The European Central Bank faces a bond market bubble followed by a crash

One of the themes of this blog is that the European Central Bank (ECB) is indulging in pro-cyclical policy rather than taking away the punchbowl when the party gets going. The dithering it displayed when the Euro area economy weakened meant that by the time it announced its 1.1 trillion Euro programme of asset purchases known as QE there were signs of a turn for the better anyway! Not only was the ECB claiming that its previous policies were working but the oil price more than halved and the price of other commodities fell too. Accordingly it has added a turbo-charger to the engine of the monetary boost it was already providing in a clear policy error.

Perhaps in a year or two’s time it will copy the words of US Federal Reserve Chair Janet Yellen who told us this yesterday.

Equity market valuations at this point are quite high. Now they’re not so high when you compare the returns on equities to the returns on safe assets like bonds which are also very low, but there are potential dangers there,

So the woman who has helped drive the balance sheet of the US Federal Reserve to over US $4 trillion and thereby pushed up all sorts of asset prices thinks they are now too high if we translate the central banker speech. No sign of a mea culpa there! Even worse she thinks that share prices are maybe okay because the prices of bonds which she has also driven higher are indeed high. Life as a central planner does not seem to involved having any awareness of the consequences of your own actions. I expect the ECB to exhibit this too as the consequences of its policies emerge in the coming months and years.

The Good News

This is that the Euro area has returned to growth as signaled by yesterday’s Markit Purchasing Managers Indices.

Eurozone growth continues as output rises across big-four nations…….April saw the rate of expansion in eurozone economic output hold broadly steady at March’s 11- month high.

This led to a forecast of solid if not spectacular economic growth in the first half of 2015.

The survey is signalling a rate of economic growth of approximately 0.4% at the start of the second quarter, similar to that indicated by the PMI in the first quarter.

Even Italy is now claimed to be expanding and Spain is at a 101 month high according to this measure. Although those with memories of the pre credit crunch era may experience some deja vu from the statements below.

Companies in Spain are seeing the largest inflows of new work for 15 years, while Ireland is enjoying one of its longest growth spells since the dot-com boom.

So whilst France is relatively stagnant and Greece is showing signs of getting even worse the ECB may think that things have finally got better and that some of the pressure placed upon it has eased.

Forecasting Problems

Regular readers will have followed my updates on the various Bank of England forecasting errors and its efforts to be the worst forecasting organisation in the world! Well the ECB has made its own effort in this regard in recent times as illustrated by this from June last year.

Headline inflation is expected to increase from 0.7% in the first quarter of 2014

Instead it dropped to negative territory and is now as shown below.

Euro area annual inflation is expected to be 0.0% in April 2015, up from -0.1% in March

Now it was never likely to be on the ball concerning the oil price drop but having mistimed matters it now finds itself trying to push inflation higher just as the oil price is rebounding! From the low of January 13th the Brent Crude Oil benchmark is up 50% to US $68 per barrel. There is a deeper issue which is why the ECB treated zero inflation as so bad as after all one of the causes of the recovery is an increase in real wages caused by the drop in price of quite a few essential goods.


There was a spell where the impact of the ECB’s bond buying was that Euro area bond markets surged and yields plummeted. There was a clear moral hazard in countries at risk of default such as Italy and particularly Portugal as the central planners chose to misprice the risk. By the way is market-rigging not supposed to be a crime?

Along this road we saw many short-dated yields go negative especially in Germany and even the ten-year yield fell below 0.1% to 0.07%. An opportunity for Germany to borrow and invest?I will leave that there as an open question which is rarely discussed, and describe the next stage of events with a children’s nursery rhyme.

Oh, The grand old Duke of York,
He had ten thousand men;
He marched them up to the top of the hill,
And he marched them down again.

And when they were up, they were up,
And when they were down, they were down,
And when they were only half-way up,
They were neither up nor down.

We can now conclude that the impact of the ECB QE programme is to create extraordinary bond volatility. The German ten-year bond or bund then fell heavily in price terms such that it now yields 0.77% or back to where it was in early December 2014. As it is the leader of the pack the other Euro area bond markets fell too in sympathy with Portugal seeing its ten-year yield surging from 1.6% to over 3%!

All of the price plunge and yield rise has taken place since the 20th of April amidst complaints that there is no liquidity and the market is broken. Well if you will rig it! But there are all sorts of consequences from such wild swings as we know that those who make profits disappear into the ether but losses seem to invariably end up with the taxpayer.

Anyway how does increasing uncertainty and destroying liquidity in bond markets help the underlying economy? It does fulfill though some of the criteria of being in a bubble.

Still there is an upside which is that the ECB can now buy these bonds at a much lower price albeit shame about the 95 billion Euros bought so far.

UK Election Day

There have been some consequences across the channel in the UK from this. As   pointed out.

UK 10yr Bond yield jumps to highest level in 2015 on election day. Gilts have underperformed US treasuries this year.


The ten-year Gilt yield has pushed above 2% but before Telegraph leader writers get into a panic that they have missed an “election crisis” headline I replied with this.

Also the lowest Gilt yield on in the modern era!
It was probably lower in the 1800s (h/t Moyeen Islam)

The Euro exchange-rate

This has reversed course somewhat in recent times as it has risen to above 1.13 versus the US Dollar and pushed the UK Pound back down to 1.34. So the ECB finds that even deploying pretty much every weapon it has may no longer be working in the currency wars game. Still the Nordic nations and Switzerland will be relieved for now anyway.


There are all sorts of themes at play today. But let us start with the central one of mistimed QE. The central planning effort has  found itself undermined by the rising oil price and the implications it has for future inflation. Thus the central planners find that the markets have treated even what are enormous sums like a mere bagatelle as we wonder if the bond vigilantes have returned? We have discussed in the past how interest-rates have been cut into a “liquidity-trap” well now the central planners at the ECB have managed to plunge bond markets into one as well. Future expectations of a tapering of the effort collide with higher yields which make it more likely to continue. Time for Ms Taylor Swift.

I knew you were trouble when you walked in
So shame on me now
Flew me to places I’d never been
Now I’m lying on the cold hard ground
Oh, oh, trouble, trouble, trouble
Oh, oh, trouble, trouble, trouble

Meanwhile outside the world of official statistics we see signs that even in Spain things may not be going as well as sometimes claimed. From Bloomberg talking to Guillermo Romero.

“I began looking for work at 20, I’m 27 and nothing has changed,” he said outside the unemployment office in the working-class district of Prosperidad in Madrid. “It’s pointless looking for work here. Most jobs pay no money or have nothing to do with your field.”


11 thoughts on “The European Central Bank faces a bond market bubble followed by a crash

  1. Hi Shaun

    How the Eurocracy can crow about growth when we have sky high unemployment rates in many countries (and youth unemployment rates much higher) beats me. Frankly I think it is outrageous.

    They are whistling in the wind and many must know this but they cannot reverse course without bringing the whole house of cards down, which I think is likely anyway at some point.

    With regard to Bondpocalypse I can easily see a scenario where, if this is extended and gets combined with a post election run on the pound, the hand of the BOE may be forced, in which case Mr Carney’s forward guidance is headed for the sewage farm – and so are we!

    • Hi Bob J

      What has intrigued my in the run-up to the election in the UK is how rarely it has been perceived to affect anything financial or economic. Some of the recent business surveys and construction in particular raised it but that is it. The financial markets have cruised on and ignored it. Of course tomorrow we will be a little clearer but there may yet be plenty of horse-trading. Will they continue to yawn? If so it is rather dismissive of our political class.

      The Labour market situation you highlight was illustrated by Eurostat today with this.

      “Employment rate of people aged 20 to 64 in the EU up to 69.2% in 2014”

      But at the bottom of the list we find a familiar crew Greece 53.3%,Italy and Spain at 59.9% with only Croatia for company in the 50s…

  2. Morning Shaun, The only thing that could have quickly helped the Euro zone is the fall in the value of the Euro but of course what is totally predictable is that as soon as there is talk of any improvement in the Euro zone, up goes the value of the Euro! I have never understood why traders are so in love with the Euro they will trade it up on the flimsiest of reasons. As for Spain I do wonder just how good this turn around is and how reliable the figures are. It gives the appearance on the ground of an economy that is definitely not getting worse and maybe a slight improvement but I do not see the economic miracle that Rajoy portrays. It is however an election year in Spain!

    • Hi Pavlaki and hi Shaun,

      It is however an election year in Spain!

      Appearances can be deceptive, as can politicians seeking election.

  3. HI Shaun,

    Aren’t 10 year gilts used as a proxy for mortgages? can we expect the rock bottom mortgages to start disappearing?

    • Hi anteos

      It is more the 5 year Gilt and interest-rate swaps in that region which are used. But it does not make an enormous difference as that yield has been rising too and is now 1.45% compared to the recent low of 0.87% at the end of January. So we should see the cheap fixed-rate mortgage offers go once they are used up and be replaced by higher rates.

      Mind you bond markets were so volatile today it must be hard for any organisation to plan.

  4. In electronic control systems you use negative feedback to correct any errors to keep the system self-correcting and stable. An important part for stability is lag. If this lag is too long you can end up with the reserve, a positive feed back system, that runs away from itself. An simple example is a sine wave error, that due to lag ends up 180 degrees out from what is intended.

    The ECB seems to be in a similar situation, that due to political lag, they raise interest rates at the height of a recession / depression and then are now belatedly introduce QE as economies are beginning to grow again! This does not bode well for a stable currency or Euro economic area!

    With UK bond yields growing, are the financial markets, playing it safe, betting on a hung parliament and political instability or a Labour/Lib Dem/SNP coalition with higher spending, deficits and Sovereign debts?

    • Markets are supposed to offer valuable information – on an item’s price. In theory a market can gently signal problems leading to correcting incentives. Rigging the market destroys it’s ability to give early warnings and gently correct an imbalance. Which increases the risk of economically harmful violent corrections.

  5. Hello Shaun,

    perhaps the CB are all heading towards this solution

    The Wörgl Experiment: Austria

    I rather doubt it , after you read the story perhaps your readers will see that instead of working for the people the CB are actually working to preserve their power ….

    Roll on Iceland !

    and somebody tell the Greeks !


    • Hi Forbin

      In many ways I prefer the view that they should get drunk, after all it all turned out well for Churchill’s reign as PM.

      As to the reference to the Hitch Hikers Guide to the Galaxy I do like the idea of the computer being destroyed five minutes before it gives the answer! “Bye and thanks for all the fish” was a work of genius 🙂

      Now we await the election result and to see if today’s whipsaw ride in bond markets took out any hedge funds. If they open a bank branch ala Goldman Sachs then the central banks will of course bail them out.

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