ECB Rate Hike Bets Are Losing Out to Still-Dim Inflation Outlook

(Bloomberg) -- Traders have a ways to go before they close the gap between their lofty rate-hike bets and the muted outlook for inflation in the euro area.

The market is now pricing in a 10-basis-point increase to the European Central Bank’s deposit rate in around three year’s time, just a third of what was expected in May. 

But forward-looking gauges show consumer-price gains will still fall short of the ECB’s target by then, which suggests expectations for any tightening will have to be pushed back even further.

“Either the market is still underpricing inflation or it is still pricing lift-off too early -- or both,” said Christoph Rieger, head of fixed-rate strategy at Commerzbank AG.

President Christine Lagarde said last month that rates wouldn’t rise until inflation of 2% comes sustainably into sight. The shift in forward guidance carries even more weight now that a surge in coronavirus cases threatens the recovery from the pandemic. 

The market move is particularly jarring considering that, in December, a 10-basis-point cut was priced in for early 2022 -- a sign of how engrossed the market became with the prospect of an economic rebound.

“The recent repricing is probably due to the gradual adjustment of monetary policy expectations to the more dovish “forecast-based” forward guidance,” wrote Giuseppe Maraffino, a strategist at Barclays Plc. 

While consumer-price gains jumped to 2.2% in July, the fastest pace since 2018, ECB policy makers have taken pains to stress the increase is transitory. Swaps show inflation will be running below 1.7% in 2024.

The central bank is likely to wait “more than the good three years that are currently discounted in the Eonia curve,” before it raises borrowing costs, Commerzbank’s Rieger said.

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