By Mike Bird and Paul Hannon
Eurozone consumer prices rose at the fastest annual rate in more than three years in December, an encouraging development for the European Central Bank but one that could bode big changes for markets that have long been shaped by its stimulus.
Driven primarily by more costly oil, consumer prices rose by 1.1% in December from a year earlier, the fastest rate of growth since September 2013, according to official statistics released Wednesday.
That increase is still below the European Central Bank's inflation target of close to 2%, but well above the 0.6% rise recorded in the year to November, and some market indicators are predicting higher prices in the future.
Even small increases in inflation could have wide-ranging effects on markets. That may be particularly so in the eurozone because inflation could push the ECB to curb its unprecedented monetary stimulus, an influence that has dominated the region's markets for three years now.
The ECB's bond-buying program, in particular, pushed bond yields to record lows and boosted regional equity markets.
"If you see inflation moving ever closer to the ECB's target, and potentially faster than expected, it will increase market expectations that they will start a proper tapering," said Mike Bell, global market strategist at J.P. Morgan Asset Management. "It clearly argues that bond yields can go higher," he added.
Consumer prices fell as recently as May, and the accelerating rise since then has allayed fears that the currency area is at risk of sliding into a long period of deflation. ECB policy makers said that turnaround explains why they have decided to cut their monthly purchases of mostly government bonds to EUR60 billion ($62.4 billion) from EUR80 billion, starting in April.
But at the same time as that decision was announced in early December, central bankers extended the program to the end of this year from March.
The main reason for their caution is that while the headline rate of inflation has picked up, the core rate -- which excludes prices of items such as energy and food that are set in world markets, and little affected by the ECB's policies -- has remained low. The core rate edged up to 0.9% in December.
Still, market measures of inflation expectations are ticking higher.
In the eurozone, the so-called 5-year, 5-year inflation swap rate reached 1.77% Wednesday, up from a low of 1.25% in the middle of last year. This derivative tracks investors' bets on what the inflation rate will be starting in five years and lasting another five. If the swap rate rises, investors expect more inflation.
Rising inflation hits debt markets particularly hard, because it erodes investor returns.
Higher inflation is already being priced into bond markets. Germany's 10-year bond yields rose to as high as 0.288% on Wednesday, up from a low of minus 0.189% last year. In the same period, 10-year U.S. Treasury yields are up from 1.356% to 2.46%. A bond's yield rises as the price of the asset falls.
The ECB's reaction to higher prices is likely to be the key factor in the eurozone. Few economists expect the ECB to change policy in its January and March meetings. What happens after that is unclear.
The speculation is likely to cause market volatility, marking coming rounds of inflation data as essential indicators.
Markets got a taste of the potential volatility last month when the ECB announced a slowdown in bond purchases but extended the program until 2017. The euro and bond yields rose as investors interpreted the move as tapering, before these moves reversed when they backed off from that judgment.
The picture is complicated by particularly high recent increases in German inflation. Inflation in Europe's largest economy hit 1.7% in December, close to the ECB's target level. German politicians and central bankers have been among the most critical of the ECB's easing programs. Higher inflation could push German officials to press the ECB harder on reining in stimulus.
While bonds will likely suffer from any tapering, some markets could benefit, including bank shares. Higher long-term yields typically make lending more profitable, because banks borrow short term but lend over longer periods. This idea has already helped lift the sector, with the Euro Stoxx Banks index rising by nearly 50% in the last six months.
Analysts believe that higher inflation will boost corporate profits. Some analysts chalk years of weak European corporate profits to low global inflation, which makes it harder for firms to raise their prices.
Barclays predicts a 2% rise in inflation in developed economies and its analysts believe that this could have a dramatic impact on earnings, particularly for industrial stocks and the consumer-discretionary sector such as car and media companies. "If we are right, the five-year stagnation in European earnings could be behind us," the bank said in a research note.
Higher inflation could also affect the euro.
If the central bank raises rates or investors expect that to happen, that could support the currency, because money tends to flow into regions with better returns. The euro's recent fall to $1.035, a 13-year low, was driven by the growing gap between U.S. and eurozone interest-rate expectations.
But if prices do rise faster than expected and the ECB still keeps policies unchanged, the currency could weaken. That is because inflation would erode returns without rising rates compensating for that change.
"Higher inflation and a loose monetary policy are also negative for the euro," said David Kohl, chief currency strategist at Julius Baer. "We see further downside from here."
Write to Mike Bird at Mike.Bird@wsj.com and Paul Hannon at firstname.lastname@example.org
(END) Dow Jones Newswires
January 04, 2017 14:28 ET (19:28 GMT)
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