Photographer: Daniel Acker/Bloomberg

Mind the Gap: Widening HICP-Core Euro-Area Inflation May Prove Deflationary

Front-end breakevens remain supported by higher headline HICP.

Euro-area breakeven rate curves may have room to flatten further, with higher energy prices supporting the front end while the rally at the long-end, which was driven by bets U.S. President-elect Donald Trump’s policies will fuel inflation, now looks stretched, Bloomberg strategist Tanvir Sandhu writes.

A weakening euro also supports front-end breakevens, with headline harmonized consumer prices expected to rise over the quarter. The widening gap between headline and core inflation rates may ultimately prove disinflationary given the real-income squeeze, lack of any structural change and risks stemming from yuan depreciation.

The rally in euro-area long-end inflation markets, fueled by expectations about potential U.S. reflation, may have run its course. The elevated levels may entice long-end issuance from core euro-area countries that may cap the widening, causing the curve to bull flatten.

Any further widening of the spread between headline and core realized inflation rates in this quarter may ultimately weigh on inflation forwards given the entrenched low price pressures. Skepticism about the European Central Bank meeting its inflation target may grow in 2017, with the limitations of the central bank’s monetary stimulus exposed as President Mario Draghi remains hostage to legal, fiscal and global factors.

Note: France’s inflation front end has been boosted by increased odds of Francois Fillon becoming next president who proposes to raise VAT rates by 2 percent which may induce near-term inflationary pass-through.

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

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