WHAT BOND TURBULENCE SAYS ABOUT INFLATION / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

June 11, 2015 5:25 am

What bond turbulence says about inflation

Ralph Atkins in London

Too early to say markets signal decisive move away from deflation

©Bloomberg

 

 

Big shifts in global bond markets play havoc with investors’ portfolios. For real economies, however, they are not necessarily bad news.

That is certainly true of the recent turbulence, which this week saw German 10-year Bund yields leaping above 1 per cent. Higher yields, which move inversely with prices, are consistent with expectations of higher inflation.

 

So the sharp global rises, led by Bund yields, might tell a positive story — of diminishing fears that Europe is sliding into a dangerous, Japanese-style deflationary slump and of markets — slowly — preparing for the US Federal Reserve to raise interest rates. Where bond markets see gloom, others could see light.

 

What matters, however, is whether bond markets get the story right; misjudgments could spell greater, more disruptive volatility, especially as the Fed moves closer to policy tightening.

Unfortunately, if you talk to bond strategists you find little conviction that trend falls in inflation globally to worryingly low levels have gone decisively into reverse — which points to large bounds of uncertainty.

What happened in the past two months looks largely to have been a retreat from an extreme position. Eurozone bond yields plummeted as a result of heavy buying under the European Central Bank’s quantitative easing programme, launched in early March.

 

But German 10-year Bund yields, which in mid-April appeared to be heading below zero, were consistent with an economic disaster scenario. Large chunks of shorter term, north European government debt traded at unprecedented negative yields.

The abrupt subsequent moves were painful for investors but have arguably returned yields to levels more consistent with a eurozone economy the ECB expects to grow by 1.5 per cent this year, with inflation within its “below but close” to 2 per cent target in 2017.

 

You can almost hear the sighs of relief among policy makers. Higher Bund yields not only point to deflation having been averted. They suggest a panic over Greece, which would have seen a rush for safe German assets, has also been avoided.

 

If Interest rates have troughed, there would also be less pressure on non-eurozone countries such as Switzerland to think of even more creative ways of loosening monetary policy to offset the effects of a weakening euro.

But it is still too early to claim bond markets are signalling a decisive shift to a less worryingly-low inflation environment. Much of the correction was the result of technical factors, including overcrowded positions. As Mario Draghi, ECB president, pointed out last week, volatility begets volatility if investors sell what have suddenly become riskier assets. Yields could fall again during the summer, when eurozone government net bond issuance will turn firmly negative.

 

Moreover, the most closely watched indicator of long-term eurozone inflation expectations — what swap markets are pricing for average inflation rates over five years starting in five years — is still flashing warnings. At 1.84 per cent, it is up from January’s lows, but still below levels late last year, when the ECB started planning its QE programme. US inflation expectation gauges remain similarly muted.

True, the stabilisation of eurozone inflation expectations adds to evidence that the region will avoid a worse-case deflation scenario. But there remains the risk of a further abrupt adjustment in bond yields.

An obvious threat is that markets are not yet pricing in sufficiently the possibility of a rate rise by the Fed, which meets next week. The vibe in bond markets remains in tune with the International Monetary Fund, which last week advised the Fed against lifting US interest rates this year.

 

“Global disinflationary trends and the pass-through from the strengthening dollar are . . . likely to act as important dampening forces to inflation,” the IMF warned. But it is not just Greeks who ignore the IMF — Janet Yellen, Fed chairwoman, may also do so.

More generally, if bond markets can sell off as violently as they have recently without any great shift in global inflation expectations, the disruption could be much greater if the story really did change. A decisive shift from worries about global disinflation or even deflation to benign “reflation” scenarios would be good news for real economies — but not necessarily for bond markets.