Market Extra: Bonds rally, euro weakens amid ECB taper talk: What’s going on?

It’s basic economics that monetary tightening should be bad for bonds but great for the currency.

Expectations that the European Central Bank could move to taper its bond buying program have been swirling for some time, but when a report from Bloomberg News on late Thursday suggested the ECB could halve its asset-buying beginning January, bond prices jumped, pulling down yields. The euro, meanwhile, faced selling pressure, although that was alleviated later by the dollar’s knee-jerk depreciation in response to weaker-than-expected U.S. inflation data.

The French 10-year bond yield

TMBMKFR-10Y, -6.90%

  fell 5 basis points to 0.82% on Friday, with the German 10-year bond yield

TMBMKDE-10Y, -9.82%

  also shedding 5 basis points to 0.40% The euro

EURUSD, -0.0930%

  followed suit in the early hours of the European trading session. The shared currency slipped as low as $1.1805 on Friday, before finding support after the U.S. data.

Analysts say the market movements were down to the disappointment of some traders. Expectations had built up around a more aggressive tapering, with some having gone as far as to forecasts the ECB would halt its purchases altogether.

“For traders expecting a more aggressive taper, the plan leaked last night is seen as “dovish”. This is why bond yields are falling in the euro area this morning (by 2-3bps) across the board for [European government bonds]. The decline in euro area yields is capping interest in buying euros too,” wrote Thierry Wizman, global currencies and interest rates strategist for the Macquarie Group.

Read: Here’s why the rising euro is defying Mario Draghi and the ECB

The plan, as outlined, would see the ECB taper its monthly asset purchases to €30 billion ($35.5 billion) from €60 billion, starting from January. The program would end in September, but ECB officials would hold the option of extending it as needed. The €30 billion forecast matches estimates made by Bank of America Merrill Lynch and the Macquarie Group.

An ECB spokesperson had no comment.

In previous instances where the ECB has hinted at tapering its purchases, market participants saw a strong surge in the euro and a selloff in European bonds. Though the ECB’s actions would only amount to a removal of very loose monetary policy, and not outright tightening, the impact on financial markets is similar.

Back in late June, European Central Bank President Mario Draghi’s remarks sparked a mini taper-tantrum, sending the 10-year German bond yield

TMBMKDE-10Y, -9.82%

  as high as 0.60% and the euro on a bullish run to touch $1.20 in August.

See: Why Mario Draghi can’t back down from ECB taper hints

The euro has been a growth play for those banking on the eurozone economy, which remains behind the U.S. in the growth cycle and thus will likely have more to give. But inflation may have suffered due to its stronger shared currency, which can cheapen imports. Eurozone inflation fell in the summer but stabilized at an annual 1.5% in September, reported Eurostat.

This has stoked speculation the European Central Bank will announce a plan as to how to reduce its bond purchasing program during its Oct. 26 meeting. Nonetheless, a plan for QE to extend beyond January would gibe with dovish speeches from ECB chief economist Peter Praet, who advocated for accommodative monetary policy but with a slower amount of monthly purchases.

Check out: ECB discussed QE tapering options at last meeting

But it could also placate those with more hawkish views. German Bundesbank President Jens Weidman said on Friday that the ECB should get a move on in terms of reducing its bond purchases, remarks which were in line with previous comments from the policy maker.