Will BOJ News Force Fresh Draghi Reassurances?

On Friday I discussed the potential European Central Bank President Mario Draghi would open his mouth.

Perhaps the odds are increasing and Draghi will offer reassurances on the eurozone economy.

And perhaps overnight news regarding the Bank of Japan will be what forces Draghi to speak.

Reuters et al are telling us the markets are skiddish this morning after the Nikkei dropped nearly 2% and the yen strengthened sharply versus the dollar. And those two things happened because the BOJ did not extend the maximum duration (from one to two years) on its fixed-rate loans.

Supposedly that would have calmed Japanese bond market volatility.

But since the BOJ didn’t act, the near-term expectations for more volatility in Japanese markets is working its way outside Japan’s borders.

Which brings me back to the eurozone …

I’ve discussed this idea before: the moves earlier this year by the Bank of Japan have helped to keep European Sovereign debt yields under control. That is: additional money pumped into the financial system courtesy of the BOJ made its way into Europe, willfully ignorant of risk, in search of yield. Naturally, the riskiest bonds of Greece and Portugal and Spain offer the highest yield.

Today, however, we learn that 10-year bonds in Greece, Italy and Spain are getting hit pretty hard:

Here is a chart of Spanish, Italian and Greek 10-year yields: 

[Click on the chart above to view the full-size image.]

Besides the fact that yields have been moving higher since middle of last month, that should give you an idea of how sentiment has changed since the pinnacle of the Greek crisis when the yield on the Greek 10-year was between 30 and 40 percent!

And it may not look like much, but today’s move in Greek yields is pretty large. And it comes not long after the IMF admitted it messed up the Greek bailout from the beginning. The news simply served as a reminder: Greece has not been healed … and similar measures will not heal other troubled nations either.

Geez, what’s a Dragi to do?

Why, channel the imaginary powers of the ECB, of course.

There is quite a lot of deep red on my quote screen this morning. Interestingly, though, the euro is pretty much flat on the day. Two years ago such price action would NOT make sense — the euro goes unscathed as Sovereign bond yields start jumping?

There used to be a tight correlation there. And when investors were "assured" yields would be contained, they had no trouble jumping in on the euro.

But what would such reassurances do to the euro now?

If the reassurances are grounded in promises of ECB accomodation, namely interest rate cuts, then the euro is likely to fall even if yields don’t budge much. To use the chart from Friday’s piece again, here’s what could happen to the euro if Draghi is compelled by the BOJ "disappointment" and rising eurozone yields to talk about what the ECB could do for the economy:

[Click on the image above to view a full-size chart of EUR/USD.]

The euro has been rising along with yields on periphery debt since the middle of May. What happens if Draghi opens his mouth? I could think of worse outcomes than a falling euro.

-JR Crooks