Trade War Traps ECB With Bund Yields at Record Low

(Bloomberg Opinion) -- The government bond market is sending a warning signal to the European Central Bank about its failure to achieve its inflation target. With investors increasingly worried by the risk that a global trade war will crush economic growth, the Frankfurt-based institution will come under pressure to do more to fulfill its mandate. But it doesn’t have a lot of ammunition.

The yield on 10-year German government bonds has declined to its lowest ever, reaching -0.213% on Friday. That’s almost a basis point below the previous low, reached on July 6, 2016.

The move in German bonds is being exacerbated by investors seeking a haven from declining equity markets, which have been discombobulated by U.S. President Donald Trump’s announcement of new tariffs on Mexican goods as well as the growing tensions with China over Huawei Technologies Co.

But the proximate cause for the decline was a set of inflation figures that showed prices in the euro region’s biggest economy are rising more slowly than before. German inflation slowed to 1.3% in May, down from 2.1% a month earlier, and just below economists’ expectations of 1.4%.

The ECB’s target is for annual inflation in the region to run close to, but below, 2%. Figures on Tuesday are expected to show consumer prices rose by just 1.4% in May, according to the consensus forecast of economists. Core inflation is anticipated to be even weaker, at just 1%. And the outlook, based on the five-year forward inflation swap, is for price gains to remain muted, with the measure averaging its lowest ever so far this year at just below 1.44%.

The euro zone isn’t the only part of the world where inflation expectations are diminishing. Treasury yields are also down, with the U.S. yield curve inverting at several points, boosting speculation that the Federal Reserve will cut borrowing costs this year to counteract a slowdown in growth. Unlike the Fed, the ECB hasn’t been able to start the process of normalizing interest rates, leaving it with little room to maneuver in the event of a worsening downturn.

The focus at Thursday’s ECB meeting will be on the details of its third round of targeted longer-term refinancing operations, a program designed to ensure the region’s banks have enough liquidity to keep lending. But the central bank will also update its economic forecasts.

ECB President Mario Draghi can expect to get grilled at the press conference about what he has left in the toolbox to counter the headwinds assailing the economy. If the bond market doesn’t like what it hears, the benchmark German yield could yet plumb new depths.

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

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