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Surge in Market Inflation Expectations Brings Hawkish ECB Risks

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(Bloomberg) —

A near-vertical rally in inflation wagers in Europe is boosting the likelihood of a hawkish surprise from the European Central Bank on Thursday, a move that could knock extremely bearish euro bets out of the water.

Investors were the most bearish on the euro in more than a decade, according to risk reversals, a barometer of market positioning and sentiment, with the market bracing for further downside as traders expect officials will point to the economic headwinds from the war in Ukraine.

On the other hand, swap rates that gauge the outlook for price increases leave less room for dovish messaging, with markets pricing inflation above the ECB’s 2% target even after the initial shock from the conflict. 

Indeed, were the ECB’s inflation projections to follow inflation swaps which roughly cover the policy-relevant horizon for the central bank, officials would actually have to increase rates immediately, according to researchers at Commerzbank. While that’s clearly not going to happen, there’s room for officials to signal strongly they will move to tame price pressures.

“The communication will be challenging,” Christoph Rieger, head of fixed-rate strategy at the German lender, wrote in a note to clients. “The market has made up its mind that the ECB would look through this latest energy-induced spike in consumer prices.”

The European economy’s proximity to Russia means it is feeling the reverberations of sanctions against the nation, with Russian gas meeting about a third of Europe’s demand. That has simultaneously sent market-based inflation expectations surging while economists predict a hit to economic growth. Talk of stagflation risks is common.

Read more: Euro Bearish Bias Faces Hawkish-ECB Risk as Inflation Surges

To be sure, while the surge in short-term inflation gauges makes sense given the rally in commodity prices, the move in medium- to long-term markets has caught many off guard as it suggests expectations for price increases becoming embedded. Some strategists argue it is not a true reflection of investor sentiment and likely a function of technical factors.

“The surge in HICP swaps is likely positioning and liquidity rather than a reassessment of long-term fundamentals,” Citi strategists, including Puja V Sawant, wrote in a note. “Sudden ECB credibility loss does not feel like a satisfactory explanation.”

Bond Issuance

The ECB’s policy outlook might also be impacted by the prospect of more joint European Union bond issuance. It could convince policy makers in the coming months that financing conditions will be kept in check, even if they pursue a tightening path. The euro rallied Tuesday after a Bloomberg report on the plans.  

“If the ECB is not willing to hike rates this year to defend the euro, we will likely revise our forecasts lower,” said George Saravelos, Deutsche Bank’s global head of currency research, in a note to clients. An EU joint-bond issuance program “to deal with the immediate impact of the crisis on growth would be most relevant for the ECB reaction function in the near term.”

©2022 Bloomberg L.P.

Surge in Market Inflation Expectations Brings Hawkish ECB Risks

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