LONDON: Evidence is growing that flickering signs of life in Europe's economies have started a slow turnaround in the region's long-muted inflation expectations.
Until recently economists and investors worried the euro zone's troubles could slow inflation to the point where prices started falling, but the recent pick-up in the economy appears to have changed the picture.
European bonds that provide protection against inflation - known as "linkers" - have begun to outperform nominal bonds for the first time in more than a year. Inflation swaps, another commonly-used gauge of expectations, have also risen.
Analysts say the moves are not so much a signal that inflation worries are returning but rather show that with the recovery coming markets are increasingly confident deflation - a fall in prices - will not take hold.
"When you think back a couple of months ago the market was really contemplating disinflation scenarios but now, even though the ECB ( European Central Bank) has been quite explicit about keeping inflation expectations anchored, the growth side of the equation is picking up," said Commerzbank strategist Michael Leister.
One- and two-year European inflation swaps, which traded as low as 1 percent in June, have now ticked up to 1.4 percent, and although some of the move is technical rather than sentiment driven, there has been an underlying upward drift.
Euro zone linkers have continued to outperform in the last week, unlike in the United States where the Federal Reserve's plans to scale down, or taper, its stimulus have weighed on inflation prospects.
"In the U.S. you have the expectations of tapering, you have seen risky assets such as equities moving lower and breakevens (the gap between yields on nominal and inflation-linked bonds) typically have some correlation there," said Barclays inflation strategist Khrishnamoorthy Sooben.
INFLATION INFATUATION
With euro zone unemployment at a record high and troubled economies such as Spain, Italy and Greece still in recession, the consensus view is that inflation will remain muted.
Once special factors like recent austerity-related tax hikes are stripped out, BNP ParibasBSE -0.53 % calculates there will be an additional 0.5 percent added to euro zone inflation over the next year. It is currently 1.6 percent.
Like other key inflation gauges, the European Central Bank's favoured market-derived measure of expectations, the five-year, five-year forward - the best guess of five-year borrowing costs in five years' time - has edged up over the last month.
At 2.25 percent, this would be still at historically optimal levels for the ECB's target of inflation just under 2 percent, but the trend is in line with surveys such as Germany's ZEW where inflation expectations have picked up in three out of the last four months after a long period of declines.
If the move were to solidify, not only could it weigh on the region's brittle recovery but it would also raise additional doubts about the "forward guidance" promises made by both the ECB and Bank of England to keep interest rates low.
Markets already suspect that central banks may have to raise rates more quickly than they are suggesting and if the inflation view changed as rapidly as it did in 2011 when the euro zone also appeared to be recovering, that concern would strengthen.
Back then the five-year, five-year forward went from below 2 percent to 2.6 in four months and the ECB raised interest rates twice. Germany's Bundesbank has already stressed the ECB's forward guidance would be jettisoned if prices spiked.
indiatimes.com
Until recently economists and investors worried the euro zone's troubles could slow inflation to the point where prices started falling, but the recent pick-up in the economy appears to have changed the picture.
European bonds that provide protection against inflation - known as "linkers" - have begun to outperform nominal bonds for the first time in more than a year. Inflation swaps, another commonly-used gauge of expectations, have also risen.
Analysts say the moves are not so much a signal that inflation worries are returning but rather show that with the recovery coming markets are increasingly confident deflation - a fall in prices - will not take hold.
"When you think back a couple of months ago the market was really contemplating disinflation scenarios but now, even though the ECB ( European Central Bank) has been quite explicit about keeping inflation expectations anchored, the growth side of the equation is picking up," said Commerzbank strategist Michael Leister.
One- and two-year European inflation swaps, which traded as low as 1 percent in June, have now ticked up to 1.4 percent, and although some of the move is technical rather than sentiment driven, there has been an underlying upward drift.
Euro zone linkers have continued to outperform in the last week, unlike in the United States where the Federal Reserve's plans to scale down, or taper, its stimulus have weighed on inflation prospects.
"In the U.S. you have the expectations of tapering, you have seen risky assets such as equities moving lower and breakevens (the gap between yields on nominal and inflation-linked bonds) typically have some correlation there," said Barclays inflation strategist Khrishnamoorthy Sooben.
INFLATION INFATUATION
With euro zone unemployment at a record high and troubled economies such as Spain, Italy and Greece still in recession, the consensus view is that inflation will remain muted.
Once special factors like recent austerity-related tax hikes are stripped out, BNP ParibasBSE -0.53 % calculates there will be an additional 0.5 percent added to euro zone inflation over the next year. It is currently 1.6 percent.
Like other key inflation gauges, the European Central Bank's favoured market-derived measure of expectations, the five-year, five-year forward - the best guess of five-year borrowing costs in five years' time - has edged up over the last month.
At 2.25 percent, this would be still at historically optimal levels for the ECB's target of inflation just under 2 percent, but the trend is in line with surveys such as Germany's ZEW where inflation expectations have picked up in three out of the last four months after a long period of declines.
If the move were to solidify, not only could it weigh on the region's brittle recovery but it would also raise additional doubts about the "forward guidance" promises made by both the ECB and Bank of England to keep interest rates low.
Markets already suspect that central banks may have to raise rates more quickly than they are suggesting and if the inflation view changed as rapidly as it did in 2011 when the euro zone also appeared to be recovering, that concern would strengthen.
Back then the five-year, five-year forward went from below 2 percent to 2.6 in four months and the ECB raised interest rates twice. Germany's Bundesbank has already stressed the ECB's forward guidance would be jettisoned if prices spiked.
indiatimes.com
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