Reasons not to see start of 'big one' in Europe's bond swings

When Europe's bond markets first hit turbulence late last month, the sharp price swings were easy to dismiss as a Blitz-crash, a sudden upset that would not last long. Weak economies and ultra-loose central bank policies were still expected to keep downward pressure on yields, which move inversely to prices.

Three weeks later, volatility is still high and the change of mood looks more profound. It now seems clear that yields had hit an - extraordinarily - low point, below which they are unlikely to drop again. But it has become harder to blame the subsequent turbulence solely on "technical factors", such as the overcrowding of investor positions or imbalances between bond supply and demand.

Economic growth data this week showed the eurozone actually grew faster than the US in the first three months of the year. At that time transatlantic differences in monetary policy suggested the opposite: the European Central Bank launched "quantitative easing" while the US Federal Reserve moved closer to an interest rate rise later this year. That has highlighted the extent to which artificially depressed European yields had diverged from economic fundamentals - and created scope for a snap back.

A fear in global financial markets is that the turbulence marks the start of "the big one" - the long-awaited sustained bear market in which yields rise over the long term from their historic lows, maybe abruptly, and potentially wreaking more general financial damage than, for instance, the bond market storms of the 1990s.

Could we have reached that point? It is not ridiculous to suggest the European turmoil could spread; statistical evidence indicates US Treasury yields have been taking their cue recently from German Bunds. Still, there are good reasons for not yet worrying excessively.

For a start, "technical" factors still explain a lot of what has been happening in Europe - although such factors could quickly develop into something dangerous. With hindsight, too many investors assumed yields would only fall. A lesson of the post-2007 crises is that aggressive central bank action encourages herding instincts. Many believed heavy ECB buying would create shortages of German Bunds, which would worsen liquidity problems. That left the market vulnerable to some kind of correction.

One trigger might have been a pickup in inflation expectations on both sides of the Atlantic, encouraged by a rally in oil prices. But inflation expectations remain modest. The gauge watched most closely by the ECB, showing what swaps markets expect eurozone inflation to average over five years starting in five years' time, still points to the central bank seriously undershooting its target of an annual rate "below but close" to 2 per cent.

Continental Europe's economic revival also needs to be put in context. Eurozone gross domestic product expanded 0.4 per cent in the first quarter, following a 0.3 per cent increase in the previous three months, which appeared to confirm the region had escaped a deflationary slump. That may damp initial expectations that the ECB's €60bn-a-month QE programme is only the start of a US-style succession of asset purchase programmes.

But the eurozone's performance relative to the US was flattered by winter-weather related weakness across the Atlantic. The improvement is far from sufficient to justify decisively higher European yields. Indeed, what was striking about Wednesday's growth data was the lack of bond market reaction. (Bond markets are the world's greatest moaners: stronger growth is bad news if it leads to higher inflation, which erodes capital values).

Bond markets rightly judge that European economic growth could splutter. Rarely has the region "benefited from such a strong conjunction of support factors" - including currency weakness, lower energy costs and loose monetary policies - yet it was "not self-evident" that the recovery would become self-sustaining, Marco Buti, head of the European Commission's economic directorate, warned recently.

The Bank of England this week cut its forecasts for UK growth, citing weakness in productivity growth. Across the continent, unemployment remains high, investment is weak and banks remain weighed down by non-performing loans.

If European bond yields continue to move wildly, it will not be because of a Blitz-recovery.

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