When Mario Draghi pledged to hold together the euro area, the endorsement in bond markets was immediate and enduring. Now it’s time to back him again as he vows to rekindle inflation, France’s biggest bank says.
With the European Central Bank president prepared to tackle lackluster price growth, investors should use derivatives to bet he’ll lift inflation expectations from near the lowest level since 2008, according to BNP Paribas SA. An advance would mimic U.S. markets when the Federal Reserve bought bonds under its quantitative-easing plan, the bank’s fixed-income strategists say, a rally that’s starting to fade as those purchases slow.
“If the ECB embarks on QE, and we believe it will, inflation expectations should rise as it shows the central bank is taking steps to raise the growth profile, including inflation,” Laurence Mutkin, global head Group-of-10 rates strategy at BNP Paribas in London, said in a phone interview on April 25. “As the ECB moves closer to QE entry and the Fed moves closer to QE exit, this trade makes sense.”
Draghi has been increasingly explicit about potential ECB policy steps to ward off deflation, saying that broad-based asset purchases are possible should the medium-term outlook for prices worsen. A report today showed euro-area consumer prices rose 0.7 percent this month from a year ago, undershooting economist estimates for a 0.8 percent advance, after a 0.5 percent increase in March. It’s the seventh consecutive month of inflation below 1 percent, compared with the ECB’s goal of just under 2 percent.
U.S. 10-year inflation swaps, derivatives tied to increases in consumer prices, surged more than one percentage point from a record low of about 1.2 percent under the first round of Fed QE that started in November 2008, according to data compiled by Bloomberg. They climbed about 80 basis points around the time of a second round of purchases and 50 basis points at the start of the third. The U.S. rate was at 2.45 percent at 1:07 p.m. London time today.
A similar euro-area measure rose two basis points, or 0.02 percentage point, to 1.66 percent, having fallen as low as 1.62 percent on March 28, the least on a closing-market basis since 2008, when it reached 1.51 percent.
“If it were to be the same kind of character as the rise that we’ve seen with QE in the U.S., then you might expect the break-even rate in the euro area to go back towards its pre-crisis average of 2.25 percent,” said Mutkin. He recommends investors buy the euro-area swaps and sell the U.S.’s.
The prospect of slowing euro-area inflation evolving into the falling prices that caused 15 years of stagnant Japanese growth is stoking concern among officials. International Monetary Fund Managing Director Christine Lagarde earlier this year urged authorities not to unleash the deflation “ogre.”
Although subdued prices for everything from transport and food to clothes can be good news for consumers, disinflation -- or slowing inflation -- makes it harder for borrowers including governments to pay off debts and for businesses to boost profits. Under deflation, or falling prices, households may postpone purchases and companies may delay investment and hiring as demand for their products dries up.
Inflation in the euro region dropped below Japan’s in October for the first time in about 15 years, and has stayed lower since. Today’s below-forecast number risks undermining the ECB’s view that consumer-price growth should rebound as temporary distortions pass and the economy recovers.
The ECB stands ready to embark on QE if needed, Draghi said two days ago at a gathering attended by lawmakers from parties that form Germany’s coalition government, according to a euro-area official. The move isn’t imminent and it’s relatively unlikely for now, the central bank president said, according to the official, who asked not to be identified because the meeting was private.
Draghi earned investors’ respect as he tamed bond markets with his response to Europe’s sovereign debt crisis. Spanish sovereign securities began a rally in July 2012 that’s pulled yields down to record lows this year from the highest in the euro’s history. The trigger was Draghi’s pledge to do whatever it took to preserve the currency bloc with the words “believe me, it will be enough.”
The ECB will probably take action within two months against the threat of falling prices, according to economists surveyed by Bloomberg earlier in April. Twenty-two percent of respondents expected the central bank to extend its long-term loans, 16 percent saw policy makers cutting the benchmark interest rate. Those who predicted the ECB would start buying assets also accounted for 16 percent.
“The trend doesn’t look good,” said Luca Jellinek, head of European interest rates strategy at Credit Agricole SA’s corporate and investment banking unit in London. “We expect the ECB to elevate its QE rhetoric and probably cut rates in June. The outlook for inflation will improve if they embark on policy measures that would lead to credit creation.”
While there are signs that the euro-area economy is recovering from a prolonged slump that followed the global financial crisis, consumer-price pressures have still weakened. Euro-area services and manufacturing expanded at the fastest pace in almost three years in April, according to data from London-based Markit Economics on April 23.
In Germany, a gauge of inflation expectations in the five years starting 2019, known as five-year, five-year forward break-even rate, dropped to 1.95 percent last week, the lowest level in almost two years. It widened five basis points today to 2.04 percent.
Inflation expectations in the region should gradually improve with the economy, according to JPMorgan Chase & Co.
“While we are not at the point where we would go long on euro-zone break-even rates, we don’t think there is enough reason to go short either,” said Francis Diamond, a fixed-income strategist at JPMorgan in London, referring to bets the rates would rise or fall. “The economy will recover gradually. This would imply a modest increase in inflation over the long run.”
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