Inflation jitters put bonds out in the cold

Europe's bond bears are growling again, forecasting a drop in government bond prices - and a corresponding rise in government borrow- ing costs - in the fourth quarter.

The Bloomberg News survey of economists' expectations for the European economy shows that demand for 10-year bonds is expected to slacken by year-end as central banks are spooked into raising official interest rates in order to keep a lid on inflation.

Those predictions come in the wake of similarly bearish forecasts for third-quarter bond performance. Some of these forecasts were off-target by as much as a percentage point."Everyone was looking for higher yields on the back of a better-performing economy that would have meant higher interest rates, but that didn't happen," said Kirit Shah, senior strategist at Sanwa International. "Yields are so low there is little money to be made. The market is over-stretched, and could snap anytime."

Two developments combined to make the forecasters look bad last quarter - US Treasury yields continued to sprint lower as inflation remained benign in the world's largest economy, while the introduction of a single European currency looked likely to go ahead as planned in 1999.

Justifying their pessimism for the fourth quarter, economists point to the prospect of the first official German interest rate increase since December 1992, with the Bundesbank poised to move its repurchase rate from 3 per cent, where it's held since August 1996.

"We expect the German repo rate to be 30 basis points higher by the end of the fourth quarter," said Philip Tyson, an economist at HSBC Markets. The median forecast of 16 economists calls for a 20 basis-point rise to 3.2 per cent.

For Germany, that means 10-year bond yields rising by about half a point to 6 per cent by the end of December.The median forecast for French 10- year yields is 5.78 per cent, up from about 5.50 per cent on 30 September.

In the UK the forecast is for yields to rise to just above 7 per cent, up from 6.45 per cent at the end of last month. With housebuyers opting for fixed-rate mortgages, a rise in bond yields would make it more expensive for banks and building societies to borrow in the wholesale markets.

As in the third quarter, however, the doom merchants could be defeated if the US Treasury market continues the rally which has driven the yield on the 30-year bond, the bellwether for world bonds, down by half a point since mid-year to about 6.3 per cent currently.

With the Federal Reserve appearing to have achieved the combination of growth plus slow inflation, investors have been willing to drive bond yields lower, ignoring the inflation warnings of bond analysts. "The problem for analysts is that we've grown up associating growth with inflation," said Gerd Neitzel, manager for Siemens in Munich. "It's a new world. It's hard to get used to deflation or non-existent inflation."

Neitzel believes demand for bonds will remain strong, and the majority offering bearish forecasts will be proved wrong. "If the US gives a lead, the others will follow," the fund manager said. "If you ask me where yields will be in six months, I would say the same level, or probably a bit lower."

He sees scope for the US 10-year yield to drop by about a quarter point by year-end to 5.75 per cent. "Why shouldn't Germany then be at 5.25 per cent?" Neitzel said.

Bond markets did better than expected in the third quarter, undoing the market decline forecast by economists polled in June. For Germany, forecasts for a 6 per cent 10-year bond yield were higher than the 5.52 per cent rate achieved at the end of the third quarter, with forecasts for French yields missing out by half a point.

In Britain, bond yields were supposed to soar to 7.25 per cent, a quarter- point rise from mid-year. Instead, the market awarded the Government better than a half-point cut in borrowing, as well as pushing the UK's funding costs closer to Germany's.

It was the performance of Europe's higher-yielding bond markets, however, that caught analysts off guard. The political will to ensure that monetary union goes ahead outweighed difficulties would-be members have in meeting the economic targets.

Italian 10-year bond yields hit 6.18 per cent at the end of the third quarter, dropping 70-odd basis points in the three months to beat the 7.25 per cent median forecast by better than a percentage point. Spanish bonds outstripped expectations by a point.

"Although people were bullish about EMU convergence, the intensity of the convergence took everyone by surprise," Shah said. "The momentum is irreversible; markets reinforced that."

Investors who've made returns of better than 10 per cent in the European bond market are likely to get antsy about those investments as the end of the year approaches, tempting them to book profits. The Bundesbank and the Fed are likely to raise rates at the first sign that inflation is accelerating, and the German central bank may feel compelled to act next month.

"There could be a setback," said Shah, who predicts a quarter-point rise in German rates by year-end and a Fed rate increase in November. "If there's a scare, people will take profits."

With additional reporting by Shobhana Chandra

Copyright: IOS & Bloomberg

Life and Style
“What is it like being a girl?” was the question on the lips of one inquisitive Reddit user this week
peopleDave Legeno, the actor who played werewolf Fenrir Greyback in the Harry Potter films, has died
Arts and Entertainment
Armando Iannucci, the creator of 'The Thick of It' says he has
tvArmando Iannucci to concentrate on US show Veep
Life and Style
Luis Suarez looks towards the crowd during the 2-1 victory over England
Life and Style
Swimsuit, £245, by Agent Provocateur

Diving in at the deep end is no excuse for shirking the style stakes

German supporters (left) and Argentina fans
world cup 2014Final gives England fans a choice between to old enemies
Arts and Entertainment
A still from the worldwide Dawn of the Planet of the Apes trailer debut
peopleMario Balotelli poses with 'shotgun' in controversial Instagram pic
A mugshot of Ian Watkins released by South Wales Police following his guilty pleas
peopleBandmates open up about abuse
Basketball superstar LeBron James gets into his stride for the Cleveland Cavaliers
sportNBA superstar announces decision to return to Cleveland Cavaliers
Javier Mascherano of Argentina tackles Arjen Robben of the Netherlands as he attempts a shot
world cup 2014
Arts and Entertainment
The successful ITV drama Broadchurch starring David Tenant and Olivia Coleman came to an end tonight
ebookA unique anthology of reporting and analysis of a crucial period of history
Four ski officials in Slovenia have been suspended following allegations of results rigging
sportFour Slovenian officials suspended after allegations they helped violinist get slalom place
14 March 2011: George Clooney testifies before the Senate Foreign Relations Committee during a hearing titled 'Sudan and South Sudan: Independence and Insecurity.' Clooney is co-founder of the Satellite Sentinel Project which uses private satellites to collect evidence of crimes against civilian populations in Sudan
Arts and Entertainment
Balaban is indirectly responsible for the existence of Downton Abbey, having first discovered Julian Fellowes' talents as a screenwriter
tvCast members told to lose weight after snacking on set
Life and Style
More than half of young adults have engaged in 'unwanted but consensual sexting with a committed partner,' according to research
Life and Style
A binge is classed as four or more alcoholic drinks for women and five or more for men, consumed over a roughly two-hour period
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business


£50000 - £70000 per annum: Harrington Starr: Business Analyst Consultant (Fina...

Programme Support, Coms, Bristol, £300-350p/d

£300 - £350 per day + competitive: Orgtel: My client, a leading bank, is curre...

(Junior) IT Systems Administrator / Infrastructure Analyst

£28000 - £32000 per annum + pension, 25 days holiday: Ashdown Group: A highly ...

Finance Officer

Negotiable: Randstad Education Birmingham: Randstad Education are seeking a Fi...

Day In a Page

A History of the First World War in 100 Moments: Peace without magnanimity - the summit in a railway siding that ended the fighting

A History of the First World War in 100 Moments

Peace without magnanimity - the summit in a railway siding that ended the fighting
Scottish independence: How the Commonwealth Games could swing the vote

Scottish independence: How the Commonwealth Games could swing the vote

In the final part of our series, Chris Green arrives in Glasgow - a host city struggling to keep the politics out of its celebration of sport
Out in the cold: A writer spends a night on the streets and hears the stories of the homeless

A writer spends a night on the streets

Rough sleepers - the homeless, the destitute and the drunk - exist in every city. Will Nicoll meets those whose luck has run out
Striking new stations, high-speed links and (whisper it) better services - the UK's railways are entering a new golden age

UK's railways are entering a new golden age

New stations are opening across the country and our railways appear to be entering an era not seen in Britain since the early 1950s
Conchita Wurst becomes a 'bride' on the Paris catwalk - and proves there is life after Eurovision

Conchita becomes a 'bride' on Paris catwalk

Alexander Fury salutes the Eurovision Song Contest winner's latest triumph
Pétanque World Championship in Marseilles hit by

Pétanque 'world cup' hit by death threats

This year's most acrimonious sporting event took place in France, not Brazil. How did pétanque get so passionate?
Whelks are healthy, versatile and sustainable - so why did we stop eating them in the UK?

Why did we stop eating whelks?

Whelks were the Victorian equivalent of the donor kebab and our stocks are abundant. So why do we now export them all to the Far East?
10 best women's sunglasses

In the shade: 10 best women's sunglasses

From luxury bespoke eyewear to fun festival sunnies, we round up the shades to be seen in this summer
Germany vs Argentina World Cup 2014: Lionel Messi? Javier Mascherano is key for Argentina...

World Cup final: Messi? Mascherano is key for Argentina...

No 10 is always centre of attention but Barça team-mate is just as crucial to finalists’ hopes
Siobhan-Marie O’Connor: Swimmer knows she needs Glasgow joy on road to Rio

Siobhan-Marie O’Connor: Swimmer needs Glasgow joy on road to Rio

18-year-old says this month’s Commonwealth Games are a key staging post in her career before time slips away
The true Gaza back-story that the Israelis aren’t telling this week

The true Gaza back-story that the Israelis aren’t telling this week

A future Palestine state will have no borders and be an enclave within Israel, surrounded on all sides by Israeli-held territory, says Robert Fisk
A History of the First World War in 100 Moments: The German people demand an end to the fighting

A History of the First World War in 100 Moments

The German people demand an end to the fighting
New play by Oscar Wilde's grandson reveals what the Irish wit said at his trials

New play reveals what Oscar Wilde said at trials

For a century, what Wilde actually said at his trials was a mystery. But the recent discovery of shorthand notes changed that. Now his grandson Merlin Holland has turned them into a play
Can scientists save the world's sea life from

Can scientists save our sea life?

By the end of the century, the only living things left in our oceans could be plankton and jellyfish. Alex Renton meets the scientists who are trying to turn the tide
Richard III, Trafalgar Studios, review: Martin Freeman gives highly intelligent performance

Richard III review

Martin Freeman’s psychotic monarch is big on mockery but wanting in malice