-- Published: Wednesday, 13 August 2014 | Print  | Disqus 

Last week, European Central Bank (ECB) head Draghi talked about the de-coupling of the ECB and the Fed’s policies, of policy divergence. Lots of pundits have suggested the same. With due respect to their views, my analysis of the data suggests they are wrong. If you own dollars, the euro or gold, you might want to pay attention to this one.

What could possibly be wrong with conventional wisdom? It shouldn’t be a surprise that pundits merely regurgitate what others say. But why would Draghi join the fray? It turns out, he has a vested interest in the ‘policy divergence’ view, as promoting it might help to weaken the euro. If indeed the U.S. interest rate path is upward, while rates in the Eurozone stay lower for longer, it might justify a weaker euro.

So, sure enough, at first blush, they have a point:

The above chart compares the “2-year swap rates” for the U.S. dollar and euro. In essence, this chart shows the market expects short-term rates to be higher in the US than in the Eurozone over the next two years. It also shows that the gap has generally been widening in recent months.

But this only tells us part of the story. That’s because the above chart reflects nominal rates to be rising, but reflects nothing about real interest rates (i.e., interest net of inflation).

If we only looked at German 10-year real yields versus U.S. 10-year real yields, U.S. yields are higher. However, the Eurozone is more than just Germany (and the ECB’s mandate is to keep Eurozone inflation close to, but below 2%). Only Germany, France and Italy have inflation protected securities akin to the TIPS available in the U.S. that are commonly used to determine market expectations for real yields. As the Italian real yield line above suggests, a blend of Eurozone yields will be higher. On a real basis, Eurozone 10 year yields are higher than U.S. yields.

While looking at 10-year real yields is an interesting exercise, let’s take the discussion closer to the present where current prices are determined:

The chart above shows that real interest rates in the U.S. are not only lower than in the Eurozone, but also that the divergence has been growing in the opposite direction of nominal rates. The Eurozone is holding steady, whereas U.S. real rates are falling. Please also see our recent analysis on the course of the Fed (Fed Exit a Blue Pill?).

So what is it now? In this currency war, one might be excused for not recognizing who is the most dovish of them all. Basically, the market currently prices in that nominal interest rate hikes might indeed be coming. But our interpretation is also that inflation, at least in the short-term is higher in the U.S. than in the Eurozone. If inflation indeed is picking up and central banks stay put, they will be “behind the curve,” meaning real interest rates may continue to be negative for a very long time.

Now let me ask you this: is the U.S. or Eurozone more vulnerable to inflation? In the U.S., the banking system is much healthier than in the Eurozone. While Fed Chair Yellen preaches we can’t have inflation given the slack in the economy, former Fed Chair Volcker has said the inflationary experience of the 1970s had proven this argument wrong.

Contrast that with the Eurozone where many banks continue to be impaired. While policy makers work hard to improve the banking system there, the short of it is that – at least in our assessment – it will be much harder for inflation to gain a foothold.

Having said that, if we do get inflation to gain a foothold in the U.S., I have little doubt that it will also be exported to other regions in the world. However, our analysis suggests that inflation may have a much easier time to build in the U.S. than Eurozone.

So while pundits, experts, policy makers – you name it – jump on the bandwagon of a U.S. “exit” and “policy divergence”, we can’t join the fray:

• An environment where real interest rates are negative, and trending to be more negative, and where Fed Chair Yellen has indicted she will be slow in raising rates is not an “exit.” In our assessment, this is financial repression as far as the eye can see.

• We see real interest rates higher in the Eurozone than in the US for the foreseeable future, even as nominal rates might be diverging. Nominal rate increases make for good headlines, but might make for poor investment decisions.

In the introduction, we mention implications for the dollar, euro & gold. If real rates stay negative for an extended period, this may bode well for gold and poorly for the U.S. dollar. And while Draghi has had the upper hand in weakening the euro for a couple of weeks now, this streak may come to an end. If you haven’t done so, make sure you sign up for this free newsletter.

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Axel Merk

Axel Merk is President and Chief Investment Officer, Merk Investments,
Manager of the Merk Funds.

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 -- Published: Wednesday, 13 August 2014 | E-Mail  | Print  | Source: GoldSeek.com

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Axel Merk Axel Merk is Manager of the Merk Hard Currency Fund

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks—with the ease of investing in a mutual fund.
The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.
Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Fund's website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.
The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Fund’s shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund’s portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund’s prospectus. Foreside Fund Services, LLC, distributor.

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