rahul.khanna's picture

Euro bond yields and forward inflation to show the way for EUR?

The rise in the Bund yields reflects increased inflation expectations. Euro 5y5y forward inflation linked swap - a swap beginning in 5 year with a maturity of 5 years whereby 5y5y gained upside when QE was announced, but the Bund diverted as market expected a bond buyoff.  However, better than expected economic data and the realisation of a possible economic recovery has pushed the Bund yields firmly up since start of May.  German 10y bond yields are steadily rising and other European sovereign yields are showing an upward drift too

(click on chart to enlarge, EURUSD, BUND 10y, and EUR Forward Inflation Linked Swap 3 months)

A pick up in inflation expectations this soon does create a problem in the ECB’s plan for continued QE well into September next year, but this is not a major issue, if the economy is set on a path of a sustained recovery (ECB can stop buying).  The key issue for the ECB is to keep the QE going to prop up the economy, and in the process keep inflation and the Euro down. 

The Euro is likely to rally along with bond yields, if market perceives a rise in economic growth as represented (for now) by a steadily rising Euro 5y5y inflation linked swap (need to stabilise around two percent).  Hence, it will be prudent to keep a keen eye on 5y5y inflation linked swap and core countries bond yields, when having a view on Euro.