Briefing, Investment: Breakevens breakout
The primary objective of the ECB is to maintain price stability, with inflation kept below but “close to 2% over the medium term”. That 2% figure represents an average, to accommodate the heterogeneous nature of the euro-zone economies.
“In 2011, outgoing ECB [European Central Bank] president Jean-Claude Trichet summed up the success of his tenure at the helm – during which time inflation averaged 1.9% – by effectively saying he had done his job as the bank had delivered price stability,” recalls David Zahn, head of European fixed-income at Franklin Templeton Investments.
Before the crisis, market indicators tended to reflect benign expectations that the ECB would successfully manage, on average, to keep inflation around its target, trading within a tight range throughout the ECB’s existence up to 2008. Since then, however, with great volatility in all markets, market-based breakeven inflation rates, whether derived from inflation swaps or index-linked bonds, have oscillated hugely.
Index-linked markets can be significantly affected by technicals, such as reduced dealer balance sheets or today’s negative real yields, which naturally depress demand.
“In the UK, in particular, with a very active pension hedging market, breakeven levels are not always indicative of where spot RPI is printing,” explains Aviva Investment’s sovereign fund manager Orla Garvey. “This is particularly true of longer maturities, which tend to reflect more of a supply-and-demand dynamic than an expectation of future inflation rate.”
Nonetheless, policymakers make it clear they do pay close attention to developments in inflation markets. The Bank of England (BoE), for example, states: “People’s expectations about future inflation play an important role in determining the current rate of inflation: when people believe that inflation will be low and stable, they set wages and prices in a way that is consistent with those beliefs.”
The BoE, ECB and other central banks all have highly sophisticated and well-documented methodologies for extracting more realistic inflation expectations – although even these can be significantly influenced by market technicals. Moreover, Europe’s inflation swaps market has developed in both depth and breadth, with better liquidity and an increasing array of instruments, to the extent that, today, swap rates are considerably less volatile than bond-based inflation breakevens. These are known to be one of the ECB’s preferred indicators.
Based on those indicators, Draghi’s ECB is no longer experiencing such a benign environment as in Trichet’s day. Indeed, the ECB’s preferred measure, the 5Y5Y breakeven inflation rate – what the market is prepared to pay to protect itself against five years of inflation starting in five years’ time – is breaching historic lows.
Garvey notes that “5Y5Y euro inflation expectations dropped from 2.2% at the beginning of the year to around 1.7% by the start of the fourth quarter. That falling inflation expectations become ingrained in the national psyche is a big worry for central bankers, as this means there is a strong incentive to defer spending and investment, which has obvious negative implications for growth. And what we have at the moment is a market that isn’t buying in to the ECB’s promised policy action boosting inflation.”
When historic levels are broken, there are always plenty of headlines, notes Robeco’s senior portfolio manager Olaf Penninga, emphasising the importance of longer-term trends. But he adds: “Unfortunately for the ECB, however, we do not think this downward move is some temporary distortion, and we believe inflation expectations are clearly moving below target.”
Since this summer, European inflation market developments have been quite dramatic. “Even during the summer of 2011 when we were at the very worst moment of Europe’s sovereign debt crisis, this inflation measure did not break down through the 2% level,” observes Erik Schiller, a principal at Pramerica. “The central bank, and markets generally, have been waiting for something of a meaningful rebound, but it just kept moving lower.”
There has been a tendency recently for central bankers to put trigger levels on various measures in order to provide guidance levels on policy, notes Jonathan Gibbs, head of real return at Standard Life Investments. Draghi’s measure of choice has been inflation expectations.
“What is dangerous now,” he says, “is that Draghi’s chosen measure has moved significantly through the 2% level and, as yet, we have had no sign of a response from the ECB. It may, though, be more the speed of the moves rather than the magnitude of them that will be more important.”
Penninga suggests that perhaps Draghi had an ulterior motive in highlighting developments in the 5Y5Y breakeven.
“We have all learned not to underestimate Draghi,” he says. “So far, he has been very effective at communicating and getting the market ‘back on side’. Perhaps he called for us all – including the bank’s governing council itself – to look at the measure, to see how significant the moves had been, to start realising that more action could be needed. It’s hypothetical, but it is possible. And for those observers who cite all the legal reasons for something not to happen, history tells us that legal obstacles are not usually the best guides to the course of national developments. We believe that QE from the ECB is a possibility.”
On current policies, it is agreed that the ECB is facing quite a challenge.
“From our perspective, it is going to take a very strong announcement from the ECB to materially alter this declining trend in inflation expectations,” comments Schiller. “The euro area is such a diverse marketplace, with mild deflation already in some areas – but there is so much political friction to overcome, and we are definitely concerned about inflation trends.”
Zahn agrees that the outlook is quite dark. “Whilst we are not extremely bearish and we’re not predicting large negative inflation, we are finding it hard to figure out what it will be that can push Europe’s inflation expectations back up to the ECB target in the next few years,” he says. “A weakening currency is one of the few positives that may boost prices, but there are more powerful negatives: Europe’s labour market is greatly under-utilised, and commodities, led by oil, are clearly trending lower.”
Gibbs warns that any sign of disorderly acceleration downwards in longer-term inflation expectations would present a very real danger of those expectations becoming “unanchored”.
“Although the ECB has, incrementally, done an enormous amount, it’s all been about reacting rather than pre-empting,” she says. “Markets are challenging the credibility of the central banks to deliver their mandates on inflation.”