ECB Impact Is Under-Priced By Front-End Inflation Rates

Further steps by the European Central Bank to bolster growth and inflation in the eurozone could be highly effective, according to Russ Oxley, head of rates and LDI at Old Mutual Global Investors.

It is now more than three weeks since the European Central Bank (ECB) unveiled a fresh stimulus package, at the more aggressive end of investors’ expectations, and yet some sections of the rates market still fail fully to reflect its potential to boost growth and lift inflation.

The ECB increased its monthly asset purchases, to which it added some company debt, and cut interest rates again. It also announced a series of four-year loans to banks, which can be as low as the new deposit rate of -0.40% – indicating the central bank may pay lenders to borrow from it.

We believe these measures, in particular the loans, known as targeted longer-term refinancing operations, or TLTROs, could be a highly effective form of stimulus.

It is worth remembering that low nominal rates tend to work: the US economic recovery was built upon the extraordinarily low rates that followed the Federal Reserve’s deployment of open-ended quantitative easing in 2012, so-called ‘QE Infinity.’ Indeed, the slight uptick in euro-area growth last year came after rates dropped across the region, triggered by the ECB’s introduction of quantitative easing.

As such, we are optimistic on eurozone growth – and bullish on front-dated inflation rates, which appear to be under-pricing the economic outlook.

The five-year German breakeven rate – the difference in yield between nominal government paper and comparable inflation-linked bonds – is only a whisker above 0.50%, suggesting investors see inflation around this level over the life of the securities. But core consumer price inflation in the eurozone, which strips out items with volatile prices such as fuel, is double this at 1.0%, year-on-year.

This is in fact a global theme, with US and Japanese front-dated inflation rates also mispricing their respective economic outlooks, following dovish words from the Federal Reserve and dovish action from the Bank of Japan.

We are not, however, bullish on longer-term inflation rates, because we do not expect the market to significantly increase the inflationary risk premium in this part of the curve.