Inflation Surprises and Negative Rates

Inflation upside and volatility: Global inflation surprises continue to point to the upside, largely driven by higher commodity prices than at the start of the year and fiscal support from China helping to stabilise manufacturing data. However, this rise of inflation surprises has come at a time when bond yields are close to all-time lows and investor positioning in bond markets is getting increasingly stretched (see FX Pulse analysis). With the markets positioned for more negative rates in both the Eurozone and Japan, we as FX strategists are starting to pay more attention to risks posed should bond yields start to rise from expectations that higher inflation reduces the need for more rate cuts. Indeed, our rates strategists are positioned for this scenario via selling Bunds vs. Treasuries, which should help the case for a higher EURUSD. Historically FX volatility has followed bond volatility closely, in contrast with equity volatility, which has managed to stay relatively low despite uncertainty about global monetary policies. Our analysis shows that GBP and CAD should weaken if bond volatility rises.

Negative rates debate: Yesterday the ECB’s Mersch was discussing the lower bound in rates, suggesting that the current level of -0.4% was mildly negative and that he wouldn’t want rates to go wildly negative. While not clear what wildly means, it suggests that there are few cuts left in the ECB’s toolkit. The market is pricing 11bp by the end of 2017, suggesting that there could be repricing should global inflation continue to surprise to the upside. Note that our economists are expecting HICP to rise more next year than the inflation markets currently price, supporting our view for a higher EUR. In Japan, the leader of Abe’s coalition partner (Nataso Yamaguchi) said that negative rates have stirred confusion among financial institutions. In addition, even though Japanese companies reduced their inflation expectations in the BoJ’s quarterly survey released overnight, it has failed to stop EURJPY from breaking beyond its 50DMA. Extreme long positioning in JPY and light positioning in EUR support this trade.