Trichet’s hawkishness appears to be a bluff

WAS Jean-Claude Trichet’s hawkishness on inflation earlier this month a bluff? He sounded tough until the market reacted, but then rolled back the strength of what he said, leaving us hanging in suspense. Now with European inflation rates hitting 2.4 per cent in January – the highest level for more than two years (see chart) – many are asking if the European Central Bank (ECB) will raise interest rates sooner than expected. The prospect of the change will be weighing on the minds of investors.

Should they fear a rise and reconsider their trades before Thursday’s rate announcement?

Traders should always be cautious when it comes to the ECB and interest rates. As RBS’s equity specialist Graham Bishop jokes: “There are three things the ECB hates: one – inflation, two – inflation and three – inflation. The old Bundesbank is historically paranoid about it.”

But it is important to get this into perspective: Eurozone inflation is only running 0.4 per cent above the target. Whereas the British inflation rate is running at 3.7 per cent and – apart from two rather large hawks – the Bank of England’s Monetary Policy Committee doesn’t seem to care too much.

Not to mention that the ECB’s hatred of inflation will need to be reconciled with its hatred of bailing out the periphery. As CMC Market’s market analyst Michael Hewson says: “If they [the ECB] raise rates anytime soon they might as well take a gun and blow the heads of the peripheral economies. The euro is already too strong for the weaker economies. If Germany raises rates it will find itself signing another round of bailout checks.”

RBS doesn’t think the Bank will raise rates either, arguing that it will be taking the market’s current expectations into consideration. Five-year forwards on German bonds, they explain, “look through the near-term cyclical distortions” and show us that the market outlook is fairly stable and that inflation will only creep up slightly.

Bishop goes as far as to advise traders to go for highly leveraged investments such as real estate, food and utilities stocks to take advantage of the inflation – avoiding companies with large cash balances.

But maybe that is advice only for the most confident of investors. Regardless, traders could well benefit from calling Trichet’s bluff.