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'The forces of monetary deflation are gathering. Global liquidity is declining and central banks are not doing enough, either in the West or the East to offset the decline,' warns CrossBorderCapital

'The forces of monetary deflation are gathering,' says CrossBorderCapital Photo: Getty Images

Eurozone fears have returned with a vengeance as deepening deflation across Southern Europe and fresh turmoil in Greece set off wild moves on the European bond markets.

Yields on 10-year German Bund plummeted to an all-time low on 0.72pc on flight to safety, touching levels never seen before in any major European country in recorded history. “This is not going to stop until the European Central Bank steps up to the plate. If it does not act in the next few days, this could snowball,” said Andrew Roberts, credit chief at RBS.

Austria’s ECB governor, Ewald Nowotny, played down prospects for quantitative easing, warning that the markets had “exaggerated ideas about purchase volumes” and that no asset-backed securities (ABS) would be bought before December.

Calls for action came as James Bullard, the once hawkish head of St Louis Federal Reserve, said the Fed may have to back-track on bond tapering in the US, hinting at yet further QE to fight deflationary pressures and shore up defences against a eurozone relapse.

“The forces of monetary deflation are gathering,” said CrossBorderCapital. “Global liquidity is declining and central banks are not doing enough, either in the West or the East to offset the decline. This may not be a repeat of 2007/2008, but it is starting to look more and more like another 1997/1998 episode." This is a reference to the East Asia crisis and Russian default triggered by withdrawal of dollar liquidity. 

Ominously, French, Italian, Spanish, Irish, and Portuguese yields diverged sharply from German yields in early trading today, spiking suddenly in a sign that investors are again questioning the solidity of monetary union. The risk spread between Bunds and Italian 10-year yields briefly jumped 38 basis points. This was the biggest one-day move since the last spasm of the debt crisis in 2012.

This sort of price action suggests that the markets fear deflation is becoming serious enough to threaten the debt dynamics of weaker EMU states. The yields are not just discounting a protracted slump, they are also starting to price default risk yet again, or even EMU break-up risk. This is a new development that may some heartburn in Frankfurt.

The markets were further rattled by an IMF warning that just 30pc of eurozone banks are in a fit state to rebuild capital and boost lending, a hint that the ECB’s stress tests could contain some nasty surprises for lenders when results are released this month. The IMF says 80pc of US banks are healthy.

Greece’s yields have soared 300 basis points to 8.73pc over the last month as markets react badly to populist plans by premier Antonis Samaras to break free of the EU-IMF Troika and return to the markets for debt finance.

This is compounded by fears that political deadlock will force a general election in February, opening the door for the Syriza party’s firebrand leader Alexis Tsipras. The latest polls put Syriza six points ahead of the government. The party has vowed to tear up Greece Troika "Memorandum", deeming the terms to be debt servitude.

One banker with Greek ties said the local sell-off is entirely political. “The Athens stock market has tanked 24pc and residual Greek bonds have lost almost half their value. That is the clearing price for a Tsipras government. But at the end of the day the EU has too much at stake in Greece to let it fail,” he said.

Professor Richard Werner from Southampton University said talk of recovery in the eurozone over recent month has been wishful thinking. “There has been a huge contraction in bank credit in southern Europe, and that means their economies are slowly imploding.”

The stress in the bond markets came as data from Eurostat showed that Italy, Spain, Greece, Slovenia, and Slovakia were all in deflation in September, as were Poland, Hungary, and Bulgaria outside the eurozone. Italy’s inflation rate has collapsed to an annualized rate of minus 5pc over the last six months, once tax distortions are stripped out. Marchel Alexandrovich from Jefferies said core inflation for the eurozone as a whole has dropped to 0.53pc when adjusted for taxes, and just 0.2pc for France.

The so-called "5Y/5Y" swap rate watched closely by markets as a deflation barometer crashed to a new low of 1.68pc in intra-day trading, ever further below the 2pc line etched in the sand by the ECB. “There seems to be a total capitulation in inflation expectations,” said Mr Alexandrovich.

The proportion of goods in the eurozone’s price basket in deflation jumped to 31pc in September from a month earlier, according to Jefferies data. The figure was 32pc in France, 45pc in Holland, 47pc in Portugal, 52pc in Spain, 57pc in Slovenia, and 76pc in Greece. Japan’s experience in the late 1990s suggests that the danger line is around 60pc.

The ECB aims to “stir” its balance sheet by €1 trillion or so over the next two years. Yet the balance has in fact contracted by €21bn over the last two weeks as “passive tightening” continues, and has dropped by roughly €85bn since the bank’s spending plans were unveiled in June.

Anna Grimaldi from Intesa SanPaolo sadi the ECB will not be able to buy more than €7bn-€11bn a month of covered bonds and ABS. This is a tiny fraction of QE volumes in the US, the UK, or Japan. “We expect total purchases to amount to just under €400bn,” she said.

The ECB is relying on a weaker euro as its main defence against deflation but Japan’s travails shows that this is a risky strategy without powerful action to back it up. Stephen Jen from SLJ Macro Partners said it will take very large outflows of capital to offset the eurozone’s current account surplus of €230bn, and then to push the exchange rate down to €1.20 against the dollar, the minimum level needed to kick start a recovery. “If the ECB’s actions are too weak, the euro could perversely appreciate, just as the yen did from 1990 to 2012,” he said.

Prof Werner, who first coined the term QE as an adviser to Japan in the 1990s, said the ECB is making the same mistakes as the Bank of Japan at the onset of deflation. “They are following BoJ script to the letter, even repeating the same demands for structural reform. But the crisis is caused by lack of demand not lack supply. Their arguments are completely false,” he said.

Richard Koo from Nomura, a specialist on Japan’s deflation, said the ECB’s cheap lending facilities for banks (TLTROs) cannot work at a time when companies and households are trying to pay down debt. “TLTROs are useless in a world of no borrowers,” he said.

The error has been compounded by demands for fiscal austerity, a destructive policy in a deflationary crisis. “The ECB is at least partly responsible for the eurozone slump, giving a helpful push to the countries of the eurozone as they dropped off the fiscal cliff. If a government stops borrowing and begins saving despite zero interest rates at a time when the private sector has done the same, the economy will fall into a deflationary spiral,” he said.