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Markets expect decade of below-target inflation even as ECB readies QE
[LONDON] Days before the European Central Bank is expected to deploy its ultimate monetary easing weapon, financial markets are showing no sign of confidence that it will push inflation anywhere near target in the next decade.
The ECB is expected to launch a programme to print hundreds of billion of euros in new money by buying government bonds as soon as Thursday, with the explicit aim of boosting inflation. Yet market-implied inflation expectations have fallen relentlessly.
The major driver has been a nearly 60 per cent drop in oil prices since June, hitting the cost of a wide range of goods and services and taking investors and policymakers by surprise.
What is striking, though, is that inflation expectations in the eurozone have fallen at a similar pace to that seen elsewhere, including the United States, where the Federal Reserve is expected to tighten monetary policy this year.
Market participants say that is because investors are beginning to doubt the power of quantitative easing as a policy tool. Some even question the ECB's credibility.
The euro five-year, five-year breakeven forward , a gauge of the market's longer-term inflation expectations, has fallen 60 basis points in the past six months and 20 bps this year alone.
The contract, which shows where markets expect 2025 inflation forecasts to be in 2020, trades at record lows around 1.50 per cent, well below the ECB's roughly 2 per cent goal. Its US equivalent stands at 2.16 per cent, down from 2.33 per cent in December and 2.80-2.90 per cent half a year ago.
It is expected to rise in Europe a bit once the ECB announces QE, but not by much.
"You can forget getting breakevens back to where the ECB wants them to be," said Ralf Preusser, head of EMEA rates research at BofA Merrill Lynch. "You've got to price some probability that it won't work."
"It is a rational market reaction to the fact that all central banks have failed to hit their inflation targets over the past four-five years. The market doesn't believe that QE is the miracle cure. It can only be part of the solution."
Nor can the ECB blame the oil price fall for the expectation it will miss this target: by ignoring the first five years of the 10 year period, the measure in theory should not be correlated with commodity prices. The impact of 2014's drop in oil prices should have long disappeared from inflation numbers by 2020, whether or not crude rebounds.
Credit Agricole inflation strategist Jean-François Perrin said monthly inflation figures have to rise over a sustained period before market-implied expectations increase markedly. eurozone consumer prices fell in December. "When QE is delivered we may have the euro getting even lower, oil prices possibly rebounding. So ... the five-year, five-year might rebound to 1.6 per cent but I'm not sure at all that it would go back up to even 1.8 per cent," he said.
While there are questions over whether the ECB has waited too long to deliver QE, some in the market also caution against being too critical.
The "five year, five year breakeven" contract depends on today's expectations of what the difference will be in 2020 between the yields of traditional five-year bonds and inflation-linked bonds.
That could be distorted by expectations the ECB may not include inflation-linked bonds in its purchases as they are not very liquid and are only issued in four of the bloc's 19 countries. If it doesn't, yields on nominal bonds would fall relative to yields on linkers, pushing the difference between them - the breakeven - lower.
"It could be that markets are worried they wouldn't buy linkers, it could be the positioning or the lack of liquidity, or that markets don't believe that the ECB would be successful in raising inflation," said Citi rate strategist Jamie Searle.
Some wonder whether a 2 per cent inflation target is even appropriate in the post-crisis world. "I wouldn't say the ECB has no credibility. I just think that maybe a lot of people think that 2 per cent as a target is not credible. It has been set years ago and the world is changing," said Marie-Anne Allier, head of euro aggregate fixed income at Amundi.
"There is a feeling that QE won't work, it won't put inflation in the system. But does anybody have a better idea?"