Defying strong euro, long-term inflation bets hold firm

Frankfurt (Aug 16)  Investor expectations for long-term euro zone inflation are holding up in the face of a strong single currency, a comforting sign for the European Central Bank as it looks to start unwinding its massive monetary stimulus.

In recent years, a rising euro -- which holds down the price of imported goods and in turn inflation -- has been met with lower expectations for long-term price growth. Similarly, a weak euro, which increases import costs, has boosted inflation bets.

The euro is the best performing major currency against the dollar so far this year, with gains of almost 12 percent.

But since mid-June, investors' long-term inflation expectations, reflected in the five-year, five-year breakeven forward rate, have risen with the euro .

This market inflation gauge -- often cited by the ECB alongside its own forecasts -- is designed to strip out the ebb and flow of prices and measure what expectations for 2027 inflation will be in 2022.

Just as the euro has affected inflation expectations, they have also historically been impacted by short-term movements in the likes of oil and copper - the metal being a barometer of economic growth owing to its widespread use in manufacturing and construction.

That may partly explain why expectation have remained stable despite the euro's rise, given Brent crude oil prices are up about 15 percent from a seven-month low hit in June, mainly on efforts by the OPEC producers group to rebalance an oversupplied market, while copper prices last week hit their highest levels since December 2014 .

But analysts say it also points to a firmer belief in underlying economic conditions and what they mean for the inflation outlook.

"If you look at core inflation, that has a strong correlation with the five-year, five-year forward also. Core inflation is still too low for comfort but at least we are moving in the right direction," Martin van Vliet, senior rates strategist at ING said.

At around 1.60 percent, market inflation expectations are close to their highest in three months. That's still below the ECB's near 2 percent inflation target, but well above record lows hit last year around 1.25 percent.

The rise in the gauge comes as the euro zone economy enjoys its best run in a decade and unemployment in the currency bloc falls to its lowest since 2009.

Core euro zone inflation, which excludes volatile food and energy prices, accelerated to 1.3 percent in July from 1.2 percent in June. It was its highest level since August 2013 and confounded market expectations for a slowdown.

"Everything stands and falls with the trend of core inflation," said Christoph Rieger, head of rates and credit research at Commerzbank.

Reuters