Deflation Woes Stalk ECB’s Monetary-Policy Outlook: Euro Credit

By Anchalee Worrachate
Sept. 28 (Bloomberg) -- The increasing cost of insuring against deflation in Europe suggests the European Central Bank will need to cut interest rates to prevent an economic slump from exacerbating the region’s debt crisis.
In France, 10-year breakeven rates measuring how much compensation investors demand to protect against rising consumer prices are the lowest in at least eight years. A gauge of what current prices say about inflation in five years’ time, a yardstick used by central bankers, slid to a one-year low.
“Everyone seems to be worried about a recession,” said Franck Triolaire, the head of inflation trading at BNP Paribas SA in London. “Breakeven rates are falling off the cliff. The market is saying it thinks the ECB should cut rates, and my view is that it should happen as early as next month.”
The cost of buying a derivative that pays out should the price of a basket of goods cost less in a decade than it does today has climbed 23 percent since the end of June, according to data compiled by Bloomberg. The contract is headed for its first quarterly advance in four. The yield difference between 10-year French index-linked debt and securities that aren’t tied to inflation, known as the breakeven rate, fell to 1.54 percentage points on Sept. 15, the lowest since at least February 2003.

Making the Case

The ECB, whose primary job is to fight inflation, raised rates twice this year, taking its benchmark to 1.5 percent, even as spending cuts from countries such as Greece, Portugal and Ireland damped the growth outlook. The central bank will keep borrowing costs unchanged until at least the end of next year, according to a Bloomberg survey of banks and securities firms, with the most recent forecasts given the highest weightings.
“We may or may not get a rate cut in October, but my view is that an argument for it is stronger than an argument against it,” said Stephen Lewis, chief economist at Monument Securities in London. “Market indicators back that call.”
The central bank has said it sets policy in aggregate for all 330 million people in the 17 nations that share the euro --a region with a combined 9.2 trillion-euro ($12.5 trillion) economy. It has attempted to mitigate the debt crisis by providing emergency loans to banks and introducing a program in May 2010 to buy bonds issued by indebted countries, including Italy and Spain.

Change of Tune

The ECB shifted its tone at a Sept. 8 meeting when officials stopped using language that typically signals their intention to push up borrowing costs. The central bank cut its
2011 growth forecast to 1.6 percent from 1.9 percent, and to 1.3 percent from 1.7 percent for 2012. Inflation forecasts were left unchanged at 2.6 percent for 2011 and 1.7 percent for next year.
The central bank aims to keep inflation just below 2 percent.
The so-called five-year, five-year forward breakeven rate, which measures current investor expectations for inflation in the euro region from 2016 to 2021, declined to 1.986 percent on Sept. 26, the lowest in almost a year.
Data today showed France’s economy stalled in the second quarter as consumer spending plunged. Gross domestic product was unchanged from the first quarter when it rose 0.9 percent, according to the final estimate published by Paris-based statistics office Insee.
“There is enough grief in other euro countries than Germany for the ECB to feel it should be more focused on growth and the risk of financial system disintegration than inflation,” said Lewis at Monument. “I expect more liquidity boosting measures for banks next month.
ECB Governing Council member Luc Coene said Sept. 23 that the central bank may act to address risks to the economy as soon as October, should the monthly data disappoint.

Depressing Forecasts

The International Monetary Fund cut its forecasts for global growth on Sept. 20 and predicted “severe” repercussions if Europe fails to contain its debt crisis or U.S. policy makers are in deadlock over a fiscal plan. The world economy will expand 4 percent this year and next, the IMF said, down from June forecasts of 4.3 percent in 2011 and 4.5 percent in 2012.
The IMF predicts that Greece will shrink 5 percent this year and 2 percent next year, reversing a forecast of a return to growth in 2012. JPMorgan Chase & Co. chief economist Bruce Kasman said the euro area’s economy will start shrinking in the fourth quarter, and that “insolvent” Greece is headed for a depression.
Interest-rate reductions probably will weaken the euro and support regional exports, said David Owen, a managing director at Jefferies International Ltd. in London. The euro rose 8.4 percent against the dollar in the first half of this year even as the debt crisis deepened, with the ECB’s benchmark rate higher than those set by central banks in the U.S., Britain, Canada, Japan and Switzerland.
“The strength of the euro, which has partly been driven by rate differentials, is not consistent with the economic fundamentals of countries like Greece and Portugal,” Owen said.
“If the ECB cuts rates and create expectations of lower rates, the euro is likely to fall. That matters hugely for the euro zone.”