From Bond Vigilantes, Feb. 28:
Inflation expectations in the US and Europe have been diverging
lately and it comes as no real surprise, of course. After all, annual
GDP growth in the US was running at a healthy rate of 2.6% in real terms
in Q4 2018. The unemployment rate has fallen below 4%, putting upward
pressure on wages, while economic sentiment indicators, such as PMIs,
are in firmly expansionary territory. In stark contrast, the economic
outlook for the euro area has darkened considerably over the course of
last year. Italy’s economy contracted in Q4 2018 and Germany only just
avoided slipping into recession. Consequently, European PMIs have taken a
nose dive.
Against this backdrop, the widening spread of US over European
inflation expectations makes perfect sense. I would argue, however, that
the magnitude of the move has been rather extreme. Comparing 10-year
inflation breakeven rates, a market proxy for medium-term inflation
expectations, the differential between US Treasury Inflation-Protected
Securities (TIPS) and German Bund linkers (which reference euro area
inflation) has shot up beyond 100 basis points (bps). To put things into
context, the US vs Europe 10-year breakeven spread has more than
tripled since late 2015.
It is also worth noting how differently US and euro area inflation
expectations have fared during the recent rebound in the oil price.
While 10-year US breakevens have leaped higher this year (+25 bps YTD)
pretty much in lockstep with crude oil, 10-year euro area breakevens
have been completely unfazed and continued to trend downward (-7 bps
YTD). Granted, due to lower fuel duties in the US oil price moves have a
more direct impact on US inflation numbers than on European inflation
rates, at least over a short time horizon. However, we should think long
and hard whether the high degree of correlation between 10-year US
breakevens and spot price moves of crude oil is justified. In fact,
unless the oil price keeps on rising year after year over the next ten
years, basis effects will kick in making the inflationary impact of the
recent oil rebound rather short-lived....MORE
