Return of inflation exacerbates the rout in eurozone bond markets

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A rout is a chaotic and disorderly retreat or withdrawal of troops from a battlefield, resulting in the victory of the opposing party, or following defeat, a collapse of discipline, or poor morale.

The opposite of a rout is a rally, in which a military unit that has been giving way and is on the verge of a rout, suddenly gathers itself and turns back to the offensive

Source: Wikipedia, (the free encyclopedia).

The rally that took yields on 10-year German sovereign bonds down to 0.04% on 17 April subsequently gave way to a full scale rout. Data on the level of inflation in the eurozone, released in the first week of June 2015, did not helped matters.

The annual rate of inflation in the eurozone was 0.3% in May 2015, up from 0.0% in April according to the flash estimate published on 2 June 2015 by Eurostat (the European Union’s statistical office). Exhibit 1 below illustrates how the headline inflation rate has bounced backed into positive territory since the start of 2015.

It’s the first time in six months that monthly inflation has registered a positive reading. So inevitably it will raise hopes that the European Central Bank’s programme of asset purchases is showing signs of success in driving the rate of inflation back up towards the ECB’s target of close to, but below 2%.

Exhibit 1: Eurostat eurozone inflation rate (%) , all items, year-on-year, flash estimate for the period from October 2001 through May 2015.

EU inflation

Data for core inflation, which shows the underlying trend in inflation by stripping out the often volatile energy and food components, was surprisingly strong at 0.9% in May (versus 0.6% in April), the highest rate in nine months. The rise in core inflation appears to be the result of rising prices for non-energy industrial goods – perhaps as a result of the weak euro – up to 0.3% from 0.1% in April, and services, which rose from 1% to 1.3% in May. Core inflation in the eurozone has been stuck in a range between 0.6 – 0.7% over the past year breaking only once to the upside in the middle of 2014 (0.9% in August). It would be imprudent to draw too many conclusions from this single piece of data – there could be seasonal effects due to Easter being early this year (and having artificially depressed the April statistic).

 Exhibit 2: Eurostat core inflation rate (%) in the eurozone for the period from January 1997 – March 2015

Eurozone core inflation rate Our view is that there is still too much slack in the European economy for inflationary pressures to get up a head of steam. But the pick-up in inflation remains a positive development. At the news conference on 3 June 2015, ECB President Draghi announced that the ECB is raising its forecast for inflation this year to 0.3% from zero previously. Draghi also went out of his way to dispel any suggestion that a better economic picture could lead the bank to scale back its programme of bond purchases before the full 1.1 trillion euro goal is achieved in September 2016. Finally, President Draghi was blunt when asked about increased volatility in bond markets at the news conference. His response was you are going to have to “get used to volatility” and he gave five reasons for the rise in bond yields (the yield on German 10-year bonds rose to à 0.90% on 3 June, its highest since October 2014 – see exhibit 3 below). The somewhat brutal nature of President Draghi’s response suggests to us that the ECB is at ease with the current rise in bond yields.

These are the five reasons ECB President Draghi gave on 3 June 2014 for the rise in yields of sovereign bonds in the eurozone in recent weeks:

  1. Changes in expectations for economic growth in the eurozone;
  2. Higher inflation expectations;
  3. A shift from longer into shorter-dated bunds which became eligible for purchase under the ECB’s asset purchase programme as their yields rose above the deposit rate threshold;
  4. Volatility creating more volatility (the feedback loop);
  5. Poor market liquidity because of the absence of “certain significant investors during this period of time.”

Exhibit 3: Volatility is stalking bond markets – the yield (%) on German 10-year bonds rose 32 basis points in two days (2 and 3 June 2015) the biggest two day rise since 1998.

Picture1

 Source: Bloomberg, BNPP IP, as of 4 June 2015

Our view on where yields go from here is that it’s too early to be sure that the phase of irrationally low interest rates is behind us.  German Bunds remain the focus of the ECB’s asset purchases and as the German government will not be selling any more new bonds this year, Bunds could become scarce. In early May the weight of investors positioned in expectation of falling German yields was such that it didn’t take much (i.e. poor demand at a Bund auction / recovering oil prices / rising inflation expectations) to trigger a sell-off that turned into a rout.

While higher yields may now appear justified from a fundamental perspective, a drought of supply in June might rekindle the scarcity fears. Add to this the uncertainty about the timing of the US rate hike and further volatility in the bond markets looks likely.

 

 

Joost van Leenders

Portfolio Manager, Multi Asset Solutions, CFA Charterholder

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