The Spanish Treasury joined the UK, Germany, France and Italy as the fifth European sovereign to issue inflation-linked bonds on 13 May, raising €5bn for 10-year paper that was four times oversubscribed. The next day, disappointing European GDP growth numbers sent peripheral euro-zone bond yields up a dizzying 15-20 basis points.

Demand for Spain’s linkers translated into a real yield of 1.835% and a 1.02% 10-year breakeven rate. Spain is suffering deflation of -0.2%, but Spanish bonds are linked to the euro-zone-wide harmonised index of consumer prices (HICP). Given the HICP is a mere 0.5% today, a projection of 1% over 10 years might not be far wrong – it’s exactly what’s priced into Germany’s 10-year point too, as it happens.

That’s pretty depressing. Based on that pricing, if we assume inflation is back to 2% 10 years from now, we can sketch a scenario in which it reaches 1% in about five years’ time – but it’s difficult to bring that point any nearer. 

It might be tempting to ascribe falling nominal yields in the periphery to the fact that, because a huge chunk of credit risk was removed by Mario Draghi’s “whatever it takes” promise, these bonds are now more sensitive to inflation expectations – and that yields could fall even further if inflation continues to falter. After all, part of the euro-zone’s disinflation problem reflects competitiveness returning to the periphery.

The day after Spain’s linker issue should have killed that temptation. For a year or more, these bonds had indeed been rallying during ‘risk-off’ periods, particularly those associated with the strife in Ukraine. But on 14 May it was as if we’d gone back three years in time. When the risk is specific to euro-zone growth and inflation, peripheral bonds suddenly don’t like it at all – even when the weak numbers come, not from Spain, but from France and the Netherlands.

We can see the same phenomenon in the strengthening of the euro over the past two years. The combination of a stronger currency and falling yields has made peripheral euro-zone bonds attractive. Given the depth of the disinflationary signals coming out of the economy, markets with any faith in the central bank would surely have sent the euro plummeting by now but, instead, it has tested the $1.40 mark, and the seriousness of the ECB’s talk of further easing. Down moves have come in response to specific dovish statements by officials rather than weak data. 

Peripheral yields are now so low that currency effects start to matter to investors: the ECB could talk the euro down too much. The only way out of this bind is full QE, providing a bid for the bonds while the currency falls, allowing export profits and inflation to recover. The fact that markets feel loath to price that in should concern us: how much worse will things have to get before the central bank makes its move? We could be in for another eventful summer as markets keep asking that question.