Euro-area bond yields have soared in recent weeks, with the German 10-year yield rising by 100 basis points from a low of 0.05% in the middle of April to over 1.0% at one point this week. This huge adjustment takes yields back to September 2014 levels (Display 1), long before the European Central Bank (ECB) launched its quantitative easing (QE) program. It’s also the biggest increase in bund yields over an eight-week period since the reunification boom in the early 1990s.

ECB unruffled

Perhaps surprisingly, the ECB has not been unduly ruffled by these developments. There are several reasons for this, in our view.

First, the ECB probably regards much of the recent sell-off as a correction from unsustainable levels—the result of what president Mario Draghi recently called “one directional investments”. In this respect, it’s worth noting that, before their recent rise, German yields had fallen to levels never seen at any stage in Japan over the past 20 years—despite the latter experiencing persistent deflation and negative nominal GDP growth, neither of which are present in the euro area.

Second, as noted by several ECB Council members, higher bond yields may reflect improved prospects for economic growth and inflation in the euro area—in other words, rising yields may be a sign that the ECB’s policies are working.

Third, unlike in other countries, QE in the euro area is not primarily about reducing long-term bond yields (which were already at record lows long before the launch of the program). Rather, it’s about underpinning inflation expectations and underscoring the ECB’s commitment to do “whatever it takes” to prevent the euro area slipping into deflation. If the ECB is successful, bund yields ought to rise—especially given their low starting point.

Inflation expectations start to rise

So is this what’s happened recently? We think the answer is a qualified yes. When the ECB laid the groundwork for QE last year, it attached considerable importance to declining market-based measures of medium-term inflation expectations. As Display 2 shows, these measures have started to rise again—though not back to levels consistent with the ECB’s definition of price stability, nor by as much as the rise in bond yields (a point we’ll return to).

And deflation risks start to recede

In addition, our own analysis suggests that deflation risk is starting to recede in the euro area. We can illustrate this using our deflation risk indicator (DRI)*, which peaked in the third quarter of last year but has since fallen back (Display 3).

It’s important to note that the DRI is a broad-based guide to deflation risk and that the recent improvement is not related to higher consumer price inflation (which is still lower than in the third quarter of last year). Rather, the improvement has been driven by the DRI components that are most sensitive to monetary policy: asset prices, the exchange rate, money-supply growth and the size of the ECB’s balance sheet.

Tighter financial conditions

But while rising inflation expectations and diminishing deflation risk may explain part of the recent surge in bond yields, a note of caution is necessary. As noted earlier, the increase in inflation expectations has not kept pace with the rise in bond yields, especially in more recent weeks. And this has led to higher real yields (Display 4) and de facto tightening of financial conditions.

Like the ECB, we are not yet too worried about the recent rise in bond yields. But one of the key factors underpinning our positive view on the euro-area outlook is the improvement in monetary conditions that has taken place over the last year. A premature tightening of financial conditions is not part of the script and needs to be closely monitored. Despite its calm reaction to recent market developments, the ECB is likely to have similar concerns. Its tolerance for yet higher bond yields is therefore likely to be limited, in our view.*

*The deflation risk indicator includes the following variables: three measures of inflation, the level and change in the output gap, economic growth relative to previous trend, the level and change in asset prices (equities and housing), change in the nominal exchange rate, level of the real exchange rate, bank-lending growth, money-supply growth, real interest rates and the size of the central bank’s balance sheet. See Deflation in the Euro Area: Are We There Yet? November 20, 2014 for further details.

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