Dam breaks in Europe as deflation fears wash over ECB rhetoric

‘We are reaching the end game in Europe. If they don’t launch real QE soon, the consequences are too awful to contemplate,’ warns RBS

A key gauge of deflation risk in Europe is flashing red, dropping to record lows on fears of fresh recession and lack of decisive action by the European Central Bank.

The sudden lurch downwards came as Bank of America warned that France’s debt ratio could rocket to 120pc of GDP within five years, unless the EU authorities take radical steps to reflate the region’s economy. Italy’s debt could threaten 150pc even earlier.

The 5-year/5-year forward swap rate monitored closely by traders plummeted beneath 1.77pc on Friday morning as a global growth scare drove European stock markets to a 12-month low.

“This rate is the most important market signal on the planet right now. Everybody is watching the chart, and it has just gone off a cliff,” said Andrew Roberts, credit chief at RBS.

Bond markets echoed the refrain, with yields on 10-year German Bunds falling to an all-time low of 0.88pc on flight to safety, though the bond rally can also be seen as a bet by traders that the ECB will soon be forced to launch full-blown quantitative easing.

Mario Draghi, the ECB’s president, has adopted the 5Y/5Y rate as the bank’s policy lodestar, used to distill expectations of future inflation. Any fall below 2pc is deemed a risk that expectations are becoming “unhinged” and could lead to a Japanese-style deflation trap.

Mr Roberts said the ECB’s plan for asset purchases – or “QE-lite” – does not yet add up to a coherent strategy. “We don’t think they can boost their balance sheet by more than €165bn over the next two years by buying asset-backed securities (ABS) and covered bonds together, given the haircut effects. The sums are trivial,” he said.

RBS estimates that the inflation rate has already dropped to below 0.1pc in the eurozone if one-off tax rises and fees are stripped out, and this measure may turn negative in October. “Deflation is already knocking on the door. We think it could happen as soon as next month given the latest fall in food prices,” said Mr Roberts.

“We are reaching the end game in Europe. If they don’t launch real QE and start reflation by the end of the year or soon after, the consequences are too awful to contemplate,” he said.

It remains far from clear what the ECB intends to do. On Thursday, Mr Draghi vowed “new measures” to head off deflation if necessary, but traders are looking past the rhetoric for hard facts. The ECB’s balance sheet contracted by €10bn last week, falling back to levels of early July. Mr Draghi has yet to flesh out his vague plan to boost it by €1 trillion.

Germany’s five economic institutes – or Wise Men – said the ECB’s asset purchases will add “hardly any” extra stimulus to the real economy and may be unworkable in any case. They said there are not enough private securities that can plausibly be bought, and noted that a previous scheme to buy €40bn of covered bonds had run into the ground.

Analysts are watching German politics just as closely as ECB language. The rise of Germany’s AfD anti-euro party raises the political bar even further for full-fledged QE, and eurosceptics have announced their intention to file cases at the German constitutional court to block asset purchases once they begin.

Full article: Dam breaks in Europe as deflation fears wash over ECB rhetoric (The Telegraph)

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