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will be strong for those currencies that have seen
solid foreign inflows beforehand.
When discussing inflation-fighting credentials, the
ECB stands out. Only last week, the ECB’s Trichet
expressed his unease at EMU HICP moving above
the ECB’s 2% ceiling. Instantly, the euro rushed
higher. However, in the case of the EUR, the
credibility of the ECB must also be viewed in the
context of outstanding credit risks, leading to nonhomogenous
monetary conditions within the
eurozone. Table 7 alongside has been constructed
with the help of the IMF. It shows debt levels and the
interest rate-growth differentials of selected EMU
countries. At the start of the currency union, rates
were way too loose for peripheral countries. The rule
of thumb suggests that nominal GDP and rates
should be at approximately the same level. The rule
should particularly apply in the long term.
Table 7: Public Debt and Interest Rate–Growth
Rate Differential (pp)
Country
Debt/GDP
2007 2009 2015 1/ Historical /2 Projected /1
France 63.8 77.4 94.8 0.8 0.5
Germany 65 72.5 81.5 2.6 1.5
Greece 95.6 114.7 158.6 -1.5 2.2
Ireland 24.9 64.5 94 -5.8 3.2
Italy 103.4 115.8 124.7 1.4 1.7
Portugal 63.6 77.1 98.4 -0.6 2.2
Spain 36.1 55.2 94.4 -2.4 2.6
Median 63.8 77.1 94.8 -0.6 2.2
Mean 64.6 82.5 106.6 -0.8 2
Source: IMF’s WEO database, BNP Paribas
Interest rate-Growth rate Differential
Chart 8: USD Liquidity vs. S&P 500, CRB
However, before the crisis, peripheral countries
enjoyed relative to their nominal GDP growth very
low funding costs, which led to booming and
consequently busting assets. The table shows that
Ireland ran a negative interest rate-growth gap of
5.6%. But now, as assets have tanked, peripheral
countries are exposed to liabilities no longer covered
by asset values.
The funding costs of these liabilities have soared and
will stay high if you believe the IMF numbers, leading
to the perverse situation that monetary conditions in
the recessionary countries of Europe’s periphery
have tightened while booming Germany faces superloose
monetary conditions. This environment will put
the inflation-fighting credentials of the ECB to the
test.
We recall the situation from August to early
November, when the ECB channelled 3mths Euribor
rates up by about 60bp. At the same time, intra-EMU
credit spreads widened, leaving us confident with our
EURUSD 1.34 year-end call for 2010. Now as
inflation is moving up and the ECB rhetoric is
becoming more hawkish, we are watching credit
spreads with interest. As long as credit does not pop
up, the euro will strengthen, supported by
expectations of a hawkish central bank reaction to
rising inflation.
However, recessionary peripheral economies facing
already-tight monetary conditions are unlikely to cope
well with monetary tightening. Inflation and the
reaction of central banks must always be viewed in
the context of credit; this is particularly the case for
EMU.
Inflation will kill the ‘quasi-China trade’
Source: Reuters Ecowin Pro, BNP Paribas
Third, the emergence of inflation might actually be
good news for countries currently stuck in deflation or
facing the threat of deflation (e.g. Japan and the US,
respectively). On the other hand, inflation represents
the biggest threat in countries where there has been
domestically built up leverage.
Above, we discussed the case of China, where
inflation will either undermine the real value of
household assets (in the case of deposit rates
remaining below inflation) or the highly leveraged
corporate sector faces rising funding costs (should
the central bank take on the fight against inflation by
increasing official lending rates). In our view, the
inflation trade is the ‘anti quasi-China trade’ working
against shares, commodities and last and not least
the AUD. Inflation will bring the USD-funded carry
trade to an abrupt halt, leading to a higher USD.
Inflation will weaken the JPY
Fourth, rising inflation globally will put the JPY under
significant selling pressure. Japan has accumulated
foreign currency hedged assets as hedging costs
became virtually zero in a world where quantitative
easing is a common policy tool. When inflation
comes back and central banks tighten policy, the
JPY will fall victim to the process.
Hans Redeker 20 January 2011
Market Mover, Non-Objective Research Section
62
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