Bond selloff indicates fears of inflation return

Bonds sold off again on Tuesday, both in Europe and to some extent in the U.S., and it’s not all good news.

Some analysts are opting for the glass half-full version and see this as a sign that market confidence about the future path of inflation is rising.

The eurozone definitely stepped away from the danger of deflation, with data for May beating analyst expectations.

Consumer price inflation was 0.3% in May year on year from April’s flat reading; but stripping out the volatile impact of fuel prices, consumer prices in fact increased by 1%.

This could partly be behind the rise in eurozone bond yields, and presents a real dilemma for the European Central Bank, which would very much prefer to see low yields and a depreciated euro.

The ECB holds its monetary policy news conference on Wednesday but Mario Draghi is unlikely to say anything that would lead investors to believe he would end the central bank’s quantitative easing programme earlier than planned.

However, the fact that this selloff comes so early after the first one seems to be another indication that central banks are losing their hold on the markets.

More data are needed to see whether inflation is indeed definitely turning up, which would be bad news for bonds.

Analysts at RBS argue that German inflation figures, released on Monday, did not suggest broadening inflation pressures.

Germany Inflation

Germany does not show inflationary pressure. Source: RBS

“We are still negative on European inflation. Unless the details of the source of the pick-up demonstrate that disinflation pressures are broadly bottoming or reversing, we will not change our mind on the basics: that prints will come down over the coming months,” they wrote in a research note on Tuesday.

In fact the RBS analysts believe the for the short term it is US data that is weighing on German bunds, and they note that the selloff started on Monday afternoon after the strong ISM manufacturing number out of the US.

“We think bunds will remain vulnerable to Treasuries dynamics in the short run, but in the long-run we expect euro rates to decouple sharply, as they are driven by domestic dynamics,” the RBS analyst noted.

The 10-year US Treasury yield had fallen by around 15 basis points over the last two weeks before recouping that fall on Tuesday.

Analysts at Capital Economics forecast that 10-year Treasury yields will end next year at 3% compared with the current level of around 2.6%.

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