Global Daily – Euro inflation slips + Blockbuster demand for EU bonds

Co-author: Floortje Merten

To begin with, in Spain both the headline inflation rate and the core rate stabilised in June, at 2.4% and 0.2%, respectively. Meanwhile, Germany reported a decline in HICP inflation to 2.1%, down from 2.4% in May. The detailed reports from the main German regions suggest that the decline was mainly due to a drop in services price inflation. Indeed, services inflation had shot higher in May due to a jump in the inflation rate of package holidays and other services due to the unwinding of restrictions in this part of the economy. A number of states reported that the inflation rate of leisure and entertainment had jumped from around 1% in April to above 3% in May and returned back to around 1% in June. Moreover, most states reported a decline in energy price inflation. In contrast, goods price inflation increased in June, particularly the inflation rate of clothing and shoes (to around to 3% in a number of regions, up from around zero in May), which probably is impacted by shifts in discount sales and the unwinding of lockdown measures. Looking forward, Germany’s inflation rate is expected jump higher in July due to the upward base effect stemming from the temporary cut in the VAT rate from July to December 2020. This will raise Germany’s inflation rate throughout the rest of this year. Considering the weight of Germany in the overall eurozone inflation rate this will also have an upward impact on eurozone core inflation.

Eurostat will publish the first estimate for eurozone inflation on 30 June. Based on the information from Germany and Spain it is likely that headline inflation declined, and returned to levels below 2% again in June. We expect a decline to 1.8% (a bit below the consensus forecast of 1.9%). We forecast eurozone core inflation to decline to 0.9%, down from 1.0% in May, which is in line with the consensus forecast. Looking further ahead, we expect inflation to remain close to current levels during the rest of the year. Core inflation will probably be lifted by base effects (e.g. Germany’s VAT cut in 2020) and a temporary rise in goods price inflation due to the impact of  supply and demand shocks in global industrial goods markets. Meanwhile energy price inflation should gradually decline during the rest of this year. More fundamentally, underlying inflation will remain subdued as a considerable amount of slack has built up in the eurozone economy during the pandemic. Therefore, inflation is expected to decline next year. All in all, we expect core inflation to remain well below the ECB target during the next 2-3 years. (Aline Schuiling)

Euro Rates: Second round of NextGenerationEU bond issuance meets smashing investor demand – To finance part of the EU Recovery Fund, the European Commission hit the market this morning with a dual-tranche transaction, issuing 5y and 30y NGEU bonds. Whereas the bonds were issued at MS -11bp and MS +22bp, respectively, we saw fair value at around MS -12bp and MS +18bp. Consequently, we judge that the 5y bond offered around 1bp new issue concession, while this was around 4bp for the 30y bond.

Demand for NGEU bonds was significant, even without the EC paying much new issue concession. Books for the 5y and 30y tranche were in excess of EUR 70bn and EUR 60bn, respectively, while the EC set the deal sizes at EUR 9bn and EUR 6bn. Indeed, with bid-to-cover ratios at 7.8 and 10, demand for EU bonds remains very strong, even more so considering that the 5y bond was issued at a relatively tight level. In contrast, the new issue concession on the debut 10y NGEU bond, which was launched two weeks ago, was around 4bp (similar to today’s 30y NGEU bond). This bond had a size of EUR 20bn, while books were 7.1 times covered.

EC has now already issued almost half of its long-term funding need for 2021 – The EC has so far issued almost half of its long-term NGEU funding need for this year. Today’s dual tranche brought issuance to EUR 35bn under NGEU, whereas its capital market funding need for 2021 has been set at EUR 80bn. With one more syndicated transaction planned for July, we expect the EC to have completed 55% to 60% of its capital market funding need for 2021 before the summer break. Clearly, the EC is taking advantage of the current excellent market conditions to get financing of the Recovery Fund up to speed. More issuance will follow from September onwards, when the EC will complement syndicated transactions by issuances via its auction platform. Furthermore, the first EU green bonds are expected to be issued from September onwards as well.

We expect demand for NGEU bonds to remain robust – The high bid-to-cover ratios highlight that many investors did not get their orders filled, if they even got any allocation at all. Consequently, much unserved demand for EU bonds remains. What is more, we expect the Eurosystem to purchase around 50% of EU supply, which is also supportive for demand. Overall, we judge that highly rated and highly liquid paper is scarce. Markets for other triple-A rated paper have been shrinking (e.g. the covered bond market), while the rise in EU bond issuance has improved its liquidity, increasing the attractiveness of EU bonds. (Floortje Merten)