Inflation expectations spurs bond sell-off

So much for risk-free assets. In 12 days owners of German benchmark bonds have seen the plummeting price wipe out more than 60 years worth of income, as the Bund sees the biggest rout in total return terms since 1994.

The move is a classic case of unwinding of a crowded trade, which had seen speculators buy eurozone bonds at yields they regarded as unreasonably low, purely in the expectation of selling them on to the European Central Bank at an even lower yield. As in Japan in May 2013, the quantitative easing trade has gone into a sudden reverse, helped by a better outlook for the eurozone economy.

Yields are not only rising in Europe. Australia even saw yields jump when the central bank cut rates this week, the reverse of what usually happens.

Partly it is just that the hunt for yield had spilled out of Europe into safe bonds elsewhere. But behind it all, the global deflation scare has evaporated, removing a lot of the downward pressure on yields.

Bond market measures of expected inflation have risen sharply since bottoming earlier this year in the eurozone, US, Japan and UK (see chart). Investors are no longer panicking about deflation taking a grip, removing one of the reasons to buy bonds at super-low yields.

The deflation scare seems to have fully reversed in the UK. Its break-even inflation rate calculated from inflation-linked bonds and the expected inflation for the five years starting in five years' time, calculated from swaps, are back to something like normal.

In the US, Germany and the thinly-traded Japan inflation-linked markets, the rebound has not been as fast, but bonds and swaps are now priced for disappointingly low inflation, not the risk of deflation.

The timing of the bond sell-off does not match the deflation scare and its reversal, which fits better with the moves in the oil price (itself up to a new high for the year on Wednesday). But the removal of the fear of deflation takes away one support from the bond market, and makes it easier for yields to rise (and prices fall).

As speculators and trend-followers switch from holding bonds to betting against them, hopes of higher inflation can only help their trade.

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