|ECB president Mario Draghi|
While the divergence story points to higher rate expectations in the US than in Europe, Merk claims the argument only shows half the picture, as it only considers nominal yields. Real yields, which adjust for inflation, might be a different story if inflation is higher in the US than in Europe.
“Real interest rates in the US are not only lower than in the eurozone but that divergence has been growing in the opposite direction of nominal rates,” says Merk. “The eurozone is holding steady, whereas US real rates are falling.
“In this currency war, one might be excused for not recognizing who is the most dovish of them all. 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 US 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.”
Yet whether inflation has enough of a toe-hold in the US to climb significantly remains to be seen.
Most agree the outlook for inflation is higher in the US than the eurozone, though US wage inflation remains low. Year-on-year growth in average hourly earnings has hovered around the 2% mark since 2009, suggesting there is not too much slack in the economy.
While the eurozone has suffered a string of disappointing economic data, the news coming out of the US has been more positive. Better-than-expected Q2 GDP figures have been supported by strong non-farm payroll releases, showing more than 200,000 jobs have been created a month. The healthier US banking sector will also give inflation an easier toe-hold than it has in Europe.
“Measured since the start of last month, the USD is the best-performing developed world currency,” says Jane Foley, senior FX strategist for Rabobank. Since July 1, it has rallied about 2.4% against the EUR, one of the poorest-performing currencies in that period.
“Bearing in mind the widely held presumption that Fed chair [Janet] Yellen would rather risk a period of too-high inflation than another downturn, there is little risk of the Fed rushing to tighten policy,” says Foley. “That said, the market is expecting the first tightening from the Fed to be several months ahead of the ECB and this has made EUR/USD vulnerable to further downside pressure.”
While inflation expectations are higher in the US, there is still plenty of downward pressure on inflation, much of which is imported, says Ebrahim Rahbari, director, global economics at Citi.
“Tradable price inflation has been below the level seen from domestic sources such as services, and the strong dollar is likely to see that continue. We see the PCE [personal consumption expenditures] deflator staying within the 1.5% to 2% range for the next year at least.”
Daragh Maher, FX Strategist for G10 at HSBC, says: “Our base view is a cautious outlook for activity in the US which is unlikely to lead to more than a temporary pick-up in inflation.”
And while the market has been anticipating inflation surprises on the downside in Europe, HSBC believes it will be flat or even slightly up later this year. “Combined with the ECB’s non-conventional stimulus, that amounts to real loosening,” says Maher.
“Real yields will keep domestic investors interested in the eurozone, and that is a very large investor-base – even the traditional borrower countries are saving more than they used to,” says Citi’s Rahbari. “So monetary policy divergence may not translate so easily into outperformance for the higher-yielding currency.”
It is also debatable how much currency traders care about the real rate. “A trader will get his carry regardless of what inflation is doing, as long as the currency doesn’t collapse,” says HSBC’s Maher. “It will have some bearing, but short-term investors will not care as much about the real rate as the nominal rate.”
However, Merk believes the opposite is true. “Nominal rate increases make for good headlines, but might make for poor investment decisions,” he warns. An extended period of negative real rates may bode well for gold and poorly for the US dollar.
“While Draghi has had the upper hand in weakening the euro for a couple of weeks now, this streak may come to an end,” concludes Merk.