Rise in German Yields, normalization after unwarranted swings

Outlook:

Everyone expects retail sales to be a catalyst but in the way of things, expectations are probably already built in and the dollar firmness ahead of the release could be all we get. And unless the numbers surprise on the upside, we could see “sell on the news.” Expectations are for dales to rise 1.4% in the May month, and 0.9% ex-autos.

We are still trying to wrap our heads around the bond yields. The simplest explanation is that the sell-off is caused by the most basic of reasons—the global economy is improving and thus the need to hide in safe-haven bonds is receding, too. In the US, we have a slew of data showing employment and wages higher and thus wage pressure sometime soon and thus inflation sometime soon, too. Pimco is so convinced of this scenario that it’s betting the ranch on TIPS, noting that the breakeven rate is 1.89%--up from 1.49% in January.

Meanwhile, BBK chief Weidmann commented on the sharp rise in Bund yields as a "recentralization," a aord that may makes more sense in German but has zero meaning in English. What he means is normali-zation after unwarranted swings. "In my opinion, the most recent rise in yields can be largely explained as a correction of a market overshooting – a kind of re-normalization." But he also warned of “risks and unintended side-effects that might outweigh the benefits” of normalization in inflation.

Market News has a piece on where the equilibrium yields will be once normalization is completed. We can all agree that the near-0.5% in Bunds was an overshoot, but where is the sensible landing point? For the US, everyone is looking for 2.50%, which leads to 3%, the highs seen in late Dec 2013 and early 2014. “U.S. data will be a key driver for Fed liftoff, still seen as more likely to be in September, than in July, as well as for the U.S. Treasury yield trajectory. However, if German Bund yields keep rising, U.S. yields could be dragged higher regardless of the data.”

One analyst notes that the German Labor Cost Index rose "a sharp 3.2% y-o-y in 1Q 2015, the most rap-id gain in two years and well above the 1.8% average over the last decade. In addition to limiting defla-tion fears, rising wages are likely a key contributor to signs of stronger consumer demand in 2015, also aided by lower energy costs."

The implication is that Bund yields are still on the rise. Another analyst estimates "The next stop for the ten-year Bund is likely to be the 50% Fibonacci retracement of 1.07%, after which it could be smooth sailing back towards the 1.30% mark." Another analyst has 1.25%. Like Pimco with its analysis of the US economy—inflation is coming faster than you think--this analyst is watching the German breakeven. It’s 1.38%, from 1.29% in early March. A third view has the Bund at 1.12-1.16%. A worry is that it will overshoot to the upside at 1.40%, the 200-week moving average.

Now consider Sweden. We don’t follow the krona but today Stockholm made a splash with consumer prices up a whopping 0.1% in May, according to Bloomberg, when a drop by 0.1% was forecast and even the Riskbank saw zero change. “Underlying consumer prices, adjusted for mortgages, rose an an-nual 1 percent, beating the 0.8 percent increase estimated by economists and the 0.87 percent rise seen by the Riksbank.”

Golly, Sweden thinks it has inflation. Does Sweden lead? Well, maybe. Why not?

If so, we can view the yield saga as a race to see which economies are getting closer to actual inflation at the faster pace—regardless of what the central banks are doing. In other words, the Fed may be behind the curve while the ECB is being silly to insist that QE will last until the bitter end (near end-2016). By then, Europe will be awash in inflation.

We don’t buy this argument for a minute. Pimco is jumping the gun on inflation in the US and Sweden’s “underlying consumer prices” up a whole 1% is not actually all that impressive. We could easily force US data to show a bundle of consumer prices up 1%. In fact, if you include mortgage rates in the calcu-lation and 10-year yields keep rising, by that measure the US will have inflation over 1% in no time. However, if rising Bund yields are what is driving the euro and those yields are headed higher to as much as 1.25-1.30%, we have to abandon our stronger-dollar thesis—even if we get one last pop today on retail sales. Hmm, heavy stuff.