ECB Official Warns Markets Are Unprepared for Inflation Bogeyman

Updated on
  • ECB official cites challenge of low inflation-risk premiums
  • Reversal in stability of prices seen as threat to global rally

The global market rally is unprepared for one potential killjoy, and the European Central Bank has taken note.

Clouds settled over the euphoria this week as 10-year Treasury yields jumped to their highest levels since 2014. That may prove a tame preview of any disruption spurred by a shock uptick in consumer prices that sends bond yields and market premiums roaring. 

A top European monetary policy maker alluded to this risk as investors signal unabashed confidence that the era of low and stable inflation will endure over the long haul.

“From a financial stability perspective, a low inflation risk premium may be a matter of concern if it indicates complacency about future adjustments,” ECB Executive Board member Benoit Coeure said in a speech in Dublin on Wednesday.

While neither Coeure nor the ECB are projecting a sharp pickup in inflation this year, he expressed concern that a “reappraisal of investors’ view about future risks to global inflation may cause a correction of global risk premia.”

The seeds of an inflation breakout may have been planted. With most major central banks still in the relatively early stages of paring stimulus from the financial crisis, policy makers have engineered the fastest global expansion since the start of the decade. Oil prices are near three-year highs and shrinking labor slack is threatening to spur faster wage gains.

Investors are nevertheless projecting subdued inflation over the long term. The cost of betting that the U.S. consumer price index will rise by more than 2 percent or less than 1.5 percent in about a year remains near record lows. And an option that offers upside to inflation averaging above 3 percent over the next decade is priced at less than one-fifth of what it was five years ago.

In the euro area, while the five-year forward inflation swap market is near a one-year high, its 90-day historical volatility is just a quarter of its 2015 peak, underscoring stable price expectations.

That confidence -- which juices the present value of future cash flows for companies around the world -- has helped to turbocharge asset valuations to post-crisis highs.

Research from Oxford Economics Ltd.’s Gaurav Saroliya shows that for the past 50 years there’s been a relatively stable relationship between low inflation volatility and a low term premium, or the extra compensation investors demand to hold long-term U.S. government bonds relative to short-term obligations.

Coeure offered support for that theory, noting in a presentation accompanying the Wednesday speech that low volatility and term premiums may share a “common underlying fundamental.”

While U.S. 10-year market-derived inflation expectations, or breakeven rates, have risen by 15 basis points this year, an estimate of the term premium formulated by the Federal Reserve Bank of New York remains in negative territory.

An inflation overshoot would reverberate beyond government bond markets, according to Oxford Economics.

“Most assets turn in positive returns because lower bond yields reduce the discount rates on all risky assets,” said Saroliya, macro strategist at the research firm.

To be sure, a pickup in productivity would feed the bulls while robust earnings expectations imply that equities can advance despite a jump in rates. Federal Reserve Chair Janet Yellen, meanwhile, has suggested that the yield curve is likely to be structurally flatter than it has been in the past, a dynamic which would cap any advance in the discount rate.

But price instability in concert with monetary tightening may be an underpriced risk.

Enhancement of unconventional stimulus programs in Japan and the euro area spurred capital flows into U.S. government obligations just as the Federal Reserve began to reduce accommodation.

Even a modest shift in price expectations could prove disruptive.

“If the market one day finds out it’s wrong, then the term premium could adjust 100 basis points higher, very rapidly,” said Thomas Tzitzouris, fixed-income research chief at Strategas Research Partners, referring to the U.S. curve. “Wrong might be as simple as something like an environment where core inflation bounces around unpredictably between 2.25 percent and 3 percent.”

— With assistance by Kristine Aquino

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