Germany, the Eurozone, and the Euro: Parity on Different Levels

The more I read about the dynamics of the German economy in relation to the rest of its Eurozone counterparts, the more it becomes clear that their ideological differences have extrapolated over time to create a competitive positioning versus one of co-ordination. Regardless, they find themselves in a monetary union at a time when the global economy is “re-evaluating” what works and what doesn’t work, and while this process is being sorted, slow growth and low inflation is presenting as normal.

Germany has built over time a trade surplus from exporting more than it imports [along with a few other smaller European economies], while most of the other larger Eurozone economies have been following the example of the US economy in running deficits and depending on foreign investments to grow.

Fast-forward to a post-crisis Europe, and foreign investors are no longer so eager to hand over their savings, and so we come to the first opportunity for parity. Germany has an option to draw down its trade surplus which stems mainly from exports to the rest of the Eurozone by investing in those same economies it trades with. This will bring Germany in line with the rest of the major Eurozone economies with running deficits to finance growth through investment. This is of course a means of buying time to allow domestic demand in the union to pick-up from the increased spending. Not likely in my opinion, since there are structural reforms that need to be made in Europe as a whole to boost competitiveness before investment and subsequent consumption demand can re-emerge.

This brings us to the other level of parity that can occur involving the Eurozone. To make Eurozone exports more competitive on the world market, the Euro needs to further devalue from its current levels. For there to be some meaningful and lasting effect on exports, parity to the US dollar may need to be reached in the foreign exchange market with the Euro. At these proposed levels the trade-weighted value of the Euro should have depreciated enough to stimulate foreign demand for Eurozone exports. This would also serve an additional benefit of increasing the prices of Eurozone imports. In short, inflation would be imported into the union, instead of generated internally.

This would give the European Central Bank (ECB) room to operate with more conventional monetary policy tools, and put the bank in a better position to manage long-term inflation expectations. Unfortunately, this would be at the detriment of the German savers, who would see their surpluses eroded away by the inflation, while the other major deficit carrying economies would see their deficits eroded away from getting to pay their debts with money that’s worth less than the money they initially borrowed.

If the German’s are willing to take one for the team, either in terms of handing over their hard-earned surpluses directly, or living with higher prices, and handing over their surpluses indirectly, the Eurozone may be able to survive its current bout with low growth from a drop-off in foreign investment, and low inflation [maybe even disinflation] from a drop-off in domestic demand. If Germany however, fails this test of altruism, then the alternative is Eurozone deflation, which will further push down wages and demand within the Eurozone, and leave German without its main export market. This will also push up the Euro which will make German exports to the world market even less competitive. At which point a German exit of the monetary union for the sake of the German economy will become the most politically appealing route.

Is the Federal Reserve Just That Good?

As the discussion of the persistently low inflation economic environment continues, the ideas, theories, and explanations continue to be formulated as to why this is the case. One argument that I found particularly interesting is the one for a market-neutral interest rate. The concept is basically the Federal Reserve aligning monetary policy with what is perceived [not empirically observable] to be an interest rate level that has a minimal effect on employment. This in theory, should allow monetary policy normalization to occur without slowing employment growth, and hence, GDP growth as well. If the Fed could indeed accomplish such a fete, then investors’ expectations of future inflation should remain anchored to the Fed’s long-term target of 2%.

Inflation expectations have also received its fair share of scrutiny as well. An interesting argument has also grabbed my attention on this topic. The argument poses that inflation expectations can be considered as the drag between real (time) economic activity and monetary policy. This is a fairly intuitive idea to internalize, as the Federal Open Market Committee (FOMC) along with investors and other market participants are basing their decision making on backward facing economic statistics when participating in market transactions. That disconnect between timely information and decision making is the alleged source of the expectations of higher future prices.

When we combine the two views, they paint a cohesive picture with one very important caveat; the Fed is extremely good at what it does. If the Fed is efficient at interpreting and re-acting to the real economy, then investor inflation expectations should remain well anchored. But, alas, as investors keep taking cues from the financial markets, while the Fed takes its cues from the macro-economy, a decoupling may occur between investor expectations and FOMC actions. This should [in theory] increase the drag between the real economy and monetary policy as market participants alter their real world investment decisions based on the evolving environment in the financial markets, which in turn affects the outcomes of monetary actions by the Fed.

Long story short, these theories and arguments are perfectly adequate until their underlying relationships breakdown. For the last five years, market participants have known what to expect from monetary policy because monetary policy has not changed in five years. All other FOMC actions have been isolated to the balance sheet relationship between the committee and the commercial banks. Somehow I believe that once the Fed starts its long road to normal, investors, academics, and pundits will be attempting to rationalize the dynamic economic environment that will result, and the underlying relationships that will be developing, in terms of inflation expectations and monetary policy evolution.

Dollar Appreciation: US Strength, or Weakness Abroad?

I’ve been watching the behavior of the dollar index via the futures contract (/DX) particularly close over the past few weeks. As an economist, I’ve been preaching the testament of the long dollar trade for some time now, and I continue to believe in that overall macro trend. However, as a trader I was caught off guard by the conviction of the dollar with regards to is most recent bout of appreciation.

Looking at the index in several different time frames, there were both weekly and monthly trendlines looking back five years and ten years respectively, that the price was interacting with simultaneously. When this happens, my trader instincts tell me the price should at least consolidate before choosing to either continue higher, or retrace lower. In this instance, nothing. Not even a pause.

First thing’s first, I rebalanced my currency portfolio to reflect the robustness of the breakout. Then I set about deconstructing the reasoning behind this particular show of confidence by market participates in the dollar.

Since I last checked, (talk to a part time worker) the economic environment in the US has not been improving at any measurably increasing rate. Financial and economic statistics have been streaming in, and at this point no alarm bells have been sounded in either direction for growth forecasts. Still the same slow growth in GDP, still the same little-to-no wage growth, still the same low inflation expectations. Overall, things are just still.

So if the dollar’s appreciation does not seem justifiable with the environment in the US, then it lends to logic that it may be from [perceived] weakness abroad. Also lending to the idea of weakness abroad, is the recent [two week] trend of the 10-year Treasury rate measured by the futures contract (/ZN). Borrowing costs for the US government has been trending lower, which indicates to me that investment capital might be seeking a safe haven in US government debt, and not necessarily seeking higher yields.

Granted economic statistics are backward facing, I am now more astute to data releases that reflect a changing or even negative sentiment in foreign markets. Over time, and usually not with too much of a delay, the statistics tend to reflect the international flows of speculative capital, as the ebbs and flows of money change the fundamentals on the ground.

Fed Normalization and a Keynesian Argument

At some point [in the near future] the Fed will begin normalizing monetary policy. In doing so, this will signal many things to many market participants across the globe. From the stand-point of a capital abundant economy, which exports a lot of that capital in search of higher (sometimes risk- adjusted) investment returns, market participants may be inclined to re-patriate a portion of said capital, as they can now earn higher yields at home.

Then there are international investors on a similar hunt for higher yields that will also redirect portions of their investment capital to the US for similar reasons.

All in all, the capital that is bound to flood the shores of the US economy will be corresponding to floods away from the shores of developing and especially emerging economies. These [developing and emerging] economies have collected major dividends from quantitative easing at the Fed and others from the Bank of England to the Bank of Japan, and loose monetary policy from the Bank of Canada to the European Central Bank. As investment yields fell, via interest rates in the developed economies, capital sought new albeit temporary homes.

The recipient economies gladly rolled out the welcome mats, and got to the business of investing the foreign capital. Local currencies would have appreciated against their developed counterparts and trade balances would have worsened as locals could have then afford more relatively cheaper foreign-made goods.

Well it’s time to unwind, and unwind we shall. As investment capital leaves the developing and emerging economies, their local currencies will depreciate, and real interest rates will fall. As the currencies fall, locals will then be able to afford less and less of the now relatively more expensive foreign-made goods. This will result in higher prices or inflation being imported. To deal with increasing price levels, the local central bank or monetary authority can tighten policy by raising nominal interest rates to reduce inflation expectations, as well as manage the exchange rates to influence local price levels.

Tighter monetary policy, however, usually has the effect of slowing growth, as funding for investment in particular becomes more expensive. This tends to spill over into the labor market as local consumption demand and production supply find new equilibria to conform to interest and exchange rates. In most cases people get fired, and it further slows down local demand and hence production supply.

This is where a Keynesian argument can be made for government to step in and offset the tightening of monetary policy. Government can be the investor of last resort. An expansive fiscal policy can buttress the local labor market, and add demand that can bolster local production supply, and in turn bolster more local demand. In a transitory (used loosely) period as this, the local government would be best served by investing in export driven growth, as growth would otherwise consist of expanding the government balance sheet, which is, when it’s all said and done; unsustainable. Support of an export driven government funded growth model would come from the Central Bank as they could manage the slide of the local currency to make local exports more attractive to foreign importers in the developed economies.

The point that can complicate such a simple model, would be the fiscal position of the local government approaching the start of Fed normalization. If the local government has a budget surplus, then they can invest in an export driven growth model without worrying about inflation expectations of foreign investors. But, if the local government is running a budget deficit, and has to borrow to fund its investments, then the credit rating of the government comes into play as well as its level of indebtedness. Too much debt already on the books and investors may demand higher and higher interest rates to lend to that government. At which point, the Central Bank of monetary authority would have to step in and be the lender of last resort to the government which is very inflationary over time, or further raise nominal interest rates to stave off higher price levels.

While the developed economies were muddling through the early days of the Great Recession, emerging and developing economies were benefiting from the then large capital inflows seeking yield. Capital flows that mitigated the impact of the global slowdown and shortages of credit and more importantly liquidity. It may not have been the best time politically to be discussing tightening fiscal policy, but as the tide ebbs so does it flow.

So as the tide of investment capital is getting ready to flow back to the US and other developed economies, as Warren Buffett puts it, “we’ll get to see who was swimming naked”.

Consumer Behavior Changes Before Our Eyes

I was looking at charts at the Atlanta Fed’s Economic and Financial Highlights section of their website, and two in particular stand out to me as illustrative of the narrative of the American consumer. The first is a measure of the Personal Savings Rate vs Real Disposable Personal Income. The 2008 – 2009 Recession clearly delineates two distinct periods, which can easily span two decades if one is allowed to extrapolate out to 2020. Going back to 2000, the data show a downward trend in both the Personal Savings Rate and Real Disposable Personal Income. It is important to keep in mind that wages through this period have not been growing.

 

The macro-disruptive shocks of the Global Financial Crisis occur, and then the US emerges (technically) from recession. Real Disposable Income has since been trending sideways if not with a downward bias, while the Personal Savings Rate has actually started trending higher, according the chart. This represents the key shift in American consumption behavior, as the rising rate of saving represents both accumulating assets and paying down debt; in a word deleveraging.

To fuel the housing bubble and corresponding economic boom, during a period where wages were not rising but the price of most measures of wealth were, savings were drawn down and a ramp-up in borrowing was observed for most Americans consumers.

It seems the debt-fueled flight was too close to the sun and will be remembered for some time to come. Evidenced by arguably the most materialistic culture on the planet; Americans are starting to postpone the gratification of current consumption for the promise of future accumulated benefit.

The second chart illustrates the constituent measures of Personal Consumption Expenditures. A measure of inflation closely monitored by the Fed.

Although the chart represents both core and headline inflation as measured by the index, their combined overall trends and relationship to the Federal Open Market Committee (FOMC) target of 2% will be the extent of the analysis. Again, going back to the beginning of the chart, the data show inflation actually trending higher. This upward trend in inflation, in the years leading up to the Global Financial Crisis, was the factor eroding away at the purchasing power of American paychecks, and so was being offset with the drawing down of savings and the accumulation of debt.

Again, the 2008 – 2009 Recession clearly delineates two distinct periods; the first characterized by inflation trending higher and at times being measured above the FOMC long-term target of 2%. The period after the macro-disruptive shocks of the Global Financial Crisis occur, is characterized by inflation, as measured by the index, trending sideways and persistently below the FOMC 2% target.

This break in inflation that has so many very smart people worried about the soundness of the recovery is actually a hidden benefit. Even though there still is no real upward pressure on wages, the low inflation environment is giving the American consumer room (albeit thin) to save and consume at more modest levels.

Now that the American consumer has demonstrated that sometimes you can teach an old dog new tricks, we wait for Washington to fall in line with the pack.