March 10, 2020 / 5:01 PM / 19 days ago

UPDATE 1-Oil, virus bring deflation risks back on radar for bond markets

(Updates with action in inflation expectations)

By Dhara Ranasinghe

LONDON, March 10 (Reuters) - Markets calmed down on Tuesday after Monday’s panic, but euro zone inflation expectations hit new record lows, below 1%, a reminder of the deflation fears that are creeping back into bond markets.

The collapse in market inflation expectations across Europe and the United States were stoked by Monday’s 30% drop in oil prices to about $30 a barrel. Lower energy prices may boost growth in the medium term, but it adds fresh urgency to how policymakers’ respond to the coronavirus outbreak.

The readout from markets is clear — the European Central Bank must act, and quickly, to head off deflation expectations before they take hold.

“Last week was all about the economic fallout from coronavirus and a feeling that there’s little the ECB can do,” said ING economist Carsten Brzeski.

“Now the turmoil in markets means that the ECB may have to step up QE (quantitative easing) to get rid of deflation expectations.”

He was referring to ECB asset purchases, which currently amount to 20 billion euros a month.

The market gauge of long-term euro zone inflation expectations — the five-year, five-year breakeven forward — dropped to a record low of 0.9239% on Tuesday after falling below 1% for the first time ever on Monday.

The measure, also tracked by the ECB, has slumped 20 basis points in the past week, moving further away from the ECB’s near 2% target.

If oil prices remain depressed “inflation in the euro zone could fall to the psychologically important 0% mark in May,” Commerzbank estimates.

Euro area prices rose 1.2% year-on-year in February, after a 1.4% rise in January.

A 10-basis-point rate cut at Thursday’s ECB meeting is priced in by markets; targeted measures to support the economy in the face of coronavirus are also expected.

Market inflation expectations in the United States and Britain also tumbled on Monday after an oil-price war between Russia and Saudi Arabia sparked the biggest oil-price rout in almost 30 years.

According to trading platform Tradeweb, U.S. inflation expectations represented by breakeven rates on Monday were at their lowest closing point in over a decade.

But years of stimulus and interest rates at minus 0.5% leave the ECB with less room for manoeuvre than its U.S. and British counterparts, especially given the hit to consumer demand from the virus-linked reduction in activity.

“The fall in 5y5y swaps is largely a reflection of the collapse in oil prices, but there is more than a supply shock going on in Europe. So, the deflation risk is rising fast,” TS Lombard economist Davide Oneglia told the Reuters Global Markets Forum.

The outbreak has led to panic buying and hoarding, but so far there are few signs that this is adding to inflationary pressures.

Tim Graf, head of macro strategy for EMEA at State Street Global Markets, urged authorities to instil “demand-focused policies to reverse the trend in (inflation) breakevens.”

He expected the ECB to act forcefully, citing “cutting rates, extending the scope for continued asset purchases, enhancing the terms of the TLTROs, adjusting tiering parameters to ease the pain for banks”.

Reporting by Dhara Ranasinghe, editing by Larry King, William Maclean

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