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How to Know if Draghi Will Succeed at Reflation


Watch for a continuation of strength in Spain relative to Germany and a continued drop in the euro.

Success is not final, failure is not fatal: it is the courage to continue that counts.
--Winston Churchill
Markets worldwide are still digesting the European Central Bank's latest decision to push negative interest rates on excess reserves, with the euro beginning to weaken in a more meaningful way.  It can be argued that the end goal of Mario Draghi is to depreciate the euro given that one of the best ways for Europe to get out of its deflationary funk may be to simply export more.  A weaker currency allows for a country to import inflation, exporting deflation to other countries.  A depreciating currency would most benefit those with the highest debt, as imported inflation helps with liability burdens.  It is for this reason that during the onset of reflation expectations, junk debt and highly leveraged stocks tend to outperform.
From a macro perspective, while Germany would benefit from a depreciating euro given how strong its export economy is, Spain would likely benefit more.  With extremely high unemployment and a tremendous debt burden, inflation would most impact equities in the PIIGS more generally.  Take a look below at the price ratio of the iShares Spain ETF (NYSEARCA:EWP) relative to the iShares Germany ETF (NYSEARCA:EWG).  As a reminder, a rising price ratio means the numerator/EWP is outperforming (up more/down less) the denominator/EWG.  Note that as expectations grew in the first part of 2014 that the ECB would further stimulate, Spain outperformed relative to Germany.

The trend remains intact, which is consistent with the market giving the benefit of the doubt to Draghi and inflation expectations rising.  A continuation of the euro's drop would confirm this.  I don't believe that negative rates will necessarily increase lending and the velocity of money organically, since banks can simply pass down negative rates to their own depositors in the form of various increased bank fees.  As I argued on CNBC recently, negative rates are like bringing a butter knife to a machine gun fight if the goal is to increase lending.  However, to the extent that negative rates end up pushing the euro lower, which the history of negative rates seems to suggest is plausible, then Europe may indeed reflate.
Bottom line? To see if Draghi will ultimately be successful, watch for a continuation of strength in Spain relative to Germany and a continued drop in the euro. The only way for Europe to reverse deflation is to export it.

Twitter: @pensionpartners
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