Rises in yields, commodities hint at global reflation

By Wayne Cole and Jamie McGeever

SYDNEY/LONDON (Reuters) – A rapid revival of commodity prices and a sudden sell-off in top-rated, low-yielding bonds have signaled the passing of this year’s global deflation scare, forcing a rethink of both the consumer price outlook and investments worldwide.

The epicenter of the rapid slide in bond prices has been the euro zone, where yields on 10-year German paper <DE10YT=TWEB> have more than quadrupled to 0.595 percent in just five days, erasing all the price gains made this year.

Specific triggers for the turnaround since last week are hard to identify, but the continued recovery of oil prices and news of the euro zone emerging from four months of deflation may have been tipping points.

Brent crude futures have now risen more than 50 percent from a six-year low struck as recently as January. If that is sustained or even increased throughout this year, policymakers largely committed to ultra-loose policy could be in for a shock.

Even if oil prices stay where they are for the remainder of the year, the 12-month headline inflation outlook in many countries will now be transformed by year-on-year ‘base effects’ that will feed into inflation indices early 2016.

“There has been a profound easing in financial conditions over the past six months – a potent dose of stimulus,” said Christel Aranda-Hassel, a research analyst at Credit Suisse.

No fewer than 27 central banks around the world have eased monetary policy to some extent this year in a battle against deflation, slowing growth or both.

The sudden emergence of “reflation” trades in bonds and commodities partly reflects the European Central Bank’s unprecedented campaign of sovereign bond buying starting to work far more quickly than even optimists dared hope.

Not only have euro inflation rates stopped contracting, but private sector bank lending is expanding again for the first time in years and inflation expectations have turned positive.

But whatever the exact trigger, some economists fear the end of the deflation scare could weigh on future economic activity by re-tightening financial conditions.

“This move is most likely position driven, but if it continues it might weigh on the economy,” said Peter Schaffrik, head of rates strategy at RBC Capital Markets.

The fact that bond markets in the United States, Britain and Asia have tracked the backup in European yields suggests investors globally are focusing on the shifting global inflation, not a stellar economic recovery or even European-specific trends.

Growth numbers have revealed a sharp loss of momentum in the U.S. and Chinese economies in the first quarter, while business surveys showed Asia remaining sluggish in the coming months. But data last week showed the euro zone had emerged from deflation, the U.S. service sector is expanding nicely and wage inflation is picking up in the United States.

Yields on 10-year Treasuries <US10YT=RR> touched a two-month top at 2.23 percent on Wednesday, having climbed from 1.92 percent in little more than a week.

Yields in Australia, Canada and Britain all hit their highest in at least four months, with British bonds bearing the added burden of political uncertainty ahead of a general election on Thursday.

TERM RISK TANTRUM

While global turning points are notoriously hard to call, commodities have also been acting that way in recent days.

Oil and copper prices have sped to their highest for the year so far, while zinc reached ground not trod in eight months.

Brent crude <LCOc1> has climbed 53 percent from its January trough to reach $69.15 a barrel, with U.S. crude <CLc1> not far behind at $62.08.

The jump in bund yields look eerily similar to that for copper, hinting at some correlation if not causation.

However, a far less benign explanation for the back-up in bond yields might be the simply that the rush for returns at ever-longer maturities drove yields so low that buyers went on strike.

This is a theory favored by RBS’s head of treasury strategy, William O’Donell, who calls it a “Term Risk Tantrum”, referring to the premium investors demand for lending money out for years and years.

“In our opinion, this macro re-pricing is synonymous with the fraying/unwinding of many ‘crowded’ trades across fixed income and risk markets. It looks like we are nearing the precipice of what could prove to be a sustained outright bearish correction.”

If the rise in yields is not a reflection of an improving economic background, then it may prove self-defeating by tightening financial conditions and snuffing out any recovery.

Key will be whether policymakers start publicly protesting at the sea change in bonds, as they have so often in recent years.

“It all reads like a global economy that is not sure if it is at a turning point or not – the long end of the yield curve says ‘yes’ but central banks still say ‘maybe’ at best,” wrote analysts at Rabobank.

(Additional reporting by Vidya Ranganathan in Singapore Editing by Jeremy Gaunt)

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