Compared to recent European Central Bank (ECB) press conferences, yesterday’s was rather uneventful. Nonetheless, one thing made a strong impression on me: while reading his prepared statement, ECB President Mario Draghi paused, looked straight into the camera and said “the euro is irreversible,” repeating his now-famous quote that caught markets by surprise on July 26, marking the euro’s absolute low (year-to-date) and the beginning of its subsequent 8% rally.
So, what was it that surprised the markets? There was no new information in that July speech. But as we all know, monetary policy is all about communication, expectations and credibility, and Draghi is embodying that. After two years of contradictory, misleading and inconclusive statements out of Europe, finally there was a break—a sudden impression that something was different.
Mario Draghi as Diego Maradona
As a passionate football—sorry, soccer—fan, I cannot resist recalling a famous speech by the Bank of England Governor Mervyn King in 2005, where he described the Maradona Theory of Interest Rates.
He referred to the two goals scored by Diego Maradona against England in the 1986 World Cup in Mexico City, where the best—and most controversial—player of all time scored two goals: first the most irreverent, and later the most beautiful in history.
Just like Maradona, Mario Draghi delivered twice. As described by King in his 2005 speech, “Maradona’s first ‘Hand of God’ goal was an exercise of the old ‘mystery and mystique’ approach to central banking. His action was unexpected, time-inconsistent and against the rules. He was lucky to get away with it.”
Similarly, on July 26, Draghi delivered an unexpected and time-inconsistent promise that, “within our mandate, the ECB is ready to do whatever it takes to preserve the euro, and believe me [pause], it will be enough.” This was also somewhat against the rules, since, as we learned, he caught all ECB members by surprise, and forced them to later work and agree to the plan. In other words, just like Maradona, Draghi got away with it.
Finally, the act of genius. King goes on, “Maradona’s second goal, however, was an example of the power of expectations in the modern theory of interest rates. Maradona ran 60 yards from inside his own half, beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight line on. Monetary policy works in a similar way.”
Draghi accomplished the same thing on Sept. 6, when laying out the outright monetary transactions (OMT) strategy. He managed to direct market expectations. If a credible central bank is committed to intervening with unlimited firepower, markets will adjust to the point where the central bank won’t need to maneuver left or right; they will need to do little or nothing at all.
An 8% rally in the euro and a 300 basis-point compression in peripheral spreads suggest Draghi’s strategy is paying off. As an aggregate region, the Eurozone has better fundamentals than the U.S., with no signs of overvaluation on traditional fair value metrics, and superior deficit and debt statistics both in the public and private sector. What weighted the Eurozone down all year was a political/tail risk premium, which is now being removed.
With his twin goals safely in the back of the net, Draghi has put the euro back in the game. Now his teammates across Europe, starting with Spain, need to play their part to bring victory home.
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