Europe's Price for Deflation Protection Drops to 17-Month Low

  • Traders pay least since Dec. '14 to protect against price drop
  • ECB's Draghi sees rebound of negative CPI in second-half 2016

Signs that bond traders are becoming more confident that the European Central Bank’s unprecedented stimulus will boost inflation are gathering as derivatives which protect against deflation dropped to a 17-month low.

Even after euro-area price growth declined last month more than economists forecast, traders are betting on a rebound. Investors are now paying the least since December 2014 to protect against deflation over 10 years. This has been helped by Brent crude oil futures climbing to the highest level in almost six months last week. Speaking after officials maintained stimulus measures at last month’s policy meeting, ECB President Mario Draghi said he expected inflation to accelerate in the second half of 2016.

The ECB’s goal for price growth is just below 2 percent and policy makers have cut interest rates and expanded the asset-purchase program in an effort to revive economic growth and avert deflation. While market indicators rise, Draghi will have to keep options for more stimulus open to ensure expectations stay anchored, according to Hendrik Lodde, a fixed-income strategist at DZ Bank AG.

“We expect slowly rising inflation rates in the second part of 2016,” Frankfurt-based Lodde said. “The base effect of the oil price reduction will start to end in September. The market is not pricing in a rapid return of inflation to the ECB’s target rate. The central bank will probably try to pull out all the verbal stops in the coming weeks to raise inflation expectations.”

The cost of a derivative that pays out should the price of a basket of goods cost less in a decade than it does today has fallen to 27 basis points, according to data compiled by Bloomberg. That would be the lowest closing price since Dec. 3, 2014.

Other indicators on the outlook for inflation have also increased. The five-year, five-year forward inflation-swap rate climbed to a seven-week high of 1.47 percent Monday. Germany’s 10-year break-even rate, calculated from the yield difference between bunds and index-linked debt was little changed at 1.09 percent, matching the highest closing level since Dec. 10.

Benchmark German 10-year bunds yielded 0.27 percent as of 4:55 p.m. London time. Euro-area sovereign bonds handed investors a 1.1 percent loss in April, their biggest monthly decline since August, according to Bloomberg World Bond Indexes, even as the ECB increased its asset-purchase program to 80 billion euros a month.

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