Euro inflation research #3 Time to position for higher inflation

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1 Investment Research General Market Conditions 11 March 2015 Euro inflation research #3 Time to position for higher inflation We see value in positioning for higher inflation especially after the oil price has stabilised and as positive base effects will support inflation in end The current market based inflation expectation is actually almost consistent with the oil price remaining unchanged at the current level during 2015 and Further out on the curve inflation is priced below 2% the next ten years, hence the current pricing suggests the ECB will undershoot its target until The attractiveness of now buying exposure for higher inflation follows as market based inflation expectations are mostly driven by changes in commodity prices. Related to this it is less important that there is downside risk to core inflation for a long time. Our forecast for inflation is above the forward rates derived from the break-even inflation curve in 2015, 2016 and Higher commodity prices support the case for buying inflation Market based inflation expectations have been declining for a long time, but recently they have started to increase and we believe the timing is now right in positioning for higher inflation. This follows as the oil price in our view has bottomed and as the latest increase in the oil price has resulted in higher actual inflation. Euro inflation research This is the third paper in our series of papers about inflation in the euro area See also: 1. Inflation to increase sharply this year 5 March 2. ECB s core inflation forecast is too optimistic 6 March Inflation forecast above consensus Euro area forecasts GDP HICP GDP HICP GDP HICP Danske Bank Consensus ECB Source: Bloomberg, ECB, Danske Bank Markets The stabilisation in the oil price should be more important for market based inflation expectations than a long period of downside risk to core inflation. This follows as the price is sensitive to changes in the oil price and as the monthly variation in actual inflation is also mostly driven by changes in commodity and not core prices. Inflation is priced below 2% the next ten years Senior Analyst Pernille Bomholdt Nielsen perni@danskebank.dk Important disclosures and certifications are contained from page 5 of this report.

2 Inflation expectations driven by spot inflation Market based inflation expectations have declined significantly during This reflects that global fixed income and inflation swap markets are sensitive to changes in oil prices and the drop in the oil price at end-2014 and the beginning of 2015 pushed down the market pricing of future inflation (break-even inflation). The lower inflation expectations are also seen in longer maturities as the break-even inflation curve to a very large extent is driven by the front of the curve as illustrated in the charts below. In some sense it is counterintuitive that the break-even inflation curve is driven by the front. This implies that a drop in the oil price results in lower future inflation although it boosts private consumption, which should support inflation later on. Added to this, the negative contribution to headline inflation from declining energy price inflation will fade when the oil price stabilises as base effects will lift inflation. Market based inflation expectations and actual inflation The break-even inflation curve is driven from the front The inflation swap market s sensitivity to movements in oil prices has also been seen with the increase in the oil price this year. 1Y break-even inflation has increased considerably from around -0.2% at the end of February to currently printing around 0.4%. The increase in break-even inflation is also likely to reflect that although actual inflation remained in the deflation area in February, it was higher than expected mainly due to higher commodity price inflation. The ECB s QE programme, which includes inflation linkers, should also have supported market based inflation expectations, but compared to the fixed income market the impact from the QE programme has been limited. The oil price also affects longer-dated break-even inflation together with monetary policy easing 2 11 March

3 Value in positioning for higher inflation We see value in the inflation swap market although the higher short-dated breakeven inflation is reflected further out on the curve. This follows as short-dated inflation was priced very low and as the break-even inflation curve has bear-flattened, implying there is still value in buying exposure to higher inflation above 1Y. The forward rates derived from the break-even curve are consistent with the market pricing in inflation at -0.2% on average in 2015 increasing to +0.6% in 2016 and +1.0% in This is below our inflation forecast in all three horizons. Further out on the curve inflation is priced below 2% over the next ten years. Including an estimated term premium, this implies the market expects inflation will remain below the ECB s 2% inflation target until In our view, the current pricing makes it attractive to start positioning for higher inflation although core inflation is likely to stay low. This follows as the variation in headline inflation is mostly driven by the volatile commodity prices, see Euro inflation research #1: Inflation to increase sharply this year. 1Y break-even inflation has increased... Implied break-even inflation is still below our forecast The market based inflation expectation is almost consistent with the view that the oil price remains unchanged just below USD60/bl until end In this scenario headline inflation will still turn positive at the end of 2015 and increase to around 0.5% in the beginning of 2016 before gradually inching higher during the year. This follows as the drag from the large negative contribution from the decline in energy price inflation will fade with an unchanged oil price and headline inflation will instead be driven by the positive core and food price inflation. Unchanged oil price: Drag from energy price inflation fades Inflation is close to market expectations with fixed oil price Source: Eurostat, Danske Bank Markets 3 11 March

4 Hedge against higher commodity price inflation The current market pricing of future inflation also opens for the possibility to hedge against higher commodity prices. As we argued above, actual inflation is mostly driven by changes in commodity prices and inflation is likely to average 2% in 2016 in a scenario where the oil price increases a bit above what we see as the new equilibrium price of around USD70-80/bl. Based on our energy price inflation model a rise in the oil price to around USD90/bl at the end of 2015 and a continued gradual increase towards USD105/bl at the end of 2016 would lift inflation above 2% in the second half of 2016 assuming the EUR/USD remains unchanged at the current level of Higher oil price: Energy price inflation boosts HICP inflation Inflation increases above 2% with a higher oil price Source: Eurostat, Danske Bank Markets We expect headline inflation to be lifted by a recovery in the oil price in 2015 as a number of indicators suggest it has bottomed. Our expectation of a higher oil price is based on 1) a steep decline in US rig count, 2) downward revisions to IEA, non-opec supply forecasts, 3) a softer stance from OPEC on oil prices, 4) stronger European oil demand supported by the ECB and 5) an expected correction following an undershooting of the medium-term equilibrium price. Nevertheless, there are also a number of factors pointing to a bumpy recovery and we see it as likely that the volatility in the oil price remains high, see Research Commodities: Bumpy road to oil price recovery déjà vu #4. Consolidation in non-opec production OPEC softening its stance Source: IMF, Macrobond, Danske Bank Markets Source: IEA WEO 2013, Macrobond, Danske Bank Markets 4 11 March

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