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Longtime macro disaster tourists eurozone-watchers will know that one of the thorniest problems Europe faced in the post-financial crisis decade was unanchored inflation expectations — on the downside.
No matter how desperately the ECB tried to reflate the eurozone, inflation expectations — as measured by the “break-even” rate differential between inflation-proofed and conventional government bonds — kept sagging. “Japanification” was all everyone talked about. Even several years of negative interest rates, started in large part in a desperate attempt to change the narrative, did zip.
But check out this Morgan Stanley chart:
That inflation break-even rates have jumped everywhere is natural, given what actual inflation has done. But the 10-year German break-even rate — a decent proxy for long term expectations for the eurozone as a whole — has shot up above the US rate for the first time since 2009.
As Morgan Stanley’s Andrew Sheets said in a note on some current market narratives yesterday evening (his emphasis below):
. . . the eurozone may now have a more lasting inflation problem: Again, price has been very supportive of this story. Both yields and inflation expectations have jumped; Germany 10-year inflation break-evens are now ~20bp higher than in the US, the largest such gap since 2009.
Inflation in the eurozone is high, with upside surprises this week, leading our economists to add another expected hike. But again, this narrative is facing an interesting near-term test: The cost of energy continues to fall, while all prices are about to lap the one-year anniversary of Russia’s invasion of Ukraine. As the calendar flips from February to March, year-on-year data will get very noisy.
Last March, the average month-ahead price of EU gas (TTF) was ~€128/MWh. It is currently €47/MWh, 63% lower. Assuming current prices hold, year-on-year declines get larger as we move further into the year, one reason why we forecast inflation to moderate — significantly — over the course of 2023.
Eurozone inflation could be more persistent. But take a step back and consider just how much confidence the market used to have in the other direction. Have all those structural drivers of lower growth and inflation really gone away? If they have, eurozone banks, at ~8x earnings and a ~5% yield, could still have significant upside. If they haven’t, market expectations that inflation will be higher in Germany than the US over the next decade look vulnerable.
To be honest, we’re inclined to agree with Sheets. It’s hard to see how inflation can become entrenched in Europe given ~gestures helplessly at everything and anything~ well, you know.
But to be honest, not so long ago it looked unlikely that European break-evens ever jump over US ones in our lifetimes. So who knows?
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