Move over inflation paranoia. Make way for deflation anxiety.
For the doomsayers who’ve been betting that bucket loads of monetary stimulus would eventually prod investors to flee bonds and fiat currencies, the past week has been painful. With price data in the U.S. and growth numbers in China both slipping below important thresholds, these hard-currency lovers have seen their favored inflation hedges fall out of bed. Gold plunged 13% in two days, copper plumbed new lows to register a 17% decline from its February peak, and a Thursday auction of $18 billion in inflation-protected Treasury securities received the lowest demand since October 2008.
So, how to play this new, inflation-is-dead story? Sovereign bond yields offer an unappealing pittance – the yield 10-year Treasury is t just 1.7%, for German bunds the number is just 1.25% – and stocks are looking frothy against underwhelming first-quarter earnings. That could leave currencies as the place to make speculative, relative-value bets.
Here’s a key point, though: politics will constrain the advanced world’s two most activist central banks – the U.S. Federal Reserve and the Bank of Japan – from taking on anymore currency-weakening stimulus, even if they want to. They’re already doing a combined $155 billion in bond-buying every month, provoking the ire of critics at home and abroad. Similarly, the Bank of England’s “quantitative easing” hand is close to fully played. Looking for big policy-driven moves in the yen, dollar and pound could be tricky.
The one shoe still to drop, then, is the euro. With its benchmark interest rate at 0.75%, the European Central Bank could still do much before it catches up with the U .S. and Japan. And the one thing that could prompt that is the threat of falling consumer prices in the euro zone.
A stubborn European Central Bank has until now insisted that it won’t be moved by the kind of economic gloom indicators that would typically drive the Fed to pump out more liquidity. Despite a relentless flood of indicators showing the euro zone mired in a painful and politically destabilizing recession, the ECB has stuck to its guns and kept rates steady. The reason: unlike the Fed, with its dual full employment/low inflation mandate, the ECB is charged only with maintaining price stability, which it currently interprets as a duty to fight against inflation risks.
But once prices show dangerous signs of getting into negative territory, that same price stability mandate should compel the ECB to act against deflation risks. That’s why there was a clear logic to the market’s quick sell-the-euro reaction when Deutsche Bundesbank President Jens Weidmann said in a Wall Street Journal interview Wednesday that the ECB might adjust policy if it receives “new information” suggesting the need to do so. Yes, Mr. Weidmann qualified his remark by saying that current policy is “already quite expansionary” and, yes, on Friday he told reporters that he had not intended to signal a change in euro rate trends. But here, nonetheless, was the leader of the ECB’s “strong money” wing at least open to the possibility of easing policy. With the ECB forecasting just 1.3% inflation for 2014, far below its 2% target, more dovish members of the ECB’s governing council are likely to be actually toying with the idea of a cut. That mere prospect is negative for the euro.
Even if the ECB’s policy-setters don’t act during the next meeting on May 2, it’s important to remember that currency strategies are all about relative expectations. It’s far-fetched to imagine the Fed adding yet more “QE” when the U.S. labor market is clearly, if fitfully, improving while the stock and housing markets are on a tear. (St. Louis Fed President James Bullard’s remark Thursday that deflation risks could prompt a further policy response is, in that sense, a theoretical notion, not a practical one.) And with the BOJ ruffling feathers worldwide after doubling its asset purchases earlier this month, it’s similarly in no position to do more. The current level of stimulus from those two central banks, enormous though it may be, is already priced into expectations.
That leaves the ECB as the only game in town, at least among the big central banks. It means the euro’s downside risks outweigh its upside prospects.
It seems that deflation is not such a ridiculous impossibility after all. Sub $1,000 gold and the RBA being forced to slash IRs below 1%. This would confirm that the intensifying global deflation has finally spread to Oz.
