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Analysis-On inflation, central bankers shouldn’t take market’s word for it

By Francesco Canepa and Balazs Koranyi

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Analysis-On inflation, central bankers shouldn't take market's word for it
© Reuters. FILE PHOTO: Bank notes of different currencies, including Euro, U.S. Dollar, Turkish Lira or Brazilian Reais, are photographed in Frankfurt, Germany, in this illustration picture taken May 7, 2017. REUTERS/Kai Pfaffenbach/Illustration

By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) – Investors are pricing in the briskest inflation rates in decades for the United States and the euro zone but central bankers may be well advised to take that with a pinch of salt given flaws in the indicator.

The so-called five-year/five-year forward gauge of market inflation expectations – or 5y5y for short – has hit 2% in the euro zone and its U.S. counterpart is even above that threshold, which is the Federal Reserve’s and the European Central Bank’s goal.

So should both central banks just declare victory and begin raising rates?

Not so fast.

Both indicators, which roughly measure how much compensation investors demand to take on inflation risk over a 10 year period, are marred by flaws.

For starters they have a poor track record of predicting inflation while they have an uncanny correlation with movements in oil prices.

This beats economic logic since one measure is the price of a barrel of crude to be delivered in short order while the other is a long-term rate of change in overall prices.

The correlation may have to do with the internal working of financial markets, where some investors use inflation-linked products to hedge other trades.

“Would the 5y-5y be a good predictor of future realised inflation? I don’t think so because it correlates to oil futures, which are bad predictors,” said Ilia Bouchouev, a managing partner at Pentathlon Investments and a lecturer at New York University.

His firm belongs to a niche of hedge funds that seek to exploit that correlation by simultaneously trading oil futures and inflation swaps when their price diverge.

In addition, the low trading volumes in the swap contracts underpinning the European 5y5y mean a relatively small number of traders can influence its price, which can also be distorted by general market turbulence.

The ECB has long been aware of these and other limitations.

It warned as early as 2006 that the inflation swaps “should not be interpreted as direct market expectations of future inflation rates” and concluded last summer that “market imperfections” accounted for 30 basis points in a 100 basis points fall in the 5y5y since 2008.

The U.S. 5y5y was no better. Unlike its euro zone peer, it is based on the so-called breakeven rate – the spread between the yield on inflation-linked Treasury bonds and their nominal counterparts.

With the Federal Reserve owning almost a quarter of the Treasury Inflation-Protected Security (TIPS) market and over a fifth of the underlying Treasuries, some investors feel that the 5y5y was losing importance as an indicator.

“Pricing on breakevens to some extent is somewhat controlled which to me implies it’s an imperfect mechanism to either get a gauge of what true market inflation expectations are or indeed to perfectly hedge against inflation,” Sonal Desai, chief investment officer of the Franklin Templeton Fixed Income Group, said in a corporate podcast.

(GRAPHIC: Oil price and the ECB’s favourite gauge of inflation expectations – https://fingfx.thomsonreuters.com/gfx/mkt/egvbkmrqdpq/euro%205y5y%20vs%20Brent.png)

ROD FOR OWN BACK

Central bankers have made a rod for their own back.

In 2014, then ECB President Mario Draghi unleashed the market’s obsession with the euro zone’s 5y5y by elevating it as the central bank’s favourite measure of inflation expectations in a speech paving the ground for a massive bond-buying plan.

This may have contributed to the 5y5y own demise based on Goodhart’s law.

This law, named after British economist and former Bank of England policymaker Charles Goodhart and later reformulated by anthropologist Marilyn Strathern, stipulates that when a measure becomes a target, it ceases to be a good measure.

The ECB’s chief economist Philip Lane and fellow board member Isabel Schnabel have already started complementing the 5y5y with the probability, implied in option prices, of inflation coming in within certain ranges.

Old-fashioned forecasts by flesh-and-bone economists were also getting mentions by policymakers.

According to a Reuters poll, euro zone inflation was likely to come in at 1.8% next year and 1.6% in 2023 and 1.6% in 2024 – still not meeting the condition for the ECB to raise its interest rates, which is that price growth is seen stably at 2%.

The Fed, for its part, has even created an Index of Common Inflation Expectations that merges surveys and market prices.

Yet both ECB President Christine Lagarde and Fed chair Jerome Powell regularly cite market-based expectations, indicating their continued relevance.

Indeed surveys may be insulated from market turbulence but they also have their drawbacks, such as a limited sample size and relative infrequency.

“In the end all indicators have limitations so we go with the preponderance of evidence,” Fritzi Koehler-Geib, chief economist at German state bank KfW, said.

Economy

RCB Bank Cyprus latest news: Bank will stop providing banking services to its clients from October 8

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rcb bank cyprus latest news

RCB Bank Cyprus latest news: As of October 8, the bank will cease to provide banking services to its customers. The bank has warned its customers that within two months it will close their accounts. The last day of banking services – October 7, 2022.

In March, RCB Bank, which had close ties with clients from Russia, said it would give up its banking license and transform itself into a management company. In an agreement with the ECB, it stopped attracting new clients.

RCB Bank news today

The bank was planning to negotiate with clients whose liabilities mature after June 2022 about the terms of early repayment with payment of the full amount of the deposit and interest for the period during which the amount was held by the bank.

After all liabilities were fully repaid, RCB planned to transform itself into an asset management company, which would continue to manage the remaining loan portfolio and specialize in providing other services.

At the end of 2020, it had €2.75 billion in deposits, of which €769 million came from retail customers. The Cypriot bank had a combined loan portfolio of 3.5 billion euros. The bank indicated in reports that the most part of the credits were given to organizations which work in Russia and CIS countries.

RCB said in June that it had sold a portfolio of corporate loans worth €356 million to Hellenic Bank. The sale of the loan portfolio will strengthen RCB Bank’s capital and liquidity reserves and create additional reserves that will enable the bank to meet its obligations to all of its clients in full. It was expected that the bank would get more than 500 million euros from the deal.

Earlier we reported that Markets get restless ahead of weekend.

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Economy

Stainless steel market news: EC to impose five-year duties on stainless steel from Russia and Turkey

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stainless steel market

Stainless steel market news: The European Commission, after completing an anti-dumping investigation that covered the period from January 1 to December 31, 2020, decided to impose duties on the supply of corrosion-resistant steel from Russia and Turkey, says the materials EC. 

How will the situation affect steel market prices? 

The investigation was carried out at the request of the European Association of the Steel Industry (Eurofer). The subject of the investigation was rolled steel with galvanized, magnesium, and aluminum coatings. Transformers and high-speed steel were not included in the investigation.

The anti-dumping duty on steel from Magnitogorsk Iron and Steel Works is 36.6%; from Novolipetsk Steel – 10.3%; from Severstal – 31.3% and from all other mills – 37.4%.

For the Turkish asset MMK (MMK Metalurji) the duty is 10.5%; for other Turkish steel producers – from 2.4% to 11%.

Imports of corrosion-resistant steel from Russia and Turkey increased more than fivefold – from 196,643 tons in 2017 to more than 1 million tons during the investigation period; the share of such metal from these countries increased from 2.2% to 13.1%. At the same time, the EC draws attention to the materials to implement supplies at prices below the average market prices in the EU.

The European Commission recalls that the sanctions imposed against Russia affect the supply of steel products in the region or directly to companies producing and exporting metal during the investigation, and since mid-March a complete ban on the supply of stainless steel to the EU was introduced.

Earlier we reported that Germany’s economic outlook for the second half of the year has deteriorated significantly.

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Economy

German Ministry of Economics news: Economic outlook for the second half of the year significantly worsened

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German Ministry of Economics

German Ministry of Economics news: The ministry said in its monthly report published this Friday that the economy is facing a “considerably worsened outlook” in the second half of the year due to shrinking gas supplies, rising energy prices, supply chain problems, and general uncertainty.

Despite the gloomy economic outlook, Germany’s 10-year bond yield, the benchmark for the eurozone, rose above 1% for the first time since July 28.

Meanwhile, money markets continue to price in a 100% chance of a 50bp rate hike in September.

Now, EUR/USD is trading at 1.0296, down 0.19% for the day.

Earlier we reported that Chip makers fear worst recession in a decade.

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