(Bloomberg) —
(Bloomberg) —
Markets are delivering a harsh verdict on the European Central Bank’s efforts to rein in inflation.
Eight months into ECB President Christine Lagarde’s campaign to bring inflation down to 2%, traders are still pushing up rate bets and sending key bond yields to decade highs. At the same time, an accompanying surge in long-term inflation expectations suggests the central bank is now seen by some as not aggressive enough in tightening policy.
That’s a stark change from just a month ago, when many expected a quick pivot from hiking. After a slew of strong consumer-price reports across the euro area this week, banks from Goldman Sachs Group Inc. to Bank of America Corp. have forecast higher ECB rates, with markets pricing in a peak of 4%. Debate is heating up as to whether traders are discounting the impact of higher rates or if they are pricing in structurally higher inflation despite the ECB’s efforts.
“There is a clear disconnect between the rates and inflation market,” said Mohit Kumar, a rates strategist at Jefferies. “If the ECB is as aggressive as the market is pricing that should mean that inflation expectations should come lower.”
Investors will get further clues on monetary policy this week, when Lagarde participates in a World Trade Organization event and Federal Reserve Chair Jerome Powell delivers a Senate testimony.
“It seems unlikely that Lagarde will be in a position to signal a forthcoming slowing in the pace of rate hikes, for a time yet,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management. “There are growing risks that rates will need to go materially higher, if demand needs to be slowed.”
After a long period of little to no price pressures in the euro area, the five-year, five-year forward inflation swap — a proxy for 10-year inflation expectations — is starting to rival its US counterpart. Commerzbank AG strategists expect long-term expectations in Europe to approach the all-time highs hit in 2008-09 as structural price pressures are factored in.
Anticipation of higher inflation means that it will take more interest-rate hikes to rein it in. Real rates — which gauge the tightness of financial conditions — have started to slip in the euro area, an indication that markets aren’t convinced the ECB is doing enough, analysts say.
“Market-based inflation expectations have risen decisively,” said Societe Generale SA strategist Jorge Garayo. “We expect the ECB to step up its hawkish rhetoric, putting further pressure on real yields across the curve.”
Longer-dated bonds could also come under more pressure as investors see price pressures lingering for longer, according to ING strategists including Padhraic Garvey.
The decline in real rates might cause some angst for the ECB. Policymakers in the minutes to its last policy decision in February, hailed a potential “end of a long era of negative real interest rates” following the two-year real rate turning positive for the first time since the financial crisis.
In the US, while inflation expectations have also moved up, real rates remain considerably higher — showing more impact from the Federal Reserve’s tightening over the coming years.
“For now, the US real yield curve is much higher than the EUR one because the Fed is pushing on rates much more,” said Vincenzo Inguscio, a volatility strategist at Nomura. “There is a risk that higher nominal rates in EUR are needed to curb inflation and that should push volatility higher.”
For the ECB, the next key move to watch is if money markets fully price in a 50-basis-point hike in May, from wagering on a 90% chance now. ECB policymakers have already signaled a half-point increase later this month.
“The re-pricing of the structural inflation outlook seems far from completed,” wrote Christoph Rieger, a strategist at Commerzbank.
–With assistance from Alice Gledhill.
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