Deflation Is the Threat for Europe and the US

By Michael A. Gayed  NOV 05, 2013 3:45 PM

Draghi's pledge to do "whatever it takes" may be a nice way of calming fears about the end of the world, but in practice it's not a way of juicing reflation.

 


Those that are the loudest in their threats are the weakest in their actions.
-- Charles Caleb Colton

Europe has come a long way since 2012 as Mario Draghi, President of the European Central Bank, took off the table a Lehman (OTCMKTS:LEHMQ) retake by pledging to do "whatever it takes" to save the euro. The pricing of crisis fears pushed the CurrencyShares Euro Trust (NYSEARCA:FXE) to levels many thought we would not see again for some time. Since July, in particular, European markets have been strong, with the iShares Spain ETF (NYSEARCA:EWP) gaining the most momentum on improved economic data and a return of confidence. Earlier Tuesday, Draghi attempted to temper expectations by stressing that while growth is recovering, it is gradual within the context of still very real deflationary pressures across the eurozone.

Deflation is the enemy of leveraged economies, since expectations for falling prices slow activity, increase unemployment, and prevent growth. Central banks know this, which is precisely why the Fed and the ECB have explicitly targeted a specific inflation rate. A rising currency cuts into inflation because it makes exports less attractive, as can be seen with recent trade data coming out of Germany. Meanwhile, aside from falling inflation expectations, actual past inflation data is weak. Consumer prices are rising well below what the European Central Bank would like to see.

Realistically, what can the European Central Bank do? Draghi has resisted the call to lower rates and embark on a US-style program of quantitative easing, presumably because he sees that our domestic policies aren't helping much either, except to the extent that they boost risk sentiment in stock values beyond what underlying fundamentals would suggest is appropriate. Whatever it takes may be a nice way of calming end-of-the-world predictions, but in practice it is not a way of juicing reflation.

Perhaps European markets are getting hip to this. Take a look below at the price ratio of the Vanguard European Vipers ETF (NYSEARCA:VGK) relative to the SPDR S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/VGK is outperforming (up more/down less) the denominator/SPY. Note that a severe breakdown has occurred on the far right of the chart, indicating an abrupt change in leadership is underway.



Could the market suddenly be realizing just how real the reflation disconnect is, and is it beginning to question whether monetary policy is able to increase inflation which is so desperately needed for most developed economies? Indeed being bearish on stocks has failed in 2013. That does not mean, however, that one should ignore disconnects. With European markets no longer leading and a growing sense of fear over deflation, it might make sense to be careful in the near-term.

Of course, honey badger's cousins love buying euros...

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