European Inflation Wagers Are on the Cusp of Eclipsing U.S. Bets

(Bloomberg) -- A once-unthinkable trade, that European inflation will outpace the rate in U.S. over the next decade, could be about to pay off.

Market-based inflation expectations in Europe are on the verge of exceeding those in the U.S. for the first time since 2009. Strategists at UBS Group AG and Citigroup Inc. are recommending trades that will profit if they keep surging.

In contrast, investors including Nomura Asset Management are betting on a decline in U.S. inflation expectations, emboldened by forecasts that consumer price increases there may be peaking. 

The moves underscore the outsized impact the war in Ukraine has had on the region. A potential ban on energy exports from Russia -- from which the EU gets 40% of its gas -- threatens to fan already record inflation, upending a dynamic that has kept interest rates in the euro area anchored below zero.

“Peak inflation in Europe is still ahead of us and the uncertainty around oil/gas embargo lingers on,” according to UBS strategists including Rohan Khanna. He expects 10-year euro-area inflation swaps to rise further, saying they could even exceed the U.S. rate. 

Swaps linked to the direction of the euro area’s Harmonised Index of Consumer Prices (HICP) over the next decade are trading around 3.1%, compared to 3.2% in a similar U.S. contract.

It’s an uncomfortable situation for the European Central Bank, which has to balance the need to curb inflation with threats to economic growth that could warrant more stimulus.

Despite a recent hawkish tilt from policy makers, the ECB is seen trailing the Federal Reserve in raising interest rates. Markets are now pricing three quarter-point rate hikes in 2022 starting in the third quarter, which would take the ECB’s deposit rate to 0.25%. 

They see the Federal Reserve, which already delivered a hike in March, raising rates three times as much over over the same time span, bringing the funds rate to a range of 2.50% to 2.75%.

Monetary Divergence

The divergence is weighing on the euro, which tumbled to a two-year low against the dollar earlier this month, potentially spurring more inflation. Euro-area inflation data was revised slightly lower on Thursday, to an annual 7.4%, nearly four times the 2% goal.

In some longer tenors, the market’s projections for European inflation are already edging ahead of U.S. expectations. The rate on 30-year HICP swaps are trading around 2.83%, compared with 2.81% in the U.S. equivalent.

Meanwhile, three-year European HICP swap rates should be driven higher by further upside surprises in inflation prints, an uncertain trajectory for food prices and a potential increase in wages, according to Antoine Gaveau, a strategist at Citi. 

The bank is targeting a move to 4.29% in a popular contract linked to an inflation index that excludes tobacco, from levels just below 4%.

Anxiety about the inflation outlook is also running high in the U.S., with one bond-market gauge of long-run inflation expectations reaching its highest in about a year this month. But given fallout from the war in Ukraine and the risk of a Russian energy embargo, the market’s attention is increasingly focused on the trajectory in Europe.

“If a full embargo is enacted, 2022 will flip from being a difficult year to a brutal one for the euro area,” said BMO Capital Markets strategists including Stephen Gallo.

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