Deflation, currency wars, oil and easy money

Published Feb 12, 2015

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THE FAILURE of the European Central Bank (ECB) and the Bank of Japan to achieve their inflation goals, together with the collapse in the oil price, has unleashed a huge wave of global monetary easing.

With inflation now very low in many places (outright deflation in some) there is little resistance to lower interest rates. But to some extent, a new currency war is also being waged. This time it is not a weak dollar, but the euro and yen which are at the heart of it. With further quantitative easing (QE) and no end in sight to low rates in these two regions, weakness in the euro and yen present other central banks around the world with a dilemma – allow currency appreciation or cut rates and expand liquidity.

So already this year, monetary policy has been eased in China, India, Canada, Australia and Denmark. The Swiss National Bank (SNB) instead allowed its currency to appreciate, although by also cutting interest rates to -0.75 percent, probably hoping that much of the knee-jerk appreciation is reversed in time.

This massive global easing contrasts with fears held by some a few months back that the termination of US QE would mean a tightening of global liquidity. Meanwhile, the US dollar is understandably firm and the Federal Reserve remains patient and watchful of events, deep down hoping to be able to raise interest rates in the coming six months or so, but recognising risks that it might be better to wait longer.

Negative interest rates

The inability of euro area policymakers to generate demand and lift inflation to anywhere near the targeted 2 percent has resulted in negative ECB deposit rates (-0.2 percent). Negative rates have been exported to Switzerland (-0.75 percent) and Denmark (-0.75 percent), the latter choosing to maintain a pegged currency to the euro and the former wanting to limit further appreciation.

Negative interest rates on deposits have filtered through to the bond market, with Bloomberg reporting a few weeks ago that $4 trillion of government bonds around the world offer negative yields. Investors are paying the government for the privilege of lending to them and those who hold these bonds to maturity will lose money with certainty, at least in nominal terms. Sounds crazy, right?

Indeed. Such bond yields could only possibly be a sensible proposition if deflation becomes entrenched; if ECB/SNB rates fail to lift off the current floor over the next 5 years or so; or if you expect the euro area to fall apart.

Greece: high stakes

Greece is the obvious immediate worry in this regard. Following left- wing party Syriza’s election victory, Prime Minister Alexis Tsipras and Finance Minister Yanis Varoufakis have entered negotiations with Greece’s European creditors. Both sides are talking tough at the outset. Syriza is campaigning for debt reduction (probably only in net present value terms) and less fiscal austerity, but wants to stick with the euro. Brussels and Berlin are naturally reluctant to give in to these demands and believe they hold the power – the alternative to a negotiated outcome could mean the ECB pulling the plug on Greek banks, triggering a collapse of its financial system and a likely exit from the euro.

With neither party wanting to force a Greek euro exit, it seems likely that a negotiated outcome is achievable. The danger is that accidents can happen. The risks of contagion in an adverse scenario, however, seem much reduced compared to 2011/12 – other euro bond markets are currently well behaved and the ECB is engaging in large-scale QE.

However, the risk is not zero and it is unlikely that Grexit could happen without ripple effects in markets.

Moreover, events in Greece will be watched closely in Spain, where left-wing party Podemos continues to attract a healthy share of the vote in polls.

Our central view remains that Greece will strike a deal with its European creditors, involving lower interest payments or longer maturities on its debt. There will be no write-down to the headline figure, appeasing the Germans.

The terms of austerity may be eased, but structural reforms will be continued. Greece will remain in the euro under the deal. Nevertheless, we are cognisant of risks to this scenario and retain a flexible mindset.

Stronger global growth

Recent macro-events have been so dramatic – the collapse in the oil price, the Swiss franc revaluation, the size of the ECB’s QE – that they spur more confusion and concern than generate confidence.

However, amid the concerns around deflation, heightened considerably by the weak oil price, there is underappreciation for the likely benefit to global economic growth from lower oil and easy money, in our view.

As we highlighted last month a lower oil price might boost global gross domestic product (GDP) by around 0.5 percent in 2015 according to JP Morgan, while the International Monetary Fund estimated in December a positive effect of 0.3 percent to 0.8 percent.

And what will QE do for the euro area? There is, quite rightly, much debate over the efficacy of QE. Its impact relies as much on its boost to confidence as anything else, as well as working via asset prices and the exchange rate, the overall effect of all this being hard to gauge. The portfolio balance effect at the margin shifts money into riskier assets, which should boost confidence, spending and may, eventually, have some modestly positive impact on lending.

But it is likely that the euro area will fare better in 2015 without us ever really knowing how much effect QE had. A much weaker exchange rate, a lower oil price, healthier banks (post ECB stress tests) and lower bond yields across the continent seem to be having some positive effect already.

There are very evident risks to Europe from politics in Greece and Spain, but in the absence of a negative shock, growth should be better this year.

Our positive view on US growth has not changed, nor has our view that Chinese growth will continue to slow in 2015 and 2016. We expect sufficient further monetary and fiscal easing in China to avoid a hard landing.

Inflation bottoming out

If our views on growth are correct, then global inflation is likely to bottom sometime around Q2/3 of this year and then start to rise gradually. We expect the oil price to remain under pressure in the first half, reflecting the current over supply.

The US labour market will be tightening further and modest wage pressures are likely to build by the end of this year, if not earlier. We therefore think that deflation is primarily a euro area problem.

The combination of falling bond yields alongside an expectation that GDP growth is likely to quicken is a positive mix for equities, in our view. Accordingly, we have lifted equity weightings across our range of Multi Asset Funds to increase the overweight position.

As pointed out in the FT recently, the US equity market has grown dividends at a double-digit pace for the past 15 quarters.

In our UCITS Funds, we have added slightly to global real estate exposure. We also continue to hold exposure to certain UK infrastructure assets in these funds.

Tristan Hanson is the head of Asset Allocation at Ashburton Investments.

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