Monday, May 4, 2015

Inflation: It is Still a Long and Winding Road Ahead

With the commodities seemingly bottoming out, we have quite a strong reversal of moods in the market about deflation. Suddenly there is lot less worry about disinflation and lot more chatter about rate hikes. It is true since the bottom in Jan, Brent is up 42%, WTI  36% and the broader CRB commodity index is up `9% since the troughs around middle March. And breakeven inflation market followed the suit across markets, in EUR, USD and GBP. 

However, we are perhaps far from writing off the disinflation fears. The goods prices, including energy prices, have bounced back from the bottoms, but the services shows a very different story. And I believe this is the story of the underlying inflation pressure once the base effects and transitory effects settle down.

The Euro area is really really far from coming out of dis-inflationary pressure. The MUICP service YoY prints has been, and still is, steadily going down in a trend that started mid 2011. There was an interesting article from the excellent IMFDirect blog about the NPA dead-weight on the banking sector. This is definitely NOT helping. As mentioned earlier, the QE impact in Euro has been less successful in terms of inflation and real rates, spectacular as it was in terms of nominal levels and exchange rate.

And as expected, UK services are quite in sync with the Euro area following the downward trend. The only one robust among this is US. 

Last week's large sell off in rates was triggered by Euro zone rates (perhaps supported by the M3 and the ECI prints from the US). However, this is no repricing of economic outlook. The sell off has been entirely in real rates, with breakeven hardly moving much. This shows the sell off was definitely driven by QE positioning. Most likely the players front running ECB has a sudden change in mind and scampering to get out, triggering lots of stop losses. 

And as Goldman Sachs explains, this can definitely be a self-fulfilling cycle. ECB pledge to buy papers floored at negative 20 bps means players can push the price of any papers subject to that floor (unlike long term investors who will abhor the negative yields). So as more and more bonds get in to negative zone, less and less papers are available for ECB to buy. So this will push down the prices of longer and longer dated papers down without any concern about fundamentals. And unfortunately it works in the other direction as well. A significant sell off can trigger further sell offs.

And this makes taking directional views on euro rates very hard. 30y swaps moved from a bottom of 72 bps to current 113 bps in merely a week! This makes the whole market very sensitive to issuance calendar determining supply. 

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