With the price of oil falling over 50% in the past six months, the Eurozone was going to be under serious threat of moving in to outright deflation as year on year prices of energy products have been slashed. The German inflation data on Monday hinted at a significant fall in Eurozone inflation on Monday. Today, the HICP (Harmonised Index of Consumer Prices) for the Eurozone and the data revealed that the flash reading for December showed a decline of 0.2%. The Eurozone is officially in deflation.
The data was lower than the consensus had forecast (at -0.1%) and the interesting reaction would always be on the euro. After an initial (and slightly confusing) 20 pip rally on EUR/USD the rate has subsequently taken on more of an obvious negative slant.
The worse than expected negative inflation figure will put pressure on the ECB to act through further monetary easing. This appears set to be manifested in full blown QE. In an interview at the weekend with a German newspaper, Handelsblatt, Mario Draghi noted that the ECB staff have been told to prepare for further easing mechanisms. The President of the Bundesbank, Jens Weidmann, remains a significant barrier to QE and it remains to be seen if he will continue his staunch obstruction of sovereign debt purchases. These is also an excuse to add to the mix, with the oil price decline largely behind the dip into deflation. If you look at the core inflation data which strips out energy prices, inflation actually increased to +0.8% which was higher than the +0.6% expected and also up from last month’s +0.7%. Will this be the excuse that sees the ECB hold off on pulling the trigger?
There is though another stumbling block for the ECB, and that is the judgement on the legality of the European Stability Mechanism (ESM) by the European Court of Justice which is due next Wednesday. The judgement will rule on the legality of the European Central Bank to conduct open market operations and if it passes then it effectively clears the decks for the ECB to engage QE. Draghi was at pains to suggest in the last ECB meeting that the ECB would be breaking the law if it did not act to enable price stability. The ECB is very close to QE now. If not this month then surely at the next meeting on 5th March.
One look at EUR/USD though would suggest that the market is increasingly pricing in QE now. Since trading resumed in earnest following the New Year break, the euro has lost almost 300 pips. Crucially also, the euro has also fallen below the June 2010 floor at $1.1875. This has taken the single currency to a new 9 year low since February 2006.
Additionally, the yield on the German 10 year Bund fell below 0.5% this week. Looking at the yield curve of German government debt shows that the 5 year Bobl yield has dropped to 0.0% and the yield curve has significantly flattened over the past month.
The markets are certainly preparing for the announcement of full blown quantitative easing. The interesting move will come if Draghi jawbones for another meeting, or if he is free to fire the bazooka.