This week, all eyes have been fixed on the relationship between the euro and the dollar. No wonder. A year ago, the eurozone was running a tighter monetary policy than the US.
This week, however, the European Central Bank embarked on a massive new round of quantitative easing, even as American monetary policy officials such as James Bullard, head of the Reserve Bank of St Louis, signalled that they want to raise American interest rates soon.
So it is no surprise that the spread between dollar and eurozone interest rates has widened as the dollar has strengthened. “It is all about the dollar and euro [now],” Bill Blain, an analyst at Mint Partners in London argued, noting that “surveys suggest that more than 50 per cent of market participants think the euro will reach parity against the dollar before Easter”.
Investors who are obsessively watching that euro-dollar rate risk missing another, equally interesting shift under way in the markets — this time between yen interest rates and euro rates.
Over the past decade, eurozone interest rates have traded well above those in Japan. Back in March 2004, for example, the 15-year forward swap rate for euros and yen (which indicates the relative difference in yields) was about 300 basis points, and four years ago the gap was still around 150 basis points. That (obviously) reflected the fact that Japan has been mired in deflation, economic stagnation and ultra-low interest rates for more than a decade.
But the picture has suddenly — and dramatically — reversed as the yield on eurozone bonds has fallen below that of yen bonds. Right now, for example, 15-year euro-yen swaps imply that eurozone rates are 77 basis points lower those of Japan. Meanwhile, the current 10-year Bund yield is a mere 22 basis points, compared with 41 basis points in Japan, and for 30-year bonds the yields are 71 basis points and 149 basis points respectively. To put it another way, as a demonstration of Alice-in-Wonderland economics, Japan is no longer the only (or best) example. The pattern in the eurozone looks even more extreme in terms of ultra-low rates.
A UBS note to clients notes that: “Yen interest rates have been used for a long time as a benchmark for how low eurozone interest rates can go and the term ‘Japanification’ has been loosely used for a convergence of Japan’s and Eurozone’s economies as well as interest rates.” It goes on to suggest “we should probably now switch to a new term: ‘Europification’”.
It is possible that “Europification” will just be a temporary blip. One reason why eurozone rates have swung so violently this month is that the launch of the ECB’s QE programme has left the central bank with a shortage of assets to buy, pushing the price of sovereign bonds higher, with a corresponding decline in yields.
It is, however, also possible to imagine a scenario where eurozone yields remain ultra low for some time. After all, the eurozone (like Japan before it) is hovering near deflation, marred by a woeful lack of demand and fragmented political structures that seem unable to promote rapid structural reform.
If “Europification” becomes the new buzz phrase, there are at least three points that investors need to consider. First, and most obvious, ultra-low interest rates have a nasty habit of distorting markets in all manner of unexpected ways, all over the world. To understand why investors are flooding into US activist funds, angel investments, laying down wine or jumping into the art market, for example, a good place to start is by looking at ultra-low rates.
Second, such rates have a habit of breeding cynicism about market signals and mechanisms in a broader sense. Or as the late Masaru Hayami, a former governor of the Bank of Japan, observed 15 years ago, the crucial problem with zero interest rates is that they create a “zombie” mentality, removing market discrimination. (One way to make sense of the recent surge in index fund investing is as a response to ultra-low rates.)
The third key point is that once low rates become ingrained into the consumer and corporate psyche, they also become increasingly hard for policy makers to remove. It is possible that the US will buck this trend, and the reason why people such as Mr Bullard are now pushing for the Fed to act is precisely to avoid that Japanification fate.
For the moment, though, investors in global markets are confronted with a low interest rate world that looks increasingly peculiar. And potentially very volatile if, or when, this era of Japanification-cum-Europification finally comes to an end.
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