Inflation expectations in the euro area have collapsed. At one point, the market was only expecting inflation of just over 1.5% in a year's time – well below the ECB's inflation target. However, this was probably only a brief excursion into such low territory. In the past few days, expectations have corrected again, and in a year's time, inflation is now expected to be around the level seen at the end of August, Commerzbank’s FX analyst Michael Pfister notes.

Real economy is the key factor for further interest rate cuts

“Correction is likely to be driven mainly by the sharp rise in the price of oil. Last week, the price of oil rose by almost $8 per barrel on the back of rising geopolitical tensions in the Middle East, which explains the rise in inflation expectations quite well. The link is also understandable: when the oil price rises, so does inflation. And now the oil price is roughly back to the level seen at the end of August.”

“Interest rate expectations have indeed corrected in recent days, but not during the period of the stronger oil price increase. During this period, rate expectations remained rather unchanged. Rate expectations only corrected after Friday's surprising payrolls, after which the market priced out a rate cut of around 25 bps. However, this tends to affect the long end; for the next 2-4 meetings, a rate cut at each meeting seems to remain the base case.”

“Inflation expectations did not rise due to the payrolls, but were driven by the oil price. At the same time, interest rate expectations were not corrected due to higher inflation expectations, but only due to the US payrolls. The market now seems to have fully bought into the story that the real economy, rather than inflation, is the key factor for further interest rate cuts.”