Inflation Markets Snub Draghi as Euro Gains Blur Target: Analysis

There’s no sign yet the European Central Bank’s latest salvo against disinflation will work, market prices show. Euro-area inflation derivatives have sunk to new lows after President Mario Draghi unveiled last month measures from interest-rate cuts to expanded asset purchases, Bloomberg strategist Tanvir Sandhu writes.

The forward inflation-swap curve shows that the ECB’s target to boost the pace of price increases to near 2 percent isn’t expected to be met even in 20 years. The so-called HICPxT swap rates with one-year tenors beginning in the future flatten from the 10-year starting point onward, at around 1.7 percent.

The derivatives are being weighed down by appreciation in the euro, which temper consumer-price pressures by lowering import costs. With inflation expectations de-anchoring from the ECB target amid large slack in the euro-area economy, a clear pickup in realized inflation is required to lift the forwards.

The euro has gained about 2 percent since the ECB’s March meeting as investors interpreted the statement to signal a shift away from rate cuts, and as the dollar lost ground amid a re-pricing of expected U.S. rate increases further out into the future.

The cost to protect against inflation exceeding the central bank’s goal remains at or near record lows across maturities. The premium on euro-denominated 2 percent 10-year zero-coupon caps has dropped to 89 basis points from as much as 208 basis points on Dec. 1, approaching December 2014 record low of 78 basis points reached amid deflationary fears.


Defying Draghi

Price expectations are abating even after Draghi indicated that a period of inflation overshooting may be necessary, after a protracted period of undershooting, to defend the ECB’s policy symmetry. At today’s meeting, the central bank is likely to re-iterate the “comprehensive package” announced in March.

The spread between the euro-denominated five-year inflation swaps starting in five years and the core HICP rate has narrowed, showing little embedded inflation risk premiums.

Moreover, the money-market rates curve has re-priced following the publication of the ECB’s March accounts and speeches by officials signaling that further rate cuts are still possible. The euro overnight index average, or Eonia, is now pricing in a 74 percent probability of a 10 basis point ECB deposit-rate cut in December, compared with 52 percent immediately after the reserve-maintenance period lapsed.

Draghi will need to ease policy again this year, according to a Bloomberg survey of 47 economists conducted April 8-14.

Diverging from oil, carry

The divergence between inflation forwards and the front Brent crude contract persists ahead of today’s ECB meeting.

A seasonal turn in the forwards to positive carry may now attract tactical investors. That follows poor carry in March for euro linkers accreting a seasonally weak January HICP print.

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.

Before it's here, it's on the Bloomberg Terminal.