The Bank of Japan is in a similarly tight spot. The differential between 10-year U.S. breakevens and Japanese equivalents is near the widest in over a year.
“We remain relatively skeptical of European inflation,” said Thomas Walker, investment director at Aberdeen Standard Investments, who has an overweight position in inflation-linked U.S. Treasuries. “There are a multitude of factors at play here, but Europe has been struggling to generate inflation for quite some time now. Even before Covid-19, the ECB has struggled to generate inflation.”
It’s a long-standing dilemma for the euro-area’s policy makers, as well as investors. The ECB is reviewing its inflation target, but flagging price pressures could potentially stymie consumer spending, worsening the economic shock from the coronavirus and cementing fears of Europe’s “Japanification” -- a state of near-permanently low inflation and reliance on institutional support.
In the worst case, price declines can become entrenched and spur a slump in wages, in a downward spiral of deflation that has historically wrecked economies.
While some of the reasons for Europe’s troubles are structural -- an aging population, for example -- others are far more recent, such as the euro’s more than 10% appreciation since a low in March. The currency’s strength is a double-edged sword; on the one hand, it reflects trader optimism in the region’s economic recovery, as well as fading fears of an EU breakup, but it also makes achieving the central bank’s 2% inflation goal a tall order.
Euro strength has undermined ECB efforts to revive inflation
When the euro broke above $1.20 this month for the first time since 2018, the central bank’s Chief Economist Philip Lane was quick to talk it down, and Bloomberg Intelligence strategists Huw Worthington and Bhumika Gupta say euro strength raises the threat that prices in the euro area will fall.
“A strong euro can stoke deflationary pressures in the EU,” they wrote in a note. “The currency is working against Lagarde’s inflation target, but options are limited, with QE having little impact on the exchange rate and rate cuts becoming toothless.”
Still, a reduction of 10 basis points or more in the ECB’s deposit rate -- already at a record low of minus 0.5% -- may prevent euro appreciation fueling deflation fears, they added.
Christoph Rieger, a strategist at Commerzbank AG, sees investor bets on a further ECB rate cut persisting. Traders in money markets currently expect such a move in the second half of next year.
“Unless inflation starts to rise or the euro starts to tumble on its own, this should keep rate-cut speculation alive,” Rieger wrote in a note to clients. “The genie is out of the bottle.”