ECB failing its' mandate

Yesterday's German inflation data release gave a clue to what will happen to German inflation in the next few months.

Although the German headline and core inflation rates are published, there is no breakdown of the inflation of the components of the basket of goods and services. North West-Westphalia (NRW), the most populous German state, does however provide a breakdown of the inflation basket, and unsurprisingly the data is highly correlated to that of Germany (my data goes back to Dec 2003). So for the purpose of the analysis below, I utilises the NRW data.

Chart below shows the sharp decline in headline inflation to 0.8%yoy in April, which was predominantly due to the decline in Energy inflation. However there was also a decline in core inflation to 1.1% yoy, touching the floor of the 2017-2019 range.

The percentage of the basket in outright deflation rose to 31%, with a further 33% with inflation below 1%. Whilst a large part of this is due to Transport (-2.9%yoy, 13% basket weighting), Clothing/Shoes, Communication and Entertainment/Leisure are all in outright deflation. The counter trend is Food inflation that has risen - something that has been seen in other countries as a result of hoarding for Covid19 lockdowns.

INFLATION TREND GOING FORWARD:

ASSUMING NO CHANGE IN OIL PRICES, the reduction in energy prices will further increase the deflation of components impacted by oil prices in the months ahead.

The bottom two charts show how the energy impacted components are likely to drag the headline inflation rate negative, just as they did in 2009 when there was a similar percentage decrease in oil prices. That will mean revert back upwards in a year's time.

More importantly is the likely delayed move lower in core inflation (red/green below) due to economic weakness - in 2010 this necessitated a continuation of extremely loose policy by the ECB.

The upcoming decline in core German inflation is likely to be led by a drop in Choice inflation (Discretionary items) due to weak consumer demand.

Germany is the most robust European country, and its' inflation rate has the largest weight in the Euro HICP basket. Like in previous economic downturns of the Euro area, other countries will probably experience even weaker core inflation data. Coming into the Covid19 pandemic, most were already experiencing lower core rates of inflation (especially Fra, Ita and Spa).

SPOT AND FORWARD INFLATION MARKETS

The spot inflation swaps curve is negative -0.47% at the very front end, rising to 0.65% for 10 year inflation swaps (left chart, green line). The 1yr forward curve (left chart black line), which shows what the market forecasts the annual inflation rate to be in the future, expects inflation to remain below 1% for the next 8 years, despite the extremely loose ECB monetary policy.

To put this into context, the right hand chart compares the current 1yr forward rate with other episodes of low inflation, namely Sep10 and Jun16. In both those instances medium term inflation expectations remained above 1.5%, despite the low immediate inflation rate at the time. The same was true at the beginning of last year. The sizeable shift down in medium term inflation expectations to current medium term expectations clearly demonstrates that the market has lost faith in the ECB to fulfill its inflation mandate.....

If the inflation market is correct, and note that inflation market is a mathematical carry market that cannot be influenced by Central Banks (unlike real yields, credit spreads etc), then market participants should expect either far more expansive monetary policy that currently predicted, or failing which, a readjustment lower for profit margin expectations on the realisation that price inflation will be very low for a significant amount of time. This has obvious huge implications for fixed income, credit and equity valuations, as well for ALM portfolios.