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Euro Area Deflation – A Turning Point?

As Eurozone inflation reaches a cyclical low, Jonathan Baltora, Fund Manager of AXA WF Universal Inflation Bonds, discusses concerns over deflation

Euro Area inflation fell to a new cyclical low in March 2014, negatively impacted as a result of the European authorities choosing a path of ‘internal devaluation’ to resolve the Euro crisis. This essentially lowered labour costs (and wages) in Southern Europe.

The market is still pricing in a severe ‘miss’ for the ECB’s inflation target (approximately 1% annual inflation for the next three years, and less than 1.75% per year over the next decade), as there wasn’t any announcement of any unconventional measures. In our view, the ECB should not tolerate such a situation, as it risks inflation expectations becoming unsettled.

Currency Depreciation Can Engineer Inflation

AXA believes that the ECB could engineer 1% inflation – enabling it to reach its target by doubling the size of its balance sheet. Last week the ECB gave strong hints that it is prepared to implement bond buying to prevent deflation. Over a 12-18 month horizon, Central Banks can engineer an inflation boost using currency depreciation, as has been seen in the US, the UK and Japan through QE.

Figures leaked by the ECB last week showed that increasing the size of its balance sheet from 50% to 100% could engineer a 20% drop in the value of the Euro that would, by historical standards, result in close to an extra 1% inflation. 

A Turning Point from the Risk of Deflation?

Any impact on the strength of the Euro could translate quickly into higher inflation.  In addition, employment expectations remain key and a survey by the European Commission confirms that we are probably at a turning point. The Euro Area is likely to rebound in the coming months and inflation momentum should improve slightly thanks to positive seasonality and stronger activity.     

Given the prospects for ECB action, we have become more positive on European real interest rates, increasing exposure to French and Italian inflation-linked bonds. There is likely to be a heavy supply of inflation linked bonds in Spring, and the market looks ready for Spain’s inaugural inflation linked bond issue.

 

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