March 4, 2015 / 3:15 PM / 4 years ago

Euro zone inflation bets rise as data challenges deflation outlook

* Euro zone data has beaten expectations so far this year

* Market inflation expectations near 2015 highs

* ECB QE helping demand for inflation-linked bonds

By Emelia Sithole-Matarise

LONDON, March 4 (Reuters) - Market bets on a revival of euro zone inflation are close to their highest this year as surprisingly strong economic data and imminent European Central Bank money printing ease fears of a deflationary spiral.

Surveys on Wednesday, a day before the ECB details its quantitative easing programme intended to kick-start inflation and growth, showed euro zone business activity accelerated in the region’s four biggest economies in February, helped by price cuts and a weaker currency.

This followed strong retail sales and data showing inflation in Germany, Spain and Italy may not turn out as low as previously expected.

“The ECB’s QE package has met the market’s confidence test of ‘whatever we must’ to arrest deflation pressures in the euro zone, with market inflation measures and business survey price gauges backing off from recent lows, helped by fading oil price disinflation,” G+ chief economist Lena Komileva said.

Two-year inflation swap rates, used to hedge inflation risk, have tripled to 60 basis points over the past week from 20 bps before the German prices data on Thursday, according to BNP Paribas.

They have surged from just below zero at the start of the year, before the ECB announced its trillion euro asset-buying programme which is due to start this month.

Long-term inflation expectations — as measured by the five-year, five-year breakeven forward which shows where investors expect 2025 price growth forecasts to be in 2020 — have risen 13 bps to 1.71 percent, near this year’s highs around 1.74 percent hit on Jan. 22, the day the ECB unveiled its QE plan.

“The economic statistics are blowing the lights out at the moment in Europe,” said BNP Paribas’ head of equity and derivatives strategy, Gerry Fowler, adding the gap between measures of how far economic data in the United States and the euro zone “surprises” at its widest in at least two years.

“What’s driving a decent chunk of this is the aggressive policy of the ECB in combination with a dramatically weaker euro.”

The euro has fallen by 8 percent year-to-date in anticipation of the ECB’s QE programme though the slide has been stemmed by the surprisingly upbeat economic numbers.

Economic data surprise indices compiled by HSBC and Citi show euro zone data beating expectations more often while U.S. numbers do the opposite.


The above-forecast data has lifted German bond yields 10 bps to 0.37 percent since Thursday, when yields hit a record low 0.285 percent.

While many in the bond market expect ECB bond purchases to drive down both lower-rated and core euro zone government nominal yields, BNP Paribas’ Fowler reckons the driver deeper into negative territory in real yields may spur a rotation into equity markets.

“We may just have passed the point where euro yields have troughed, at least temporarily,” he said, adding that as inflation and yields pick up through the spring, there could be an asset allocation switch to equity.

Some in the market also expressed doubts that the pace of the nascent economic recovery would be enough to achieve the ECB’s medium-term target of inflation of close to but just below 2 percent. Although the five-year five-year inflation gauge has bounced off a record low of 1.48 percent hit before the ECB QE announcement, it remains well below levels of just above 2 percent where breakeven forwards trade when inflation expectations are considered to be anchored.

“The sentiment surveys show a risk-positive change in growth direction, but will the magnitude raise economic activity to levels consistent with lasting inflation and debt-stability?” Komileva said. (Additional reporting by Mike Dolan, graphic by Francesco Canepa; Editing by Toby Chopra)

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