The European Central Bank just can’t get a break. After many years of unconventional monetary measures that have drawn lots of political criticism and attacks and forced it to intervene uncomfortably in the functioning and pricing of financial markets, it was hoping that a pickup in euro-zone economic activity would allow it to declare victory and gradually normalize policy.
Well, the economic pickup is materializing, but it is being accompanied by lower, rather than normalizing yields on risk-free government bonds.
The beginning of the week brought a spate of data releases that spoke to the health of the euro-zone economy, with several readings surpassing consensus expectations. On Tuesday, the Purchasing Managers Index for manufacturing and services pointed to higher growth and inflation. This was followed on Wednesday by a relatively strong reading of the Ifo business climate index for Germany, the economic area’s biggest and most influential economy.
Admittedly, these better cyclical data are, at least as of now, not strong enough or sufficiently sustained to lift concerns about the structural headwinds to high and more inclusive growth. But according to most economic theory and market models, they should have led to an uptick in interest rates. Instead, the opposite has tended to happen.
Registering another new record low, the yield on two-year German government bonds touched an eye-popping minus 0.92 percent on Wednesday. And this was part of yet another downdraft in risk-free rates in the euro zone that will not just complicate the ECB’s conduct of monetary policy but also increase its vulnerability to popular dissatisfaction and the political attacks on its operational autonomy and its credibility.
Add to the ECB’s discomfort a spread differential between yields in France, the second-largest economy, and those of Germany that is more reminiscent of the dark days of Europe’s debt crisis than of increasing economic growth. This unwelcomed dispersion renders even more complex the design and implementation of a “one-size-fits-all” monetary policy.
The challenges are not limited to the ECB and the euro zone.
Notwithstanding the more encouraging economic readings, lower yields translate into a weaker euro, adding to the currency appreciation pressures pushing the dollar higher. The longer this continues, the greater the complications for the Federal Reserve, which is facing an economic context suggesting that markets are too complacent in playing down so much the timing of likely interest rate hikes. Dollar appreciation also acts as a headwind to U.S. economic growth and corporate earnings, which risks sparking renewed protectionist political rhetoric.
Higher political risk in Europe is the proximate cause for this latest decoupling between economic data and market pricing. As I argued in Tuesday’s Bloomberg View column, market participants have no choice but to pay greater attention to the phenomenon of “angry politics” and how it can influence some of the parameters governing the functioning of economy.
This phenomenon cannot be ignored. And its resolution requires European policy-makers to step up to their governance responsibilities and deal more effectively with the turmoil’s fundamental cause: too many years of growth that has been both excessively low and insufficiently inclusive.