Deflation trade done, market volatility picking up
It was only four months ago that the eurozone slipped into deflation for the first time since October 2009, raising the spectre of a Japanese-style deflationary spiral.
At the end of January, one of the most closely watched gauges of inflation in Europe, the 10-year German “break-even” rate (which measures market expectations of average inflation in Germany over 10 years by comparing the yield on conventional 10-year bonds with its inflation-protected equivalent), sank to just above 0.5 per cent - sharply below the European Central Bank’s 2 per cent inflation target.
It is now veering towards 1.5 per cent. Having turned negative in January, Germany’s headline inflation rate is ticking back up again and now stands at 0.4 per cent. A four-month spell of deflation in the entire eurozone has also come to an end, with consumer prices remaining flat last month.
Meanwhile, in the US, 10-year breakeven rates have shot up from a low of 1.5 per cent in January to nearly 2 per cent.
The surge in oil prices this year - Brent crude has risen from less than US$50 a barrel in mid-January to $67 on Wednesday - is boosting inflation expectations and contributing to a sharp and unexpected sell-off in long-dated government bond markets.
Having nearly turned negative last month, the yield on 10-year German Bunds has surged to 0.61 per cent - and rose by an unprecedented 40 basis points in the space of just several days. Southern European bond markets have also suffered a sharp sell-off, with yields on 10-year Spanish and Italian debt increasing 60 basis points since the end of last month.
The sell-off in eurozone bond markets is putting upward pressure on US Treasury bonds, with the benchmark 10-year Treasury yield now standing at 2.24 per cent - its highest level since early March.
This begs the question: is this the end of the long-running rally in bonds and the start of a “reflation trade”?
What is clear is that an “inflation scare” is far from materialising.
In the eurozone, the epicentre of the bond market sell-off, headline inflation is still woefully below the ECB’s 2 per cent target. Even core inflation, which excludes volatile food and energy prices, still stands at a meagre 0.6 per cent - unchanged from its level in January.
In the US, meanwhile, headline inflation has turned negative - although this stems from the effects of cheaper energy prices and is therefore likely to prove short-lived. As for Japan, which has been flirting with deflation, the central bank now accepts that it can no longer meet its goal of raising inflation to 2 per cent within two years of launching its aggressive quantitative easing (QE) programme in April 2013. It now hopes to fulfil its objective by the end of next year.
In emerging Asia, inflation remains remarkably subdued. Many of the region’s central banks are cutting interest rates because of a sharp oil-driven fall in consumer prices and a slowdown in growth. Thailand, which loosened monetary policy last week, is one of a number of emerging Asian economies suffering from deflation.
A more likely explanation for the recent sell-off in government bond markets is that investors simply became too pessimistic about the outlook for inflation and placed heavy bets on bond yields falling further - especially with the ECB having launched its own QE programme in March.
Only several weeks ago, German government debt with a maturity of up to eight years was trading at negative yields. The prevailing view in the markets was that it was only a matter of time before the country’s benchmark 10-year yield dipped into negative territory.
It’s now clear that the “deflation trade” went too far.
While a shift in inflation expectations is taking place due to the dramatic recovery in oil prices, the bond market sell-off has more to do with a technical correction as opposed to fears that inflation is about to take off.
Growth, particularly in the eurozone, remains far too feeble for investors to start panicking about inflation. Yet the cat is out of the bag. The deflation trade has run its course, removing a major prop for bond markets.
The danger now is that markets become much more volatile in the coming days and weeks as investors speculate that bond yields will rise more sharply.
Current trading conditions are not for the faint-hearted.
Nicholas Spiro is managing director of Spiro Sovereign Strategy