A fall in euro zone government bond yields, rallying regional equity markets and a stronger euro suggest that six months after Mario Draghi pledged to save the euro zone from collapse, the European Central Bank (ECB) chief appears to be winning his battle with financial markets.
On Thursday, the ECB's unanimous decision to leave benchmark interest rates steady sent the euro soaring against the dollar and yen. The single currency was trading at around $1.326 on Friday, not far off 8-1/2 month highs hit last month.
The contrast could not be more stark than six months ago, when Draghi was forced to reassure markets that the ECB would get the region's debt crisis under control as soaring bond yields in Spain fueled concerns about a break-up of the currency block and sent markets into a tail spin.
Analysts say the recovery in sentiment and the bounce back in European markets is a key part of the ECB's monetary policy strategy: an increase in confidence means the central bank can afford to keep monetary policy steady for now.
Kathy Lien, managing director at BK Asset Management in New York, says investors realize that Draghi's satisfaction with improvements in financial markets means the ECB is less inclined to ramp up stimulus measures.
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"With financial market sentiment improving significantly, tail risks removed and funding conditions at satisfactory levels, Draghi believes that the financial markets have now returned to normalcy," she said in a research note.
"The main takeaway from the meeting is that the ECB is no longer in crisis fighting mode because the battle with the financial markets has been won," she said.
While economic growth in the euro zone remains weak, a slew of steps taken by the ECB and European policymakers such as setting up a fund to help those countries that might need financial assistance have helped renew investor confidence.
Since late July, yields on Spanish government bonds have fallen more than 200 basis points, while European shares have climbed almost 15 percent and the euro has rallied 10 percent against the dollar.
"The economic outlook has not changed much, but market indicators are higher and stocks are higher so the ECB is more comfortable holding interest rates where they are," said Nizam Idris, head of strategy for fixed income and currencies at Macquarie. "Sentiment is very important and we had a fantastic Spanish bond auction yesterday (Thursday)," he said.
Spain sold 5.8 billion euros worth of government bonds in a well-received auction on Thursday.
"We are seeing buyers come back into Europe, betting that this is the bottom. This is why we are seeing a run-away market," Boris Schlossberg of BK Asset Management told "Squawk Box."
Buying Time?
Analysts add that by helping restore market confidence in the euro zone, the ECB has bought itself some time – saving up an interest rate cut for the months ahead and any potential headwinds that may unsettle markets such as Italian general elections, scheduled for February 24-25.
"Draghi wants to keep his ammunition dry for policy reasons and political reasons," said Adolfo Laurenti, deputy chief economist at Mesirow Financial in Chicago.
"I think the possibility that Spain will go to the ECB and ask for help remains. We also have elections in Italy coming up and there might be some tensions there, so clearly the ECB wants to have some margin to maneuver if things get worse," he added.
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And while Draghi may have won a battle with financial markets for now, confidence may start to wane if an economic recovery in the euro zone fails to materialize later in the year, analysts said.
Data released earlier this week showed that unemployment in the euro zone hit a record high of 11.8 percent in November, while business surveys released last week showed that euro zone factories fell deeper into a recession in December as new orders tumbled.
"(ECB) policy is on hold, because the market crisis is over," said Kit Juckes, global head of forex strategy at Societe Generale in a note. "The fact that there is no growth and rising unemployment is something that requires political action and Super-Mario is handing the baton over."
