Central bankers like Janet Yellen and Mario Draghi talk a good talk. Indeed, their lines of argument fuel headlines, which in turn send signals to the market.
But portfolio manager Axel Merk of Merk Investments is warning investors to consider the vested interests at stake and to be guided neither by rhetoric nor by nominal rate policy but rather by real rates.
The headlines du jour concern a divergence between U.S. rates, which are headed up as the Federal Reserve tapers off its bond-buying, interest-rate-suppressing monetary policy, and European rates, which must remain lower longer because of the eurozone’s weaker economy.
European Central Bank chairman Mario Draghi has surprised observers by aggressively justifying the euro’s recent exchange-rate decline.
His talking down the eurozone’s currency, especially at a time when U.S. interest rates are thought to be on an upward trajectory, would tend to have the positive — from Draghi’s point of view — effect of weakening the euro and thereby strengthening Europe’s export sector.
And indeed these expectations, of higher U.S. rates and lower European rates, are reflected in the 2-year swap rates between the dollar and euro, Merk shows.
But the currency funds manager points out that this policy divergence reflects nominal rates. Looking at real rates — calculated after the effect of inflation or deflation — tells a different, actually opposite, story, he says.
One way to view real rates, via tradable investments, is to look at Treasury Inflation Protected Securities, or TIPS. Only a few European countries — Germany, France and Italy — have such securities.
While German bonds have lower real yields than U.S. TIPS, the Italian rates, which Merk suggests are more reflective of the eurozone as a whole, are substantially higher than U.S. rates.
But more to the point, looking at current central bank data, Merk shows that real interest rates in the U.S. are not only lower than in the eurozone, but also that their divergence has been increasing.
“The eurozone is holding steady, whereas U.S. real rates are falling,” he writes.
How could that be?
Well, if inflation in the U.S. is picking up but rates are unchanged (apart from mere discussion about eventually raising them), then “real interest rates may continue to be negative for a very long time,” Merk says.
Indeed, here’s where Federal Reserve Chairwoman Janet Yellen joins Mario Draghi in talking up a line that serves her vested interests.
Inflation can’t happen with so much slack in the economy, she repeats, though Merk, citing Paul Volker, points out that that the experience of the inflationary 1970s refutes this claim.
Therefore, Merk summarizes, real U.S. rates are negative and trending downward, all while Yellen must be slow in raising them since she argues that the absence of inflation makes it imprudent to raise them hastily. Meanwhile, European real rates are persistently higher than in the U.S., despite headlines that focus on nominal rates.
Merk’s conclusion: This can’t be good for the dollar, but may bode well for gold. And Draghi’s lucky streak in talking down the euro may soon come to an end as policy rate reality (i.e., real rates) becomes better appreciated by markets.
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