his subsequent comments that volatility in the bond market was here to stay.
Tightening of financial conditions
Following the upward trend in bond yields and the euro of the last few days, financial conditions have tightened somewhat more than the ECB assumed in its projections for this year (see chart). Given current market prices, weighted average eurozone bond yields and the EUR/USD are somewhat above the levels assumed for this year, while the gap was more significant earlier on Wednesday when the bond sell-off was in full flow. The ECB’s projections show inflation just about reaching the target in 2017, at 1.8% compared to the its price stability goal of close to but below 2%. This means that the sell-off in the bond market and euro strength could eventually threaten the ECB achieving its goal.
The ECB’s options
So what can the ECB do next given that Mario Draghi’s dovish commentary fell on death ears earlier in the week? The ECB’s next step could be to step up verbal intervention by various degrees. The central bank could say that it saw an ‘unwarranted tightening of financial conditions’ making explicit its displeasure at recent market developments. The next step could be to mention ‘tighter financial conditions’ as being a downside risk to economic growth. If words do not work, it may have no choice but step up QE, though that is not our base case scenario.
US job market report set to be solid in May
We are forecasting a 235K increase for May’s nonfarm payrolls to be released this Friday. Slightly higher than April’s increase of 223K. The unemployment rate should remain unchanged at 5.4%. The pace of job creation has slowed in the first part of the year to an average of 193K down from an average of 259K in 2014. This slowdown in momentum is, however, to some extent a reflection of the weak economic activity, resulting from the harsh winter weather and other temporary factors.
Most other labour market data have been positive
We think that the labour market will firm in the coming months. In May the employment components of Markit US manufacturing PMI and the ISM Manufacturing surveys improved. Meanwhile, Markit services jobs index rose at fastest rate since June 2014. Jobless claims, a measure of unemployment benefits, have also been trending down recently. Furthermore, May’s ADP private employment report show an acceleration in job growth compared to April. Finally, most indicators in Chair Yellen’s dashboard are showing a firm recovery.