Europe Inflation Markets Show Oil Slide Trumps QE Pay Off: Analysis

Crude is causing Mario Draghi a headache. Pricing of pick up in euro-area inflation is now more adverse than it was when quantitative easing began in March, zero coupon swaps, options and forwards show, Bloomberg strategist Tanvir Sandhu writes.

Before European Central Bank’s meeting last month, inflation swaps were holding up on nascent signs of economic growth, helped by a favorable base effect, although oil prices headed further south. Since then, inflation outlook has worsened as oil and commodity prices tumble amid a global disinflationary backdrop stemming from heightening of China woes.

Correlation between inflation expectations and oil has become positive once again.

Ahead of the last ECB meeting, investors were clamoring for more easing but his action (cutting deposit rate by 10 basis points and leaving QE untouched) disappointed. Eonia is currently pricing a rate cut in June, assuming 10 basis points cut and 7 basis points Eonia-depo corridor while 3-month Euribor has fallen to -0.14 percent.

Decline in headline inflation since May was mostly a function of declines in the energy component index whereas core inflation has been broadly stable. But core inflation could be pressured if the currency doesn’t continue its weakening journey that started in the middle of 2014. It has retraced slightly since the December policy meeting, with EUR trade-weighted index increasing about 1.3 percent.

The improved core inflation from weaker currency is transitory and fades over time, all else being equal.

Forward inflation swap rates shows investors believe low inflation is here to stay for a prolonged period. EUR 10-year zero coupon harmonized index of consumer prices, excluding tobacco, swap is at 1.14 percent vs 1.46 percent on the eve of last policy meeting. 5y5y inflation forward swap is at 1.58 percent, declining from 1.83 percent on Dec. 2.

The cost of insurance to protect against inflation going above ECB’s 2 percent target has dropped to the lowest since October 2015 and is still way below historic levels.

Euro 2.5 percent 10-year zero coupon cap has dropped to 65 basis point vs 113 basis point on December 2. It reached 27 basis point on December 17, 2014 amid deflationary fears.

Hedge funds and corporate accounts use such option instruments in structured products to protect against inflation.

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.

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