Euro zone inflation expectations hit seven-month high

LONDON (Reuters) - Investor expectations for long-term inflation in the euro zone rose to a seven-month high on Tuesday, an encouraging sign for the European Central Bank as it prepares to step back from its extraordinary monetary stimulus.

A picture illustration shows Euro banknotes in Zenica January 26, 2015. REUTERS/Dado Ruvic

Strong business and bank lending surveys on Tuesday provided more evidence the ECB is likely to announce at its meeting on Thursday that it will cut back its monthly bond purchases.

Europe's benchmark German 10-year bond yield, sensitive to changes in inflation expectations, rose 4 basis points to its highest in nearly three weeks at 0.48 percent DE10YT=TWEB.

All other euro zone yields were 2 to 5 bps higher on the day. U.S. Treasury yields US10YT=RR hit their highest in over five months.

The five-year, five-year breakeven forward rate, a euro zone inflation measure closely tracked by the ECB, rose to 1.6571 percent EUIL5YF5Y=R, the highest since March.

That is still below the ECB’s inflation target of just under 2 percent, but up from lows around 1.50 percent set in June.

“Inflation (expectations) had some bearing on the market, but how much is it going to affect the ECB meeting?” said Antoine Bouvet, a rates strategist at Mizuho.

“The ECB has come to terms with the fact the economy is moving in the right direction ... as seen with the PMI data this morning,” he added.

The ECB faces technical constraints in its asset-purchase scheme and is looking for signs of both stronger growth and inflation to start scaling back its 2.3 trillion-euro asset- purchase programme.

Recent indications from policymakers have fanned speculation it will opt for a reduction in monthly asset purchases to 30 billion euros from 60 billion euros from January for nine months.

“The ECB is signalling that it will do all that’s needed to push inflation higher and an expectation of a soft exit from its stimulus scheme is also supporting inflation expectations,” said Commerzbank strategist Rainer Guntermann, referring to business activity surveys.

There are some other encouraging signs.

The euro has weakened almost 3 percent from recent 2 1/2- year highs above $1.20 EUR=. However, the five-year, five-year forward rate was creeping higher before that, in defiance of euro strength.

Data earlier this month showed prices at the factory gate in the euro zone rose a stronger-than-expected 2.5 percent year-on-year in August.

Jonathan Baltora, a portfolio manager at AXA Investment Managers, said a rise in oil prices in recent months was a key reason for the pick-up in inflation expectations.

Oil prices, a key component of inflation indexes, have risen about 30 percent from 2017 lows hit in June. LCOc1

“I think that the ECB is going to welcome the move,” said Baltora, referring to the pick up in market inflation expectations.

“Euro zone inflation had flirted with zero in the past two years, but if you look at core inflation that is now rising and we think it will continue to rise.”

Additional reporting by Fanny Potkin; Graphic by Ritvik Carvalho; Editing by Pritha Sarkar, Larry King