David Roberts

Are we wasting energy by looking for eurozone inflation?

David Roberts

The third week of each month used to be one that bond managers cared about. Traditionally, it was the time most G7 governments released monthly inflation data. And the bond market used to care about inflation – actually, I’d argue the bond market does still care about inflation, it’s just those famous bond vigilantes have been beaten into submission by a decade of central bank ZIRP (zero interest rate policy) and QE (quantitative easing) inspired market manipulation. For those buying the average G7 government bond, on the odd occasion the yield is positive, chances are it will be deeply negative in real terms once inflation is taken into account. As I’ve said many times before, those lending to G7 sovereign states are doing so way below any economically sensible rate.

Last week, the third of 2021, the European Central Bank (ECB) released inflation data that singularly underwhelmed the market. Although consumer prices did nudge up a little (headline numbers up 0.3% on the month), over one year, prices fell by 0.3%. This is not great, and on the face of it enough to have the mandarins of Frankfurt reaching for the big red button marked “buy more bonds”.

But wait! Let’s remember we are in the teeth of a global pandemic which, amongst other things, has led to a collapse in consumer spending: taking a few basis points off 10 year bund rates really won’t alter that much (although ECB staff academics might argue the point with me).

Never mind consumption though, one of the most volatile parts of the global market has been the energy sector. Remember, a year ago we all got excited as oil appeared to trade with a negative price?

Well that collapse in energy continues to have a direct impact on eurozone inflation. Take a look at the chart from Pantheon Macroeconomics below. The green bars indicate how falling energy prices have dragged down overall inflation, significantly.

Eurozone Consumer Price Index components (% year-on-year contribution)

Eurozone Consumer Price Index components

Source: Pantheon Macroeconomics, 20.01.2021.

For almost a year, energy prices in Europe have been deeply negative. Adding to low oil and gas tariffs, the euro has also strengthened against the US dollar; with most energy contracts priced in dollars, that has added to the downward pressure. Even now, with oil back above $50 per barrel, first-order energy prices still knock around 0.7% off eurozone inflation (the green bar in the chart above, making a negative contribution since early 2020).

First-order effect is market code for the direct data impact of an event such as the price fall of a barrel of oil. Another way falling energy impacts inflation is as a production input for other goods: a second-order effect. Low and behold the cost of goods produced has also just turned negative – that’s the orange bar – so the impact of those lower energy prices is even greater.

Think back to 2018 and 2019. We were told repeatedly by the ECB that the spike in the Consumer Price Index (CPI) we saw then was caused by rising oil prices and was “transitory” and “not something we can control by raising interest rates”. That rhetoric was part of a decade plus of ECB QE market manipulation. Perhaps, we’ll now hear from European monetary policy setters that they remain “concerned” and “surprised” at the low level of inflation and need again to address it by buying more German, French and Italian government bonds.

I’m not concerned, nor am I surprised. We are sticking with our conviction and maintaining our low duration exposure in our funds. However, many in the bond market will follow the ECB lead and buy bonds, despite the lack of logic that involves.

Of course, now that oil and energy prices in general have recovered, many estimate that in a couple of months’ time they will be making a major positive contribution to eurozone inflation. The following indicates April to be the likely peak. If that happens just at the time consumers are freed from the shackles of Covid-19 lockdown, the Consumer Price Index (CPI) might move materially higher. However, I’m sure the ECB will dismiss it and find a way to convince us all to add more Bunds to our portfolios at a yield of -0.70%.

Eurozone Consumer Price Index Energy

Source: Pantheon Macroeconomics, 20.01.2021.

As they say in Frankfurt:

  • High oil prices, inflation rises: “nothing we can do about it”
  • Low oil prices, inflation falling: “worrisome, concerning, let’s cut rates”

Energy price volatility proves central banks can have their cake and eat it…

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Thursday, January 28, 2021, 12:26 PM