Euro Surges, Bunds Tumble On Unexpectedly Hawkish Draghi Comments

The euro surged to its highest in two weeks after Mario Draghi, speaking at the ECB forum in Sintra, Portugal, surprised markets who expected yet another dovish speech from the central banker, who instead signaled that stimulus tapering may be closer than the market anticipated and said factors weighing on inflation in the euro zone were "mainly temporary" and the central bank could look through them.

Speaking at the ECB's annual policy forum, Draghi highlighted a recovering euro zone economy that “the threat of deflation is gone and reflationary forces are at play” and that that the effects that keep inflation subdued are temporary and won’t let inflation deviate from its trend over the medium term. but added that stimulus in the form of the ECB's monetary support was still needed.

The market broadly interpreted his unexpected comments as opening the way for the start of tapering even as core inflation readings fail to reach fresh highs. As Reuters adds, Draghi's comments "sounded to investors like he was ready to give more ground on German demands that the ECB get on with starting to reduce the volume of extra euros it is feeding monthly into the economy."

The euro surged as Draghi spoke, rising as much as half a percent on the day to $1.1255, its highest level since Jun. 14. It had earlier traded around the $1.1187 mark.

In a comparable kneejerk reaction, confirming the market is preparing for an end to the ECB's ultraeasy policy, 10Y Bund yields jumped by 4bps to 0.28%.

Bund futures tumbled with wave of selling seen across 5-10y sector from fast money after Draghi’s speech. Schatz auction met with strong demand. Treasuries slid with bunds.

The Euro strength pulled the dollar index to an eight-day low of 96.973, dropping sharply (-0.5%), as the yuan surged earlier, spurring speculation of central bank intervention.

"Draghi's comments I would say were quite optimistic on the growth outlook, talking about a broadening recovery and even saying growth was above trend," said Niels Christensen, currency strategist with Nordea bank in Copenhagen. "While talking about inflation he said mainly temporary factors were slowing inflation at the moment, so he's not too concerned about the fallback in at least headline inflation."

Draghi's comments contrasted with a dovish tone he took on Monday, saying that super low interest rates create jobs, foster growth and benefit borrowers, while rejecting calls to exit super easy monetary policy quickly.

Separately, traders await speeches by Fed officials for signs on whether the central bank will stick to its guns and raise rates this year; key among these will be Janet Yellen, who addresses the British Academy in London at 1700 GMT (1pm EDT), less than two hours after an address by Philadelphia Fed President Patrick Harker in the same city at 1515 GMT. Fed officials have signaled they will look through a slowdown in inflation and continue on their current trajectory of interest rate hikes - though investors are skeptical and market pricing shows only a 40 percent chance of a rise at the Fed's December meeting

As Dudley noted yesterday, the Fed appears to be intent to keep hiking regardless of the data, in order to burst asset bubbles. As Reuters adds, a positive view from Yellen despite a recent batch of weak U.S. economic data would support the Fed's forecast for another rise in policy rates this year.

"A notion increasingly shared in the market ... is that the Fed is continuing to normalise monetary policy regardless of more muted inflation developments - this is the message which has been provided during the last week by several Fed speakers," said Manuel Oliveri, currency strategist with Credit Agricole in London.

"This suggests that the market-based rate expectations have additional room of adjusting to the upside should this notion become even a bigger one."

Should the BOJ's Kuroda also echo Draghi's hawkish remarks when he also speaks in Sintra, suddenly risk assets may find themselves above a trapdoor as suddenly the global central bank balance sheet expansion that has been the reason for the YTD rally grinds to a halt, and may even goes into reverse.