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I see an inconsistency between inflation market pricing, ECB rate hike pricing and the 2% inflation target. Markets are pricing the ECB to accept an inflation overshoot. Bringing an Oct hike into play would be stop-and-go in this fine-tuning part of the tightening cycle. 2024 inversion is challenging the GC’s view. Markets are pricing a virtually 50% probability that inflation will be between 1.5% and 2.5% in 5y time, but it is heavily skewed for higher than 2.5% at 40%+. On the very short projection horizons and for policy guidance, I think the ECB has had a stronger track-record of inflation projection this year. Markets have wanted to be long duration, pricing the end of policy tightening in 5-6m all through 2023, and the risk is that the right point to go long may be pushed further out. Two pieces of very important data were released this week, with employment growth at +0.2% qoq and wage growth at 4.2%.
My chart of the week on the euro area (Markets do not trust the ECB to deliver to the 2% inflation target)
- Do markets trust the ECB’s ability to get inflation in line with its target? I think the answer is no, so Frankfurt: we (may) have a problem. Trying to square the current inflation pricing with the ECB’s 2% medium target is not straightforward, as, for example, markets do not price a single spot inflation fixing at 2% at any one point in time and 5y5y is setting new 10y+ highs of 2.65%. Much focus will be on the headline inflation decline in the very near term with a trough priced at 2.7% in November, yet as we have discussed in recent months, the question is not about whether inflation is declining but the pace of the decline and at what level it will settle. Right now, an inflation rebound towards the turn of the year is expected before inflation settles around the 2.3-2.5% range from spring next year – and that is assuming no shocks to inflation or the economy.
- Today’s final inflation details for July were not a game changer to that view. We still see underlying inflation coming lower, but it will take time for a return to the 2% target to materialise (core to average more than 3% through 2024). This chart here shows a breakdown of what has been behind the headline inflation drop since the peak in October last year. The 5.3pp drop in headline is mainly due to housing-related items (4pp) and transport (1.3pp), which, in other words, means due to energy. Food is yet to show a meaningful decline.
- Today’s chart shows the probability distribution of where inflation could print in 5y time, derived from zero coupon inflation options. I like to use this chart to see any potential low- probability events appearing but also see how markets price the probability distribution of future inflation. I think the option market often serves as the canary in the coalmine. This chart shows that, with a virtually 50% probability, inflation will be between 1.5% and 2.5% in 5y time, but it is heavily skewed for higher than 2.5% at 42%. This has been virtually unchanged through this year but is in stark contrast to the pandemic pricing where essentially there was no probability of inflation being anywhere but below 1.5% in 5y time. For as long as historical data is available, the probability distribution has never been this skewed.
- The higher than 2% target from the market should be of concern to the ECB as the question arises of why markets are pricing the ECB to cut rates next year if medium term inflation projections are not in line with the target and the risk is heavily skewed to stay above 2%. Is this due to over-reliance on the ‘patience’ argument, as nominal deposit rates are set to settle in the 2.75%-3% area, i.e. having a moderately restrictive policy setting for a longer period of time due to a scare of too much activity slowdown or perhaps not a scare but just a ‘tolerance’ of inflation being above the target, just as the 2021 strategy review allows for? Either way, this is a problem. Lessons from the past year have shown that the ECB focuses on inflation and not growth. That means there is risk of no absolute or relative easing from the ECB also through 2024 (see our discussion here). Of course, growth is important, but it is inflation that is the highest priority. Lane summed this up very neatly in an ECB podcast released earlier today: ‘And the trick for us is basically to make sure demand does not add on supply. So, it’s not a question of driving demand deeply negative. It just has to grow more slowly than supply‘ = soft/no landing
- Markets having a baseline of the ECB not achieving its primary mandate is a problem. Consequently, markets are pricing too loose financial conditions relative to what would have been wanted by the ECB for it to achieve its target – and, from a historical perspective, financial conditions are still relatively loose. Today, FCIs are only some 10% higher than the trough before the Ukraine invasion last year and hence also some 20% below the levels seen in the 2016-2018 period. After all, the ECB needs the market to project its intended monetary policy stance through the setting of financing and financial conditions. What I heard mostly in the run-up to the July meeting, starting already before the Sintra conference, was that ECB GC members are not appreciating the inversion of the curves through rate cut expectations, and any rate cut speculation is premature now. We haven’t heard much since then. Right now, markets are pricing 65bp worth of rate cuts next year.
- In conclusion, I see an inconsistency between inflation market pricing, ECB rate hike pricing and the 2% inflation target. As you know, I think there is a risk of inflation fixings being above the target for longer than currently priced, and, consequently, the ECB could remain in a tightening stance for longer. The possibility of us adding additional rate hikes to our baseline profile, which would bring an October hike into play, depends on the monthly dynamics of inflation which we will only see upon the inflation releases. We are in the fine-tuning episode of policy tightening, so careful steps are the right way. That also means ECB peak pricing is stop-and-go for additional hikes right now. Markets are currently pricing 13bp for a September hike, which essentially means a 50% chance of a hike and another 7bp beyond that. To get the inflation market pricing, rate hike pricing and the 2% target to match up, we either need 1) patience and allowing a longer time for inflation to reach the inflation target, 2) more rate hikes / tighter financial conditions or 3) the ECB acknowledging that inflation will stay above the target. I doubt 3) would be seriously discussed; hence, we expect either option 1 or 2 to play out.
- Now, who is ultimately the better inflation predictor; markets or the ECB? While history shows that markets have been quicker to change their probability outcomes of where inflation will be, on very short horizons and for policy guidance, I think the ECB has had a stronger track-record this year. I’m saying that also because markets have wanted to be long duration, pricing the end of policy tightening in 5-6m all through 2023, and the risk is that the right point to go long may be pushed further out. 2bp worth of rate hikes is priced for December. While this is modest, it is still not zero or negative, meaning we are more likely to see an ECB hike in Dec than a cut (unchanged most likely, though).
- Finally, we already discussed the short end vs. the longer-end risk outlook in COTW last week, where I highlighted the wrong-footed positioning as a reason, and now the long end UST curve seems to be in the driver’s seat. The next points that I’m looking for are the PMIs and the Jackson Hole conference next week, as well as the inflation figures the following week. On the PMIs, I will clearly focus on services, as we all know the manufacturing sector is weak, so the question remains how the service sector is doing here in the tourism season of August. Note also that the PMI release will be the most important activity indicator before the September meeting. At Jackson Hole, Lagarde is due to speak next Friday at 21:00 CET.
The strong labour market
- Two pieces of very important data were released this week. First, the employment data for Q2, showing that the number of employed people in the euro area grew by 0.2% in Q2 this year. While this is the slowest growth since the pandemic, it is still quite remarkable at this point in time, given dour confidence and the gloomy economic outlook.
- The job portal Indeed’s wage tracker was released for July this week. Overall, the wage tracker shows moderation on a euro area aggregate level to 4.2% (from 4.5% in June). However, the Spanish economy, which shows signs of strength (grew 0.4% qoq in Q2), saw a rise in wages to above 6% in July. Only France also rose, albeit to a lesser degree. The rest of countries showed moderation.
- As a result, a back of the envelope calculation shows that the wage sum (number of people in employment multiplied by the wage growth) is up 3.1% through H1. Unsurprisingly, this has kept inflation at elevated levels.
