Despite European Central Bank President Mario Draghi’s attempts to say nothing whatever after this morning’s meeting of the European central bank, the euro jumped to a new two-year high against the US dollar.
Between 2007 and 2013, German and US “real” yields (the yields on inflation-linked bonds issued by the governments of both countries) were virtually identical. German yields headed down and US yields headed up in a great divergence that must eventually converge once again.
What drove the divergence? There were several factors to which Asia Unhedged has drawn attention in the past. One is that US TIPS yields were low in the aftermath of the Great Financial Crisis because investors bought them as catastrophe insurance, just as they bought gold. The price of catastrophe insurance (out of the money puts on the world) has fallen, so TIPS are less valuable as the paper equivalent of a sack of gold coins buried in the back yard. Another factor is Europe’s financial crisis: with the Club Med countries at risk of bankruptcy, everyone who needed ultra-safe bonds in Euros bought German Bunds rather than their Spanish, Portuguese, Greek or Italian counterparts. And the European Central Bank’s aggressive program of monetary ease (negative short-term interest rates and aggressive purchases of European government debt) drove yields down.
Everyone knows how this movie will end (less stimulus, convergence of US and German yields, higher EUR/USD); the only question is when. To bet on a rising Euro vs. the dollar means to own negative-interest rate Euro assets and sell higher-yielding US dollar assets. Most hedge funds have to justify their returns month by month, and they are loathe to bleed income for a period of months in order to cash in some time in 2017. Today’s jump in the Euro shows how nervous they are: Any time the European Central Bank might say anything (whether it does or not) investors are inclined to stampede into the European unit. Hedge funds also are afraid of being too late.
Even at the micro level (1-minute interval tick data), we see that a shrinking spread between Bunds and Treasuries corresponds to a higher Euro, although the correspondence is uneven and sloppy. It depends on the market’s perception of political wrangling among European governments.
What we can say with a fair degree of certainty is that German Chancellor Angela Merkel and her one-time economic advisor and now Bundesbank President Jens Weidmann won’t put up with an ultra-low interest rate regime forever. The Club Med countries will have to reform their economies, or sell assets to foreigners, or give up a degree of governance over their budgets and financial systems. The Germans are savers and the countries of the southern periphery are borrowers, so artificially low interest rates transfer income from savers to borrowers. Eventually the German pension systems will go bankrupt at negative-to-barely-positive yields. The Germans reluctantly stepped in to help their feckless European Union partners, but they won’t commit suicide.
Call it “The Market Without Qualities.” The great novel that no-one in the English-speaking world has read is Robert Musil’s “The Man Without Qualities,” set in Vienna just before the outbreak of World War I. The reader knows, but the characters do not, that their comic-opera world is about to come to a terrible end. Investors know that the Euro should trade on the interest-rate differential between the US and Germany, but they also know that if they wait for yields to converge, it will be too late. So we expect the pattern of mini-stampedes into the Euro to continue.