Euro Inflation Risk Premium Ignores Oil, ECB Overshoot: Analysis

Inflation forwards remain depressed, entrapped by structurally low growth in services prices, despite the sharp rebound in oil and debate over whether the European Central Bank would allow inflation to temporarily exceed its target to compensate for the undershooting, Bloomberg strategist Tanvir Sandhu writes.

The forwards have remained largely unresponsive to recent improvement in macroeconomic data and remained relatively stable since March, showing lack of conviction in reflation. Services inflation remains near all-time lows amid substantial slack in labor market, which Draghi cannot ignore.

Front-end inflation swaps, which are more sensitive to oil futures, have repriced higher, largely related to carry effects.

ECB may likely publish minor upward revisions to its CPI projections given the rally in euro denominated Brent and approximately 2 percent fall in euro Trade Weighted Index which may help awaken now complacent inflation expectations.

Euro-dollar decline on hawkish tone of Fed speakers is providing relief to a currently low delta ECB.

However, downside risks remain to ECB’s core inflation trajectory with ongoing slack in the economy weighing on broad price gains.

Amid large output gap and low wage pressure, rally in oil prices may be treated asymmetrically by ECB to allow inflation target overshoot which may flatten the real yield curve. Front-end nominal yields are already facing reduced downside following policy shift away from rate cuts to more QE.

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.