There are growing signs of a marked increase in inflation in the Eurozone. It will not be long before the consequences of this are felt. Soon afterwards there could be a noticeable rise in yields.
Yields on 10-year German Bunds dropped below 0% for the first time ever this week. This time the renewed decline in yields was not sparked off by the European Central Bank (ECB) launching a fresh programme of sovereign bond purchases but by mounting concerns over Brexit. Latest opinion polls reveal a sizeable gain in the number of supporters for Great Britain’s exit from the European Union. They now have a lead and thus Brexit is perceived as a possibility. All investment vehicles responded negatively to this development. But yields on Bunds were already at a very low level of only 0.05 percent even before this.
It would be unfair, however, to apportion the blame for the current absurdly low level of yields solely on the growing likelihood of Brexit. The ECB is primarily responsible for this. With its huge buying programme for sovereign bonds from the Eurozone, it has nudged yields to this low level.
These low yields make little sense in real economic terms. The ECB’s primary objective by introducing its purchase programme was to fuel inflation expectations and thereby stimulate lending growth. Yet at most such growth could only be noted among real estate loans, while demand for credit among companies has hardly risen at all. For companies, the cost of capital appears to be of no relevance. Until now the underlying fundamentals have been too weak to prompt a tangible increase in demand for loans.
The current low level of yields on Bunds is being accompanied by very low inflation. In the Eurozone, inflation lies at -0.2 percent at the moment, due above all to last year’s marked decline in the oil price. However, the days of very low inflation in the Eurozone appear to be coming to an end. In recent weeks, the oil price has risen strongly and now lies at around 50 dollars a barrel. The oil price can be expected to remain at the level now reached. The surplus supply on the world market for crude oil is evidently being wound down more quickly than appeared to be the case a few weeks earlier, due largely to unscheduled interruptions in oil production. At the same time, estimates for global demand are being revised up slightly. But the oil price is not expected to spin out of control because the higher price will, for its part, cause production volumes to spiral upwards. In the United States, for example, exploration activity in the fracking field is likely to increase again and a number of emerging markets, which in some cases were hit considerably by the price fall, can be expected to raise their oil production volumes again.
Higher oil prices have the effect of stimulating inflation. By the end of 2016, prices in the Eurozone will probably increase by around 1 percent year-on-year, and in the first quarter 2017 inflation can even be expected to lie at around 1.5 percent. Over the course of 2017, it should then settle down at this level. The ECB’s inflation target of 2 percent would then be within reach.
As inflation creeps up, the fundamental conditions underlying the bond market will also change. The excessive overvaluation of the bond market will become clearly visible for all, with real yields then probably already hitting the minus 1 percent mark by year end, with economic growth estimated at some 1.5 percent. A huge price adjustment can therefore be expected on the bond market, regardless of whether the ECB makes further sovereign bond purchases or actually ends its asset purchase programme in the course of 2017.
The majority of investors should have sumptuous profits on the bond exposures in their portfolios. The higher inflation will most likely culminate in a revaluation of the bond market. Thus, the more inflation creeps up, the greater the willingness of investors will be to sell their bond exposures and thereby take profits in anticipation of a marked price fall.
If inflation develops as described above, the bond market can expect to undergo a sizeable revaluation. Considering the extent of the overvaluation on European bond markets and the extremely scant market liquidity, this revaluation could also unleash panic on bond markets – causing the bond market bubble to burst. Within a few days or weeks, such a development would cause yields to rise sharply.
A rapid surge in yields of this kind could, by extension, have negative repercussions on growth again, also burdening the government budgets of the southern Euro countries. This is because such higher yields could unfavourably influence the investment decisions of companies. Over time higher interest rates would make financing much more expensive for governments and thus place a considerable burden on their budgets.
The risk on bond markets is therefore considerable. As soon as the first signs of inflation start to emerge, investors can be expected to reposition themselves accordingly. The consequences for the real economy would be clearly negative in a case of this kind. And the ECB would be unable to do anything to prevent such a development. At the final count, this would be the consequence of the policy the ECB has been pursuing in past years. In the event of Brexit, the revaluation process on bond markets would be delayed somewhat at most, but on balance the problem is only likely to intensify even further.