Deflation is the scariest word!
The FOMC statement last night managed somehow to avoid saying what surely should be what is on every member of the FOMCs’ lips- DEFLATION.
The recent Federal Reserve Bank regional surveys have shown that inflation is falling and quickly, and the recent Business surveys from ISM in the US have continued to show that inflation is falling. As all of you will know, I have been banging on about this for the past few years and it has been the basis for the long duration positioning of the Fixed Income Portfolios for the last year. Now it seems that the risk of deflation has grown considerably and is finally impacting the financial markets. And it really should because deflation has bigger risks than inflation to financial stability. Just think of a mortgage- a Bank lends 75% of the value of the property for 25 yrs- if there is price deflation of 3% per year then within 10yrs the collateral behind the loan will be worth less than the original loan. Now obviously a normal mortgage pays down some principal every year but the risk of deflation means that banks will have to increase the principal repayments or increase the initial margin. Certainly the recent property price increases in some regions of the US will help, but deflation will reverse these improvements and quickly. Property prices will not keep going up when everything else is falling.
And because collateral values would be falling in a deflationary environment- Banks would be the biggest risks and biggest losers.
Similarly, industrial credits with high debt/earnings levels will also have weakening credit metrics as revenues fall and countries with high debt/GDP levels will also see their credit metrics weaken on lower tax revenues.
So that is why the FOMC had the line “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” in the release from last night. It is the insertion of the word “increase” into the report that is so important as the FOMC had previously only been talking of tapering QE. QE will be increased when inflation falls further, and it will. And because QE is less and less effective in raising inflation it will mean that QE will just as we have found in Japan, never ending because the threat of deflation is so huge.
But in Europe the ECB does not have the ability to enter into QE. Forward Inflation expectations haven’t fallen significantly in Europe and in April, Germany saw prices fall by 0.5%. That’s not that uncommon in Germany but there is definitely a trend to lower inflation which is gathering pace and German annual inflation fell to just 1.1% in April, from 1.8% in March.
Talk is that the ECB will cut the official Repo rate from 75bp to 50bp today. When German 10yr Government yields are at 1.20% and 2yr German Government Bonds are at Zero, so what will affect will a 25bp cut in the Repo rate have on stimulating the German economy or raising inflation expectations? Reducing short-term interest rates normally weakens the currency against its trading partners and a lower FX rate would normally cause inflation in imported goods. In this case the Euro has been strengthening and amid a situation where all Europe’s trading partners are trying to weaken their own currencies a cut in interest rates is no longer a guarantee of imported inflation. So any cut in the Repo Rate from the ECB is a purely cosmetic change. It is deflation that the ECB should be concerned about! And that will need more than a cut in the 2 week Repo Rate to address.
10yr UST’s and 10yr German Bunds remain attractive investments at these levels given the inflation prospects (or lack of inflation). I would look for yields to continue to trend lower- to 1% for Bunds and 1.50% for US Treasuries.