Derek Halpenny, European Head of GMR at MUFG, suggests that a crucial element of central banks’ efforts to stabilise inflation expectations would surely be a recovery in the price of crude oil and in that light central bankers must have been pleased to hear of a deal between Russia and Saudi Arabia to freeze production at January levels. Key Quotes “Markets were not so impressed however with a key caveat for a deal being that other producers join the deal. Hence negotiations move today to Tehran where it is hoped that Iran and Iraq will join the deal. The problem is that Iran’s oil production plunged in 2012 when sanctions were intensified and Iran has already indicated that it intends to revamp production back to 2010-11 levels, implying an increase in production of 1mn barrels per day. The scepticism of a deal being reached is clear to see with Brent crude oil currently trading close to 10% below the intra-day high reached yesterday prior to the Russia-Saudi announcement. If this deal fails to lift crude oil prices then we are where we were before – investors concerned over low growth, low inflation and central banks’ inability to act to change that. We think this scenario is one which is currently helping to support the euro and the yen versus the US dollar. The BOJ of course has acted already and given the ongoing market turmoil had little impact on either equities or the yen. Part of that is down to the fact that inflation expectations are currently being driven more by crude oil prices and general market volatility rather than from monetary policy measures from central banks. Where investors are most sceptical about inflation moving higher is in Japan and the euro-zone. What that means is that real yield differentials have moved in more in favour of the euro and the yen. Economic growth, the jobs market and actual inflation are all stronger in the US meaning the actual real yield for the US relative to Japan and the euro-zone has come down. For that to change either the Fed will have to raise interest rates to push the US nominal yield higher or the BOJ and the ECB will have to ease policy further to lower nominal yields there. For the Fed of course, the likelihood is that the FOMC has moved to the side-lines probably until June at the earliest. It’s no surprise to us that PM Abe’s advisor, Etsuro Honda, stated today that more BOJ stimulus could be on its way next month as the BOJ tries to get back ahead of the curve. Based on our calculated 2-year real (actual inflation) yield spread between the US and Japan, USD/JPY could fall further – to below the 110.00 level.” For more information, read our latest forex news.