Euro Macro: After Easter volatility, core inflation back to flat trend – France and Belgium are the first two eurozone countries that have published inflation data for May. In France HICP inflation declined to 1.1% in May, down from 1.5% in April and in Belgium the non-harmonised CPI inflation rate declined to 1.9% from 2.1%. The detailed data for each of the two countries show that package holidays, airplane tickets and holiday villages had a significant downward impact on inflation after they had lifted it in April due to the timing of Easter. In France (which published a more detailed report of the main components of inflation than Belgium) this resulted in a decline in the inflation rate for the total services sector (with a weight of almost 50% in the total HICP index) from 1.0% to 0.7%. On top of that the French report shows that the inflation rate of manufactured products fell from -0.5% yoy in April to -0.6% in May, which combined with the drop in service sector inflation implies that the core inflation rate fell noticeably. Besides the decline in core inflation, food price inflation fell in both countries (in France from 2.5% to 2.3%), while energy price inflation increased in Belgium but fell in France. All in all, the data from France and Belgium are in line with our view that the jump in core inflation in the eurozone as a whole in April (to 1.3%, up from 0.8% in March) was largely due to the one-off impact of the timing of Easter and that core inflation will have drop again in May. The flash estimate for eurozone HICP inflation will be published on 4 June. We have pencilled in 0.9% for core inflation in that month.
All this means that eurozone core inflation is still very much following the sideways trend around the 1% mark that has been in place since early 2015. To put it another way, eurozone core inflation is showing no sign at all of any kind of upward trend. We expect underlying inflationary pressures to remain subdued. There is still slack in the labour market and the slowdown in economic growth suggests that the downward trend in unemployment will flatten out. Although wage growth has accelerated moderately, companies seem to have absorbed this in their margins. In addition, going forward we think companies will most likely repair margins by reducing the total wage bill (either by reducing wage growth or cutting headcount) than raising prices. This is more likely in an environment of soft demand as well as low and falling inflation expectations. Indeed, market inflation expectations as measured by the 5y5y inflation swap continue to decline and are now not too far off the record lows seen in July 2016. Over and above that, a number of structural forces seems to be dampening inflationary pressures globally, including technological progress, globalisation and weaker employee bargaining power. We continue to take the view that the ECB’s inflation forecasts will prove too optimistic. At the same time, inflation expectations look to be dislodged. As a result, the odds that the ECB will need to adopt a more aggressive monetary stimulus continue to build. (Aline Schuiling & Nick Kounis)
US Rates: Downward pressure on yields to persist in the near-term – US bond markets have seen some aggressive moves in recent days, with 10y yields falling 20bp over the past week to the lowest level since September 2017. The renewed downshift in yields started in early May following the unexpected re-escalation of the trade war, and has intensified over the past week as investors see little sign of any near-term resolution to the dispute. As a base case, we see some kind of truce announced at the G20 summit on 28-29 June, delaying further tariff implementation while talks continue between the US and China to forge a deal, although our conviction level on this is low. In the meantime, downward pressure on yields is likely to persist. The breakdown of the fall in yields suggests increased Fed rate cut expectations have been the primary driver, with safe haven demand likely explaining the remainder of the move. Rate cut expectations to end-2019 have moved from 15bp of cuts priced on 3 May to 36bp priced as of today (a 21bp move); over the same timeframe, the 10y yield has fallen 30bp while the 2y yield has fallen 26bp. We continue to think Fed rate cuts are unlikely on our forecast horizon to end-2020, meaning much of this move could unwind if a truce is announced. However, should the currently threatened tariffs be implemented more quickly (as soon as the end of June), the risk then is of a further escalation, eg. a raising of tariff rates, which would then pose significant risks to the growth outlook – and in turn, potentially prompt a Fed rate cut. (Bill Diviney)