Reuters
London
Eurozone inflation-linked bonds could be big winners in a currency war that has accelerated last week with the start of the European Central Bank’s €1tn money-printing scheme.
Demand for the bonds, known as linkers, has picked up over the past month as investors anticipated the launch of the ECB’s quantitative easing programme, aimed at reviving inflation and economic growth in the 19-nation currency area.
This demand has driven up breakeven rates – the difference between the yield on nominal bonds and the “real” yields on linkers and seen as a proxy for inflation expectations – though they remain below the ECB’s inflation target of near 2%.
For instance, breakeven rate on French 10-year bonds is around 1.37%, having clawed off lows of around 1% in early February.
Many analysts expect linkers to make further gains as the ECB bond purchases push the euro lower and inflation higher.
Investors are emboldened by developments in the Japanese market, where inflation-linked bonds outperformed nominal government debt by 9% from end-2011 to February 2015, according to Barclays benchmark indexes. In the same period, the yen dropped by more than 50% against the dollar.
The euro has slid close to parity with the dollar this week after the ECB kicked off its QE programme, following Japan and other central banks in pumping in stimulus.
It has fallen about 25% against the dollar since last May and many analysts see it breaking below parity in coming months as ECB QE picks up pace and the US Federal Reserve moves closer to raising interest rates.
The currency’s tumble is expected to lift price pressures by making imports more expensive, with some analysts estimating a 0.5-0.7% boost over the next 12-18 months.
A rough rule of thumb is that a 10% drop in the euro’s trade-weighted value ends up boosting inflation by 0.4-0.5 percentage points. The trade-weighted euro is down 5.25% since Jan. 22 when the ECB unveiled its programme.
“What the ECB has been doing for the last days since they started QE is massive and we don’t want to oppose that,” said Jonathan Baltora, who manages inflation-linked bond funds at AXA Investment Management.
“Euro inflation-linked bonds offer value as the euro area stands to be a winner of the currency war in the year to come.”
The AXA inflation-linked bond funds switched back fully into linkers early this month, having held up to 15% in nominal bonds as a hedge against the impact of last year’s plunge in oil prices.
Baltora said he prefers Italian and Spanish linkers, which offer higher potential returns than German and French peers, whose real yields have fallen further into negative territory.
He also considers them attractive relative to nominal bonds, whose yields have withered to record lows.
Investors are also piling back into Italian inflation-proof bonds ahead of their reinstatement into Barclays’ World Government Inflation-Linked (WGILB) and Euro Government Inflation-Linked (EGILB) bond indices from March 31.
Spain will also be included after Barclays lowered its minimum credit- rating requirement to Baa3/BBB- from A3/A-.
“What the ECB has done is make it harder to short breakevens,” said Citi strategist Jamie Searle. Anecdotal evidence from traders points to interest from investors who aren’t traditional linker buyers coming into the market to scout for cheap QE trades as oil prices stabilise.
“We do believe that the depreciation of the euro will start to impact inflation and the market vastly underestimates that,” Searle said.
“The euro is seen reaching parity with the dollar, that was already our forecast, and a large part of that is down to the currency wars that seem to be going on.
There are signs that the ECB is doing a good job on that, though it’s not an explicit target to weaken the euro.”