Euro Area Interest Rate and Inflation Expectations Diverge

Bank of America (BofA) believes that European Central Bank (ECB) interest rate and inflation expectations have diverged, creating an opportunity for traders to profit from this mismatch.

The bank noted that prices in the euro area have reached new highs since the start of the war in Iran, leading markets to price in nearly four full ECB hikes for this cycle. However, strategist Ralf Preusser argued that this move is overdone and that even with the recent surge in natural gas prices, futures markets are pricing in a scenario consistent with the ECB's base case.

The weighted average of gas and oil implied by futures remains aligned with the ECB's June base case and below its adverse scenarios. For the central bank to be pressured into doing more than the 60 basis points of cumulative hikes embedded in those forecasts, significant upside surprises to energy prices would be required.

Preusser also pointed out that the real yield curve is now steeper in forwards than the nominal curve, a setup he sees as too steep, leaving real rates looking cheap. BofA expects hikes this year to be followed by cuts next year, a view that is not priced by either curve.