Is Europe turning Japanese? The combination of a huge current account, a deflationary spiral and a central bank stuck at the zero bound makes the eurozone look like Japan. Econ 101 would clearly call for a stronger currency as:
i. A positive current account not matched by strong financial outflows makes the euro in short supply.
ii. Any decline in inflation (even worse in the deflation case) increases domestic real yields.
The chart below highlights the second point: The value of the EUR/USD is closely linked to the 2-year real yield spread between German and U.S. sovereign bonds.
There is nonetheless a serious disconnect since late 2013. As can be seen, the current real yield spread would call for a pair closer to 1.38 than 1.32. The ever growing real yield spread can be explained by the strong deflationary forces that have been registered in Europe recently. The associated expectations of a more aggressive ECB (coupled with the Fed exit) could explain why the pair did not react to the ever widening spread.
In the medium run though, there must be some reversion to the mean. Either a stronger EUR/USD or an adjustment in real yields.
The table below presents my 2-year yields and CPI forecasts for the next quarters. The year-end target for 2015 is circled in red. It suggests that, by that time, the EUR/USD should reach 1.18 - the lows of 2010 and 2012. Interestingly enough, the reason is attributable to two factors:
i. The Fed tightening (clearly visible in my 2-year nominal yield forecast).
ii. The rebound in headline inflation in the eurozone (oil related mostly, as core inflation will remain stable around 0.9% in 2014 and 2015). If you expect inflation to fall to 0% in the eurozone, your target for the EUR/USD should be higher, that is 1.28. A deflation scenario would not necessarily bring the EUR/USD sharply lower, unless the ECB goes ballistic.
The recent disconnect between the EUR/USD and the spread of real yields has to be explained. The chart below shows that the pair does not reflect the perceived changes of monetary policy expectations anymore. It used to track the relative changes in the Eurodollar and Euribor slopes. The change in the relative steepness of the Euribor curve against the Eurodollar curve could have called for a 2% rise in the EUR/USD over one month.
It is true that in absolute terms the EUR/USD has followed the steepening of the Eurodollar curve, but the disappearance of the relationship can only be explained by ECB's forward guidance: The flatness of the Eonia curve on the 1-day/2-year tenors makes it totally immune to any bad economic news (an inverted curve is impossible at the zero bound). As a result, the 1-month change in the money market slopes spread failed to capture the worsening of the eurozone news flow in Q2.
And, as can be seen below, the weakness of the EUR/USD is mostly explained by the huge divergence of economic activity (PMI here) between the U.S. and the Euro area.
Along with this came the expectation of a very aggressive monetary policy in Europe. We know that, on the 4th of September 2014, official forecasts for inflation and GDP will be revised on the downside. But should we expect more than more details on the ABS program, upbeat forecasts on the bids at the TLTRO and an upbeat comment on inflation expectations? Caution is in order here, on peripherals spreads and German Schatz in particular.
Before I conclude, and assuming that the EUR/USD will drift downward, could we expect a Japan-like rebound for the equity market? The chart below shows that the relative performance of the Nikkei against the S&P 500 is perfectly and naturally hedged by the USD/JPY: whenever the Nikkei outperforms the S&P 500, the USD/JPY rises (see today's disconnect for an arbitrage opportunity).
The relationship holds also in Europe even though it is much noisier and sometimes fails to materialize. In particular, the recent decline of the value of the EUR/USD would have called for a significant outperformance of European stocks. If the downward trends for the EUR/USD continue, playing the outperformance of European equity indexes against U.S. stock indexes might be a call for the second half of the year (especially since earnings growth forecasts for 2014 have already been adjusted on the downside).
Bottom Line: contrary to what is often stated, a deflationary scenario for the eurozone would not necessarily drive the EUR/USD on the downside (Japan story). The reason is that, at the zero bound, it would increase real yields. Of course, aggressive action by the ECB could help, and this is clearly what many investors expect, even though the odds for QE by the ECB remain low.
Cyclical and monetary policy divergences with the U.S. will drive the EUR/USD further down. A trend that is confirmed by my forecast of 2-year real yields. I clearly see here the opportunity to adjust the positioning towards a relative outperformance of the euro equity market.
Lastly, in a world where global trade remains lackluster, a lower EUR/USD would of course reduce the risk of deflation, but the net impact on the growth rate of the eurozone would not be straightforward. As can be seen below, net exports (exports less imports) tend to be positive when the euro rises, not when it falls…
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.