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Fixed income… An unusual situation in the eurozone

23 July 2018

Unlike in the United States, eurozone growth is running out of steam (the consensus has already been revised down from 2.4% to 2.3% for 2018), while inflation is accelerating, albeit moderately, but with the trend taking it towards the ECB's target.

The initial estimate for eurozone inflation was 2% y/y in June, mainly driven by positive base effects from energy prices. Underlying inflation is still low, however (1% y/y), despite the euro's recent weakness, and has so far been only minimally impacted by the second-round effects of the rise in energy prices: we should see it return towards its long-term average (1.5%) in 2019, as wage inflation picks up. The ECB has raised its forecast for underlying inflation to 1.6% in 2019 and 1.9% in 2020, thereby indicating its confidence that inflation will move towards its target in the coming months, despite the gradual reduction in its monthly purchases. Nonetheless, it does not appear to have convinced the markets as yet: inflation expectations are lagging in terms of assessing the path for inflation going forward, which we do not think is justified. With the exception of the Italian indices, it is interesting to note the relative resilience of the markets since the start of May, given all the stress around Italy and then the escalation of the trade war rhetoric favouring a flight to quality and benefiting core inflation.

French inflation it is also accelerating, and should benefit from the rise in regulated prices (+7.45% on gas from 1 July, the biggest rise for six years). Moreover, as part of the French government's planned €5 billion cut in spending on assistance to businesses, the benefit of reduced VAT rates for certain sectors will come to an end. We estimate the potential impact of these measures as 0.25% on French inflation. Furthermore, the changes in the rules for calculating the return on regulated savings in France over recent years have dampened demand from French banks for domestic inflation, which has significantly underperformed European inflation on the inflation swap market: the spread is at its lowest level for 10 years. That makes two good reasons to favour French inflation expectations.

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