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Lagarde Has Investors Betting on Easy Money for Europe

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07/03/2019 | 08:05am EST

By Paul J. Davies

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 a record low of minus 0.397%, almost falling to eurozone interest-rate levels, while the euro initially slipped against the dollar before recovering. Other benchmark yields also declined, with French government debt also touching a record low of minus 0.098%. Italian rates saw one of the biggest shifts, dropping as much as 0.158 percentage points to 1.705%.

Ms. 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%. 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% on an annualized basis in May and the central bank currently forecasts a rate of just 1.3% for 2019, rising to 1.4% next year.

However, Europe faces challenges that rate cuts and bond buying alone will struggle to solve, according to Mr. Draghi, so investors may be hoping too much for quick monetary-policy action.

Ms. 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 U.S.-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," Mr. Odenius said.

Ms. 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," Mr. 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 U.S.'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 U.S. Federal Reserve because that tends to weaken the dollar.

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. Mr. Draghi has called many times for more government spending or other fiscal measures to support monetary policy -- and that is where Ms. 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," Mr. Drucozet 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 Mr. 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 Mr. Odenius.

The market's reaction Wednesday, though, suggests that Ms. Lagarde's nomination is a welcome move.

"She will be seen as supporting the continuation of Mr. Draghi's policy framework," said Salman Ahmed, Chief Investment Strategist, Lombard Odier IM. "We think QE is coming and appointment of Ms. Lagarde implies that additional QE-focused policy easing is now a certainty."

Write to Paul J. Davies at paul.davies@wsj.com

Corrections & Amplifications

This item was corrected at 2:46 p.m. ET because the surname of Frederik Ducrozet, a strategist at Pictet Wealth Management, was misspelled Drucozet.

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