The Short View

July 30, 2014 9:50 pm

Bond markets hold a little bit of hope

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Government bonds of major economies are not supposed to see yields triple, then fall all the way back to where they started, in a year. Investors in the eurozone may be blasé about such moves after the near death experience of peripheral debt. Even so, the performance of German 5-year bonds since last May has been extraordinary.

German 5-year yields soared from 0.3 per cent to just above 1 per cent as they tracked US rates upwards. As the reality of the eurozone’s stagnant economy and stagnant prices sank in, they fell all the way back – and longer-dated yields have come down with them.

This week the 10-year yield hit the lowest ever, while the 30-year was lower only briefly amid eurozone implosion fears.

Yesterday the surprise strength of the US economy helped lift yields, but European data showed again the problem the eurozone faces. German inflation was only 0.8 per cent, while Spain has deflation again. Over the past 60 years, Spanish prices have fallen faster only for six months in the post-Lehman depression.

Eurozone-wide inflation figures due today are expected to come in at only 0.5 per cent. With the region’s economy about to be pressured by the sanctions on Russia, this is not a good starting point. It is also far below the 2 per cent target of the European Central Bank.

The bond market has little faith in the ECB hitting its target any time soon. Bond markets are pricing eurozone inflation at 0.64 per cent over the next five years, on a par with the depths of the 2012 crisis (though above 2009).

If right, such a rate will make it harder for periphery countries to reduce costs relative to Germany, while preventing them inflating away their vast debts.

Grasping for good news? Well, bond markets do not expect Japan-style deflation. Inflation may be following the same course as in Japan after its bubble burst in 1990, but bond futures suggest prices will rise more than 2 per cent for the five years starting in 2019. It isn’t much, but it is hope.

james.mackintosh@ft.com

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