“Be near me when my light is low,
When the blood creeps, and the nerves prick
And tingle; and the heart is sick,
And all the wheels of Being slow.
Be near me when the sensuous frame
Is rack'd with pangs that conquer trust;
And Time, a maniac scattering dust,
And Life, a fury slinging flame.
Be near me when my faith is dry,
And men the flies of latter spring,
That lay their eggs, and sting and sing
And weave their petty cells and die.
Be near me when I fade away,
To point the term of human strife,
And on the low dark verge of life
The twilight of eternal day.”
― Alfred Tennyson, In Memoriam
Commentary & Analysis
Deflation: Good or bad for the euro? A contrast with Japan…
The Eurozone movie we’ve been watching is starting to look eerily familiar.
Of course, I am referring to the similarity between the economic and monetary path in the Eurozone to that of Japan during its many years of deflation. Mr. Draghi has strenuously argued the Eurozone is not at all like Japan and inflation will indeed pick up, especially now given the ECB’s decision to move to negative interest rates on bank deposits and lowered benchmark rates.
But are deflationary pressures in the Eurozone really all about money?
I don’t think so. I think the problems are structural and go much deeper than merely creating more liquidity. But what I am most concerned about is this: How will Europe’s single currency react if the zone is following down the path Japan has blazed?
If the euro acts as the Japanese yen did during those deflationary years, the euro is set to appreciate against the US dollar steadily for years to come. So let’s take a look at some of the similarities and differences…
The idea of falling relative nominal yields (and/or zero interest rates) as the raw material for an appreciating currency seems perverse. That’s because we generally associate a currency’s strength with higher or growing relative yield compared to its competitors i.e. higher and rising yields in a normal economy generally suggest relative growth; that in turn helps pull in foreign direct investment (FDI), and also hot money flows to take advantage of the yield differential.
The equation looks like this: Currency = Relative FDI + Hot Money ƒ (yield spread)
Japan during that deflationary period…
- Japan had a great deal of external investment that was repatriated during those deflationary years as internal risk rose. Thus, it tended to take the place of FDI to a degree.
- Real interest rates in Japan were above nominal rates thanks to deflation, i.e. real yield = nominal yield – inflation rate (a negative inflation rate or deflation boosts real yield)
- Japanese government bond purchases overwhelmed any international impact and most bonds were held by domestic buyers.
- This point seems to be what many didn’t talk about—the 10-year benchmark yield spread between Japan (JPY) and the United States (USD), applying only nominal interest rates, was growing in favor of Japan during those deflationary years. Check it out in the chart below…
10-year Benchmark Yield Spread (Japan – United States) versus USD/JPY Weekly: This is a long-term view. You can see as the yield spread moved in favor of Japan its currency appreciated, i.e. the black line shows USD/JPY—a fall in USD/JPY means the yen is appreciating as it requires fewer yen to buy one US dollar. But also notice when the trend began to change. It was a combination of Japan’s new economic program under Prime Minister Abe and a reverse in the yield spread which moved against the yen and in favor of the US dollar (Fed taper sentiment has likely helped).
Now as the Eurozone struggles with deflationary pressures…
- Eurozone banking is deleveraging, effectively repatriating money locally and hedge funds have been feasting on periphery bonds. And of late, major vulture funds are investing in Europe. Thus, a substitute for FDI I think.
- Real interest rates rise as inflation shrinks across the Eurozone (German savers cannot be happy; but keep in mind deflation helps the German government debt holdings).
- The ECB has said it will be the buyer of last resort of any European sovereign debt that comes under pressure. But this is a mixed bag and represents credit risk the bank of Japan didn’t face. Plus, more of European debt is held by international investors than was Japan’s.
- The 10-year benchmark yield spread between Europe (EUR) and the United States (USD) is now moving in favor of the US dollar.
So, there are some key similarities with Japan’s deflationary period, but as it might impact the currency, the differences in points 3&4 above seem important pieces of the puzzle as it relates to the currency.
10-year Benchmark Yield Spread (Europe – United States) versus EUR/USD Weekly: From the year 2000 onward, there has been a decent positive correlation (though lagged at times) between the path of the currency and yield spread, i.e. as the yield spread favoring the euro (blue) moved higher, EUR/USD followed higher and vice versa. But what sticks out like a sore thumb (or bruised and/or crushed currency account) is the fact that since October 2012 the yield spread and currency price have been negatively correlated, i.e. relative euro yields plunging against the US yet, EUR/USD has rallied.
So, the key question is this: Is relative yield irrelavent now that the Eurozone may be entering Japan-like deflation territory?
My short answer is yield still matters. And if we factor in the mix of sovereign debt risk the ECB has to mollify, the potential for international hedge funds to book some nice profit and cut and run, and the rising anti-euro political risk (something else the Japanese government didn’t have to deal with), I don’t think the euro will rally as the Japan yen did during its deflaitonay “lost years.”
Of course there is also the other side of the argument: 1) Mr. Draghi is correct and inflation will rebound across the eurozone; 2) the eurozone business enviroment will continue to improve and relative yields will rise accordingly; 3) international funds will continue to invest heavily into Europe periphery real asset opportunities, and 4) there is a Toohth Fairy.
Anyway, the reality is we don’t know. We can only create plausible scenarios (which there are many more) and go with our best guess. For now, still betting euro falls over time on yield. But, my confidence is in the medium zone given what we have witnessed since 2012, i.e. the gapping divergence in yield spread and currency price action.
I leave you with the first three paragraphs of Frederic Bastiat’s brilliant essay, “What is Seen and What is Not Seen,” as it sums up why we should never be too confident in markets and warns there may be a lot more going on underneath the surface that we don’t see and that which we don’t see often is of more importance:
In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must before seen.
Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.
Have a great weekend.
President, Black Swan Capital
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