Internal Merrill Lynch Research Memo on Eurozone Inflation Expectations

Best Inflation Trades Mark Capleton David Beker MLI (UK) Merrill Lynch (Brazil) mark.capleton@baml.com david.beker@baml.com Sebastien Cross Athanasios Vamvakidis MLI (UK) MLI (UK) sebastien.cross@baml.com athanasios.vamvakidis@baml.com Inflation party starting but Eurozone not invited « Eurozone breakevens have benefited from US move, but we see its sub-target problem becoming more entrenched. Sell OATei 2047 vs OAT 2066 « FX pass-through considerations and the prospect of firmer oil prices and leave us favoring breakevens in Thailand and Mexico. » We expect inflation divergence in G10 economies. Our analysis of inflation and deflation risks support buying USD/JPY and selling CHF/SEK. Rising Eurozone breakevens - the triumph of hope over experience? The rally in Eurozone breakevens and inflation swaps looks mild compared with the recent US experience, for obvious reasons, but it has still been meaningful. The widely followed 5y5y has rallied from a 1.25% low to 1.58% and the 10y20y forward rate is at 1.96% (which qualifies as meeting the ECB’s ‘below but close to 2%’, we’d say, albeit without the inflation risk premium we were used to in the past). It is hard to argue with what looks like a beta-weighted response to the US move, perhaps. After all, there is a global component to inflation and if the US is driving that now, then Eurozone inflation expectations should firm, it can be argued. And if we are in for a Reaganomics-style fiscal stimulus, then it is quite possible that we will get the dollar strength associated with that experience; if so, the Eurozone might get to import a little inflation by being on the other side of that currency move. However, we are somewhat troubled by the fact that the inflation options market has priced out the risk of deflation almost completely (Chart 24). Has that threat really been extinguished? Yes, inflation expectations have risen but the rise in real yields has also tightened monetary conditions and there remains the threat that in December the ECB fails to commit to ongoing stimulus on a sufficient scale to satisfy markets that it can return inflation to target. Chart 24: Euro inflation expectations rally; long term forward at target, Chart 25: Perceived deflation risk goes; 5y ZC 0% inflation floor price, c % 120 100 80 60 40 20 0 10 11 12 13 14 15 16 Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bank of America Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 13 Merrill Lynch HOUSE_OVERSIGHT_014743