Inflation Bonds Show No Trichet Accord Amid Double-Dip Threat: Euro Credit
Bonds that signal investor inflation expectations show that traders disagree with European Central Bank President Jean-Claude Trichet’s declaration that another recession isn’t “in the cards.”
The gauge of how the market perceives consumer-price growth over five years beginning in five years’ time, a yardstick Trichet says is used by the ECB, slid this week to the lowest level in at least six years. In France, the yield difference between 10-year notes and inflation-linked debt fell to 182 basis points from this year’s high of 229 basis points in April.
While Trichet said yesterday risks to the inflation outlook are “slightly tilted to the upside” after policy makers kept their main interest rate at an all-time low of 1 percent, JPMorgan Chase & Co. estimates investors have bought a record $20 billion worth of derivatives that protect against the risk of deflation this year. Consumer-price gains won’t exceed 2 percent next year in Germany, the region’s biggest economy, amid austerity programs enacted in nations from Ireland to Portugal to Greece, analyst surveys compiled by Bloomberg show.
“Demand is huge, indicating some in the market have a very pessimistic view on inflation and growth,” said Jasper Falk, the London-based head of inflation trading at JPMorgan. “In the past, the possibility of having 10 years of cumulative deflation in the euro region was seen as remote and the cost of protection against that was very low. No one thought it was cheap. They thought it was irrelevant.”
Trichet said last month it’s unlikely the euro region will sink into a double-dip recession. He maintained that stance yesterday when he said “the positive momentum remains in place.”
ECB Vs. Fed
The ECB has told investors since its founding in 1998 that its top priority is fighting inflation, which erodes the value of fixed-income securities. By contrast, the Federal Reserve and the Bank of England have signaled they’re more willing to pump money into the economy to support growth. The Bank of Japan said Oct. 5 that it would keep its benchmark rate at “virtually zero” until deflation ends and also set up a 5 trillion-yen ($60 billion) fund to purchase assets such as government bonds, a tool known as quantitative easing.
The so-called five-year, five-year forward breakeven rate, which currently measures investor expectations for inflation in the euro region from 2015 to 2020, fell to 1.91 percent on Oct. 4, the lowest since Bloomberg began collecting the data in 2004.
Rates declined even as Europe’s economy expanded at the fastest pace in four years in the second quarter, according to data reported Oct. 6 by the European Union statistics office.
“Growth will come under pressure as countries like Greece, Ireland and Portugal cut spending aggressively,” said Mohit Kumar, a fixed-income strategist at Deutsche Bank AG in London. “Our strategy is to sell deflation risk in the U.S. and buy deflation risk in Europe.”
U.S. Treasury Inflation Protected Securities, or TIPS, and U.K. index-linked bonds outperformed their European peers as the Fed and the Bank of England suggested they are open to injecting more cash into the economy through bond purchases.
TIPS have gained 9.3 percent this year, compared with the 7.6 percent return of U.K. inflation bonds and the 6.1 percent advance of German index-linked securities.
Reports from the euro region highlight the two-speed economy of the 16-nation group. While growth in Germany and France picked up in the second quarter, Ireland’s economy unexpectedly contracted as consumers cut spending.
Greece’s government repeated its forecast on Oct. 4 that the gross domestic product will fall 4 percent this year and 2.6 percent in 2011 as the country seeks to reduce the deficit. The Portuguese economy may shrink 1.4 percent next year, the International Monetary Fund forecast.
In May, the European Union and the IMF offered a 750 billion-euro ($1 trillion) rescue fund for Greece and others of the so-called euro peripheral nations to reduce the chances of a sovereign default. The loan package imposed budget rules on distressed euro-area members. Governments in Greece, Spain, Italy and Portugal have pledged to step up deficit cutting.
Some of the peripheral nations are struggling to implement spending reductions to meet the 3 percent budget-deficit limit demanded of common currency members. Spanish workers went on a general strike last week for the first time in eight years to protest austerity measures. In Greece, the main union for state workers, ADEDY, shut down hospitals and schools, and disrupted flights yesterday to protest the proposed 2011 budget.
Tepid growth and sovereign-debt burdens are “liable to send the euro zone into a deflationary spiral,” billionaire investor George Soros said Oct. 5 in prepared remarks for a speech at Columbia University in New York.
Soros’s view contrasts with Graeme Caughey, who helps oversee about $235 billion at Edinburgh-based Scottish Widows Investment Partnership. Caughey said the drop in inflation breakeven rates presents “a good opportunity” to buy index- linked bonds as the ECB will almost certainly succeed in preventing deflation.
“In the end, I think the ECB will do all they can to prevent that scenario,” Caughey said. The breakeven rate, a gauge of market expectations for inflation, is derived from the yield gap between regular and index-linked bonds.
When investors buy inflation-protected bonds, they receive so-called real yields, which tend to be lower than those of nominal bonds. The advantage of index-linked bonds is that their principal increases with inflation. In the euro zone, the figure is based mainly on consumer-price indexes for the region.
While longer-term inflation expectations are declining, index-linked bonds suggest investors are wary about the shorter term. France’s one-year breakeven rate is close to the highest in at least five months, reached at the start of October, according to data compiled by Bloomberg.
“Euro inflation is liable to move above 2 percent in early 2011, potentially well above that if further value-added tax increases are announced,” said Alan James, head of inflation- linked bond research at Barclays Capital in London. “The euro area in aggregate is likely to continue its economic recovery into early next year when the impact of fiscal tightening is likely to start to be felt.
Italian index-linked bonds, a proxy of inflation securities for the region’s non-AAA market, fell during the first nine months of this year for the first time since 2006, according to indexes compiled by Bank of America Merrill Lynch. The securities underperformed the regular bond market by 3.7 percentage points, the most since 2008 when U.S. investment bank Lehman Brothers Holdings Inc. went bankrupt.
“The risk of debt deflation is just too great and the market is trying to pass on that message to policy makers,” said Stuart Thomson, a fund manager in Glasgow at Ignis Asset Management, which is selling euro-area inflation bonds.
The ECB claims that, unlike the Fed or the Bank of England, it hasn’t resorted to printing money. It has bought bonds from peripheral countries to stabilize the market and issued short- term money market instruments to absorb excess liquidity in the market, a process known as sterilization.
Quantitative easing tends to lead to inflation and a decline in the currency, said David Owen, chief European economist at Jefferies International Ltd. The euro has dropped about 13 percent against the dollar from its peak in July 2008 to $1.3928 as of 4 p.m. in London. Yet, the currency remains stronger than its five-year average of about $1.35, according to data compiled by Bloomberg.
“A weaker currency is exactly what the ECB needs to boost the economy,” said Owen. “Trichet has talked up recovery, but I’m more pessimistic than he is. I’m inclined to think the Federal Reserve and the Bank of England will be more successful than the ECB in supporting growth.”
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