What does the chart show?

The chart shows the German 10-year inflation breakeven rate, derived from the difference between conventional nominal and inflation adjusted government bond yields of the same maturity. Its value indicates what market participants expect inflation to average annually over the next 10 years. It is coined the breakeven rate as it refers to the average level of inflation that would need to be achieved to make an investor indifferent from buying an inflation linked bond or a nominal bond. If you think inflation will exceed this breakeven rate over the period, buy the inflation linked bond; if you think inflation will fail to hit this level, buy the nominal bond. Germany’s 10-year breakeven rate has risen materially in recent weeks amidst soaring commodity prices leading to further rises in inflation expectations. The rate has recently surged as much as 43 basis points since the beginning of March to an all-time high of 2.62%, in a sign that investors are moving to price in higher, persistent inflation for the years ahead.

Why is this important?

Prior to events in Ukraine, the ECB had been widely expected to draw back stimulus at a faster pace in an attempt to tame inflation – with the Euro Area flash CPI print for February coming in at 5.8%, its highest level since the formation of the single currency. Now, Russia’s invasion of Ukraine has unleashed significant uncertainty since the EU relies on Russia for some 40% of its gas supplies. In the last few days the EU has committed to cut Russian gas imports by two-thirds within a year, and we have also seen the US and UK move to ban Russian oil imports. Energy prices are a key component of inflation baskets and thus these developments are expected to push inflation sharply and rapidly higher. These risks surrounding higher energy prices are unlikely to dissipate in the short term and remain a threat to short-term market stability. The ECB is now widely expected to keep its monetary policy settings unchanged at its March meeting (which will have been announced by the time this note is published) a 180-degree turn since its shift to a more hawkish stance at the February meeting. With the price of oil and gas soaring in a very short space of time, economies have little time to react to absorb those jumps and its impact on consumer spending and confidence could instead tip economies into recession and prove to be deflationary over the long-term. Who would want to be a central banker now?!