EUR Inflation & Rates Expectations Diverge

With the ECB still maintaining the official line that the current inflation shock will prove largely transitory - increasingly diverging from the Fed and BoE - markets have started to pare back tightening expectations as reflected by the recent downward shift in the EUR OIS curve.

• Nonetheless markets continue to project a sustained rise in inflation over the medium term with the EUR 5y5y forward inflation swap - one of former ECB President Mario Draghi's key indicators to watch - still holding close to 2%.
• There is now quite a significant divergence between inflation pricing and expectations for policy rates, as reflected in the chart below showing the EUR 5y5y forward inflation swap alongside EUR 5y1y forwards.
• Compared to the Fed and BoE, the ECB appears far more scarred by the previous prolonged battle against lowflation and is more concerned about the risks of premature tightening. The ECB's recently reformulated monetary policy strategy also stresses that deviations of inflation above the target will be tolerated in the same way as deviations below. These factors could perhaps explain some of this divergence. However, a more pessimistic interpretation is that the ECB may have less scope to raise policy rates in the face of higher inflation given the scale of indebtedness across the euro area and threat to the economic recovery from renewed lockdowns.