Rates spark: Inflation pricing sends mixed signals

Markets are fearful of near-term inflation risks, reinforced by this week's US CPI numbers, yet the structural outlook looks benign. We think markets risk underestimating the possibility that mounting fiscal pressures leave central banks having to tolerate higher inflation.

Long-term inflation pricing is not reflecting upside risks

Markets are anxious about near-term inflation surprises but seem to view structural inflation very benignly, a risk we see as possibly underpriced. Despite this week’s US inflation surprise and still-high energy prices, long-term market measures of inflation expectations remain low by historical standards. The 5Y5Y EUR inflation swap is just 2.07%, only slightly above the ECB’s target. Before the global financial crisis, this number was often closer to 2.4%. For the US, the difference is even bigger.

We have seen lower inflation swap rates since 2008, when inflation failed to return to 2%, but we argue this should be seen as quite an exceptional period. Current growth dynamics remain healthy and central banks have plenty of room to ease policy if needed. Structural growth challenges remain, but so does the increased risk of supply shocks amid global tensions. Low unemployment rates also mean wages can quickly add to price pressures.

One could even argue that central banks might be forced to tolerate higher inflation in the future. High government debt piles are hard to sustain if policy rates are kept too high, which can trigger financial stability concerns. The volatility around France is a test in the making and a similar parallel should be drawn with the US. In an environment of deteriorating fiscal conditions, central banks might be more comfortable leaning on the dovish side than risking a sovereign debt crisis. So, whilst our baseline sees quite favourable inflation dynamics going forward, we do think the risk is tilted to the upside.

Long-term inflation pricing looks low compared to pre-GFC period

Thursday’s events and market view

After UK GDP numbers, we turn to weekly US jobless claims and October's Federal budget balance. We also have a list of central bank speakers, including the ECB's Nagel and Lagarde, and from the Fed, Schmid and Williams.

In terms of supply, the UK will auction £4bn of 6y Gilts. Italy will auction 3y BTPs, 7y BTPs and 20y Green BTPs for a total of €7.25bn. The US will auction $25bn of new 30y Bonds.

Read the original analysis here