The European Central Bank (ECB) uses the 5-year, 5-year EUR inflation swap rate to measure Eurozone-wide inflation.
Before the ECB meeting on September 12th, European 5y5y inflation swaps were trading at 1.26%. Following the announcement of a cut to the deposit rate and the reintroduction of Quantitative Easing (“QE”), the inflation swap peaked at 1.32%.
After today’s European PMI data, which fueled further recessionary concerns, the benchmark inflation swap traded as low as 1.20%. Our interpretation is that the market does not believe QE is “truly” open-ended or will generate higher inflation. Therefore, further weak economic data could lead to inflation expectations becoming un-anchored if QE lasts for less than one year.
As a yardstick, the trough level for this key inflation measure was 1.14% before ECB President Draghi spoke in June at Sintra. We believe a break of this trough level – 1.14% – would signal that investors demand more from the ECB, including more deposit rate cuts and a larger monthly asset purchase amount with no time limit.
This inflation measure should be watched closely as a proxy for a weaker euro exchange rate or lower European fixed-income yields, especially the German BUXL.
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