Crumbling Inflation Outlook Fuels Surge in Bunds to Gilts

The outlook for inflation across Europe is sagging and that’s music to the ears of bond investors as they accept ever-lower yields to hold German and U.K. debt.

With reports today showing Italy is mired in recession and German factory orders are shrinking at the fastest pace since 2011, gauges of the outlook for euro-area consumer prices in bonds and derivatives markets slid toward record lows. Even in Britain, the quickest-growing developed economy, competition among retailers drove down shop prices in July, sending the 10-year break-even rate to its lowest level in more than 18 months.

Slowing inflation helps to preserve the value of fixed payments on bonds, providing a fillip for the safest assets and adding momentum to haven demand fueled by geopolitical tension in Ukraine. Ten-year bund yields set a record low today and Germany’s 30-year borrowing costs dropped below 2 percent, while rates on Britain’s 10-year gilts fell to the least in a year.

“Inflation is very low,” said Luca Jellinek, head of European rates strategy at Credit Agricole SA’s corporate and investment banking unit in London. “There’s no way to call the bottom on bund yields. People have tried and got their fingers burnt.”

Bondholder Elixir

Germany’s 10-year break-even rate, which strips out the difference in yield on bunds and index-linked securities to gauge inflation expectations, fell to 1.27 percentage point at 2:51 p.m. London time, the least since 2012. That year it touched 1.26 percentage point, the lowest rate since Bloomberg began tracking the data in 2009. Euro-area five-year inflation swaps, derivatives tied to consumer prices, were at 1.145 percent, a level last seen on a closing-market basis in 2008.

While that’s an elixir for bondholders, it’s a frustration for European Central Bank policy makers, who are due to give a decision on interest rates tomorrow. Just two months ago they unveiled a package of measures designed to resuscitate inflation in the region, with consumer prices rising at less than half their goal of just under 2 percent. Policy makers will keep the main refinancing rate at 0.15 percent and the deposit rate at minus 0.1 percent, according to economists estimates.

Bunds also gathered support today after Poland warned that Russian President Vladimir Putin may be preparing to invade Ukraine amid a renewed buildup of troops on the Russian border.

Yields on Germany’s 10-year debt tumbled seven basis points, or 0.07 percentage point, to 1.095 percent, a record, and 30-year rates fell as much as eight basis points to 1.99 percent, the lowest since June 2012.

Hungry Investors

“The market is hungry for fresh all-time lows in 10-year bund yields,” said Marius Daheim, a senior fixed-income strategist at Bayerische Landesbank in Munich. “Equity indices are down quite strongly, supporting the geopolitical risk-off argument for stronger government bonds.” The 10-year German rate may increase 20 basis points in the next three months as “these levels are not justified,” he said.

Yields on gilts dropped to a one-year low as data showed U.K. shop prices fell the most on record last month. Britain’s 10-year break-even rate, which measures future expectations for retail-price inflation, dropped two basis points to 2.82 percentage points, the lowest since Jan. 9, 2013, based on closing-market data. The 10-year gilt yield fell as much as eight basis points to 2.50 percent, the lowest since August 2013.

The Stoxx Europe 600 Index of shares fell 1.2 percent, leaving the index up 2.6 percent for the year, including reinvested dividends. German securities are beating that, having returned 5.5 percent this year through yesterday, Bloomberg World Bond Indexes show. Gilts also beat stocks, earning 5.2 percent.

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