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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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"The 5yr /5yr inflation swap rate" - it may sound a bit of a mouthful, but it's just a measure of inflation expectations... and right now it's not looking too healthy

April 16, 2019

ref: - "Decline in inflation outlook raises pressure on ECB to act", The Financial Times, International Section

 

Right... First up, let's get the definition out of the way. If you google it, you might be amazed at how many ways there are to say the same thing but we've plumped for the simplest:

 

"The five-year, five-year inflation swap rate is a measure of the market's EXPECTATION of inflation over five years, starting in five years’ time".

 

If you're new to markets and find the very sound of a 5yr / 5yr forward inflation swap a bit intimidating, don't worry... we're not going into the mechanics of it (though they're a lot more straightforward than one might think) and besides... you wouldn't be alone. When European Central Bank boss Mario Draghi disclosed that it was a measure the ECB liked to follow back in 2014, it left a good many ECB watchers in the dark too. According to the FT, it was such an obscure instrument at that time that it wasn't even quoted on Bloomberg (Heaven forbid!). One can only imagine the consternation that must have caused among some financial journalists back then, but now, of course, the 5yr/5yr inflation measure is widely followed and carries a lot of weight with policymakers.

 

The reason why it's so important (or one of them at least) is that it's become accepted that expectations of inflation are self-fulfilling. If you expect prices to remain flat, then you're not going to be in such a rush to make purchases if you're a consumer. That affects both retail prices and wage demand. It also means that companies are less likely to make investments in infrastructure.

 

The ECB's inflation target is 2%, and it's proved pretty elusive. When the central bank called a halt to further quantitative easing in December, the 5yr/5yr inflation swap rate was just 1.6%. That was enough for some to question whether an end to the stimulus (or at least a beginning of an end) was such a good idea, but the ECB (in common with other central banks) remained hopeful that inflationary pressure would eventually percolate through the system. They would also have been keen to make even the most tentative start to monetary policy normalisation, which might offer the central bank some more ammunition should they have to tackle another downturn. With sub-zero interest rates and a bloated balance sheet of assets purchased through QE, they have precious little room to manoeuvre at present.

 

Sadly, the slowdown in economic growth in the eurozone has put the mockers on one of those aims and may do the same with the other. The 5yr/5yr is down to 1.36%, the lowest since 2016. That puts the pressure on the ECB to reconsider its decision to reconsider its monetary policy... in particular whether they should think about re-starting the QE bond purchases.

 

While Mr Draghi has always been super-cautious about tightening too quickly, he's also on record as saying that stronger growth has been delayed rather than derailed. That would imply that the next ECB policy meeting in June will see no noteworthy new measures beyond the cheap funding for lenders (TLTROs) already announced, but make no mistake... the pressure is on.

 

One other thought highlighted by the FT... Mario Draghi steps down from his post in October. Some believe that has played a significant part in the fall of the 5yr/5yr inflation swap rate. Super Mario has proved himself innovative and prepared to use unconventional methods in attempts to meet both inflation and other targets. Remember his famous commitment to do "whatever it takes" in 2012? There's a fair chance that Mr Draghi's successor will come from the more hawkish (Northern European?) members of the Eurozone... Jens Weidmann of the Bundesbank for example, who voted against Mr Draghi's measures to boost inflation more than once. Mr Weidmann has reigned back on some of his most hawkish positions of late, but even so, it's hard to imagine him subjugating traditional Germanic discipline in favour of the kind of free-spending, inflation-boosting measures that some believe will be required.

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