Great Graphic: German Bunds, Inflation Expectations And The Euro

Deflation, as measured by a year-over-year decline in headline CPI did materialize. CPI in the euro area was negative from December through March. It bottomed at -0.6% in January. It was flat in April and rose to 0.3% in May. The bund yield bottomed when it became clear to investors that the downside risks of deflation were subsiding, helped in part by the recovery of oil prices and the stronger eurzone economy in general. 

The white line in the chart shows the 10-year German breakeven. This is the interest rate differential between the conventional yielding bund and the inflation-linked bund. This is a market-based measure for inflation expectations. What the chart shows is that inflation expectations were rising in Q1 even as bund yields fell.  

The 10-year breakeven rose from 59 bp in early January to 1.29% in late March.  Bund yields fell by about 45 bp over that period. The breakeven rose to 1.33% on the day that the 10-year bund yield recorded its low near 5 bp (April 17). Today it reached 1.38%, the highest since last August. 

This means year-to-date, the 10-year breakeven has risen by about 60 bp while the bund yield has risen by about 50 bp.  Liquidity is an important caveat. If the liquidity of conventional bunds is problematic, it is even more true of the inflation-linked bunds.  

The euro and 10-year bund moved in the same direction about 83% of the time over the last 50 sessions. This is just off the peak set in February (95%). As bund yields were falling so was the euro in much of Q1. That correlation has been fairly stable this year. The implication is clear.  If you are trading the euro keep an eye on German bunds.  Selling of German bunds (higher yields) at the same time as the euro appreciates.  US economic data is of secondary importance in this environment. 

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