Inflation Below Japan’s Hints at More Draghi Action: Euro Credit

For the first time since the euro was introduced almost 15 years ago, the region’s inflation rate is dropping below Japan’s, and derivatives traders are betting the most since 2008 it’s going to stay that way.

Expectations for euro-area consumer-price increases in the next two years, as implied by inflation swaps, fell to a 16-month low of 1.09 percent on Nov. 4. That followed a drop in the inflation rate to 0.7 percent in October, less than half the central bank’s target level of just under 2 percent. In Japan, where officials have tried to prevent deflation for the past 15 years, the equivalent gauge of price growth was 1.1 percent in September, and the two-year swap rate is at 1.72 percent.

It’s taken a pledge by the Bank of Japan to buy more than 7 trillion yen ($70 billion) of government bonds each month to revive inflation expectations in that nation. While the European Central Bank, led by President Mario Draghi, unexpectedly cut its benchmark interest rate by a quarter-point to a record low 0.25 percent on Nov. 7, it too may require asset purchases to avoid the region slipping into deflation, according to Societe Generale SA global strategist Kit Juckes.

“The risk of the current low inflation turning into something worse should not be ruled out,” London-based Juckes said in a phone interview on Nov. 11. “The ECB should do much more. Quantitative easing would be high on my wish list.”

Inflation Gap

The gap between two-year inflation swap rates for the 17-nation euro area and Japan was 61 basis points, or 0.61 percentage point, at 1:06 p.m. London time, after reaching 63 basis points on Nov. 4, the most since Bloomberg began collecting the data in 2008. The consumer price index was at 1.1 percent in the euro area in September, matching Japan’s for the first time since the single currency’s introduction in 1999.

The euro region faces the prospect of a “prolonged” period of low inflation, Draghi said last week after the ECB cut its main refinancing rate to 0.25 percent from 0.5 percent.

Prices of two-year derivatives protecting against deflation in the euro area rose yesterday to the highest since June.

“We should be prepared for more of the same as there is still an easing bias in the guidance,” said Richard Barwell, a senior economist at Royal Bank of Scotland Group Plc in London. Slower inflation in the region’s most indebted nations “leaves little room for the necessary improvement in competitiveness through falling unit labor costs,” he said.

Losing Momentum

While inflation is slowing, unemployment has risen to the highest level since the currency bloc was formed. Data this week may add to evidence the region’s nascent recovery is losing momentum.

Euro-area gross domestic product rose 0.1 percent in the third quarter, according to the median forecast of 41 economists in a Bloomberg News survey. The report will be published tomorrow. Analysts also predict data releases to show growth slowing in Germany and stalling in France, with Italy remaining mired in an unprecedented slump.

Such an outcome would confirm that the recovery is slowing to a crawl after a second-quarter growth spurt of 0.3 percent that ended the region’s record-long recession. The European Commission last week cut its forecast for euro-zone growth in 2014, anticipating a 1.1 percent expansion instead of the 1.2 percent forecast in May. Officials see unemployment averaging 12.2 percent next year, higher than the 12.1 percent they predicted six months ago.

Turning Japanese

A report today showed consumer prices in Spain dropped 0.1 percent in October from a year ago, according to the National Statistics Institute in Madrid. A separate gauge, using a harmonized European Union method, showed prices stagnated.

German index-linked bonds lost 3.4 percent this year through yesterday, putting them on course for their worst annual performance since the country issued inflation-protected securities in 2006 for the first time, according to a Bank of America Merrill Lynch index. Japan, which resumed issuing the securities in October after a hiatus of five years, has provided a 3.6 percent return on its inflation bonds.

Since last month’s inflation data, “some people were looking to see how they could best express their view that the same thing that happened in Japan will happen here in Europe,” said Kari Hallgrimsson, head of European inflation trading at JPMorgan Chase & Co. in London. “But those are short-term investors. Real money or long-term investors are still hedging against long-term inflation.”

Disinflationary Pressure

While two-year inflation expectations in Europe have declined, the longer-term outlook remains steady, according to data compiled by Bloomberg. A gauge of bets on price increases in the five years starting from 2018 was at 2.24 percent today, compared with the average of 2.32 percent in the past 12 months.

Consumer-price growth in the euro area will be steady at 1.5 percent next year while Japan’s will accelerate to 2.4 percent, from 0.3 percent this year, according to economist estimates compiled by Bloomberg.

Adding to disinflationary pressure is the strength of the euro, which has gained 6.3 percent this year, making it the best performer against its developed-market peers, Bloomberg Correlation-Weighted Indexes showed. The yen tumbled 10 percent.

The ECB now has just one more quarter-point cut left before reaching zero, increasing the likelihood of unconventional tools such as additional longer-term refinancing operations and a negative deposit rate if prices slow further or the economic recovery stalls, said Societe Generale’s Juckes.

“There is a lot of opposition to running any risk of inflation in Europe, as there always has been,” he said. “But when I look at the economy with falling bank lending, falling inflation and a strong currency, I can’t get away from a view that policy makers should do everything they can with the monetary policy.”

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