The Change In Policy…The Divergence in European Spreads - Why Now?
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So, without further ado, let’s jump into the problem with the Euro. Back in May 2007, we wrote a piece entitled “Part 2-So What Should We Worry About“.
In that ad hoc comment, we wrote: “The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption d) in the US, the subsidy has by and large been captured by individual consumers e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed f) we see little reason why, in the near future, the subsidy should be removed but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world) while h) Europe could go through a debt crisis (far more problematic).”
We went on and wrote: “Last week, and against most observers’ expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country’s inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank’s apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.
This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.
One could argue that a change in monetary policy in Asia could end up being a “triple whammy” for Western economies. It would mean that:
- Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
- Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
- As Asian exchange rates start to move higher, Asia’s private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.
Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about “excess leverage” in the system, or the threat of a “private equity bubble”. We also do not fear an “economic meltdown” or a brutal end to the “Yen carry-trade” (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities — a hedge against rising real rates — makes sense to us - as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.
Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.
Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.
Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.
And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the “stronger” signatures (Germany, Holland, Austria, Finland, Ireland) and the “weaker” signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland…).
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Tags: Asia, asia exhange rates, Bank Reserves, Credit Crunch, Debt Crisis, Divergence, ECB, europe, european gdp, Exchange Rates, Food Prices, Global Currencies, Indian Stocks, Inflationary Pressures, pension systems, politics, recession, us mortagesAbout the Author
As a recognized expert and leader on investment issues, Millennium Wave Investments president John Mauldin is primarily involved in private money management, financial services, and investments. John is a prolific author, writer and editor of the free popular Thoughts from the Frontline e-letter which goes to well over 1,000,000 readers weekly, and is posted on numerous independent websites. John is a Fort Worth, Texas businessman, and the father of seven children, ranging from ages 11 through 28, five of whom are adopted.