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Euro Zone vs Deflation Monster

May 22, 2016

“I think my mask of sanity is about to slip.”
Patrick Bateman (Christian Bale), American Psycho (2000)

Sell in May and go away – one of many legendary expressions connected to the world of trading. It’s not always the case but this year, it seems that Euro is following the pattern. In 2015 a decline in EURUSD exchange started on the 18th of May and lasted almost until the end of the month. This year things are a bit different as the common currency started losing ground against the dollar right in the beginning of the month and is now, more or less, 450 pips lower, measured from the recent high. The big question is of course, how much lower it will go and how long this weakness will last. Unfortunately, I cannot answer those questions for you but I can try to put things into some kind of perspective.

First and foremost we should focus on the recent inflation data which confirmed that the Euro area (and actually the entire European Union) is back in deflation. The annual EZ CPI came in at -0.2 percent, basically in line with what the market was expecting, and while Mr. Draghi also mentioned that in the coming months, inflation will be on the negative side, it is quite clear that the ECB will not tolerate this situation for very long. It is true that Mr. Draghi said couple of press conferences ago that the rates have reached their lower bound and that the QE is working well, hinting that there will be no changes in the monetary policy in the near future, it is still very much possible that they may act again because it is their job is to ensure price stability in the Euro area.

Of course, unconventional monetary policy as such, has its limits but we may be far away from the point where the CB’s must raise their hands and admit failure. It’s no secret that many economists have expressed their fears that the policy makers are running out of ammo because the QE hasn’t worked as expected, even when it’s combined with negative rates. While there is definitely a significant amount of truth to those claims, I’d say the day when for example the European Central Bank says that they have nothing left to give, is very far away.

“Helicopter money” is perhaps one of the best known, relatively new ideas about how to create artificial wealth in an environment where inflation does not exist. This week the mentioned subject was brought up again and this time by the head of the Riksbank (Swedish central bank) but I do believe that we have at least one more, intermediate level to pass before we can realistically start considering the concept of the so called helicopter money.

One of the possibilities to create inflation out of nowhere is through loans to general public with negative rates, meaning that if you borrow €150 thousand to buy an apartment, then you pay back less than that amount. Let’s be honest, two or three percent interest rate on a 25 year loan is quite a lot but if someone (the ECB in this case) would compensate that amount to the banks so they could give out loans with zero or even negative rates, then borrowing should become a lot more attractive than it is today. Clearly, there are going to be side effects as well such as a sharp rise in real estate prices but isn’t that what they want – higher prices which eventually will lead to higher inflation. It’s hard to predict if something like that could ever happen in the euro zone on a large scale but in my humble opinion, negative rates on typical loans sounds a bit better than the concept of helicopter money.

Now, coming back to the euro exchange rate, one doesn’t have to be a rocket scientist to figure out that everything described above, will have a negative impact on euro. While home loans with negative interest rates and helicopter money aren’t a reality these days, then the focus should shift on to the next ECB press conference. Due to the recent drop in inflation I do believe that Mr. Draghi may surprise the markets with some pessimistic forecasts that could hurt the euro exchange rate quite a lot. On the other hand, it is relatively unlikely that the ECB would change its monetary policy in the beginning of June but it’s quite possible that they may give very direct hints that they are ready to act again if the inflation outlook should worsen.

Capital Properties FX
22.05.2016