In this space I write a lot about inflation, but specifically I focus mostly on US inflation. However, inflation is substantially a global process – a paper by two ECB economists in 2005 (and our independent followup) found that nearly 80% of the variance in inflation in the G7 and G12 could be accounted for by a common factor. This observation has investment implications, but I’m not focusing on those here…I’m just presenting that fact to explain why I am about to show a chart of European inflation.
Right, so technically it’s my second article in a row in which I mention European inflation. In last Friday’s “Potpourri for $500, Alex”, I noted that core European inflation rebounded to 1.1% after being counted for dead at 0.7% last month. But what is illustrated above is the inflation swaps market, and so is forward-looking. I think this looks a lot more dramatic: investors expect 5-year European inflation to average 1.5% over the next 5 years (a year ago, they were at 1.1% or so and two years ago the market was at 0.7%), and to converge up towards 1.8% where the 5y, 5y forward inflation swap indicates the approximate long-run expectation since it’s not significantly influenced by wiggles in energy.
What is especially interesting though is not the overall trend. Inflation markets everywhere, with the exception of the UK, have been trending higher for a couple of years – you are forgiven if you hadn’t heard that, but the ‘disinflation’ lobby is strong (most of the equity houses have some skin in the game in that direction, after all). No, what is most interesting to me is that inflation swaps have been trending higher recently even though energy prices have been in retreat and even though European yields (outside of Italy) have mostly been in decline. It isn’t as if Euro area growth has been setting the world afire. The currency has been weakening as US growth seems to be outstripping growth on the continent and as the European ‘experiment’ once again looks to be under stress.
What Euro inflation investors may believe, though, are two things. First, a trade war is really bad for inflation, and probably moreso for Europe than the US since there is a larger external sector. Trade frictions are bad for everyone, of course, but a splintering of the Euro bloc would be the ultimate in trade frictions. Second, the ECB is being much slower to stop QE and raise rates than is the Fed. Heck, the ECB’s deposit facility is still at -0.40%, where it has been for 2016. While I am in the camp that rates are of limited importance when economic liquidity is far larger than the economy demands (that is, when there are inert excess reserves), that’s not a mainstream view and as much as I would like to believe otherwise, markets respond to the mainstream view and not mine!
For some time, we’ve favored European ILB over US ILB, and that has been a steady if unexciting trade. Even after this move, European inflation bonds are still considerably cheap to US TIPS, which are themselves still fairly cheap relative to nominal US rates.
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