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Deutsche Bank – Fixed Income Research
Special Report – Euroglut here to stay: trillions of outflows to go
10 March 2015 (9 pages/ 370 kb)
Last year we introduced the Euroglut concept: the idea that the Euro-area’s huge current account surplus reflects a very large pool of excess savings that will have a major impact on global asset prices for the rest of this decade. Combined with ECB quantitative easing and negative rates we argued that this surplus of savings would lead to large-scale capital flight from Europe causing a collapse in the euro and exceptionally depressed global bond yields.
This is indeed strange- the notion that a current account surplus causes currency depreciation?
The current account surplus, in general, is evidence of restrictive fiscal policy that constrains domestic demand, including domestic demand for imports, along with depressing wages which adds to ‘competitiveness’ of EU exporters. Normally, however, this causes currency appreciation that works against increased net exports, unless the govt buys fx reserves. But this time it’s been different, as ECB policies and uncertainty surrounding Greece and related political events have managed to frighten global portfolio managers into doing the shifting out of euro financial assets in sufficient size to cause the euro to fall, particularly vs the $US, giving a further boost net EU exports.
With European portfolio outflows currently running at record highs, this piece now asks: Can outflows continue? How big will they be? The answer to this question is critical: the greater the European outflows, the more the euro can weaken and the lower global bond yields can stay.
Again, this is a very strange assertion, as exporters selling the dollars earned from their exports for euro needed to pay their domestic expenses in fact drain net euro financial assets from the global economy.
What can happen is that speculation and portfolio shifting can be associated with agents borrowing euro or depleting ‘savings’ which they sell for dollars, for example, to accomplish their desired currency weightings. And these new euro borrowings and savings reductions do indeed create new euro deposits for the purpose of selling them, which drives down the value of the euro as previously discussed. This leaves those selling euro for dollars either ‘short’ euro vs dollars, or underweight euro financial assets in their portfolios.
However, at some point the drop in the euro that makes EU real goods and services less expensive for Americans to import, and at the same time makes US goods and service more expensive for EU members, can cause EU net exports to increase. That is, Americans buy imports with their dollars, and the EU exporter then sells those dollars to get euro to pay their EU based production costs, and generally keep their net profits in euro as well. That is, EU exports to the US are facilitated by exporters selling dollars for euro, which is the opposite of what the speculators and portfolio managers are doing.
To review the process, speculators and portfolio managers sell euro for dollars driving the euro down to the point where the EU exporters are selling that many dollars for euro, all as the exchange rate continuously adjust as it expresses ‘indifference levels’.
And should the speculation and portfolio shifting drive the euro down far enough such that the net export activity is attempting to sell more dollars for euro than the speculators and portfolio managers desire, the evidence will be a reversal in the exchange rate as the dollar then falls vs the euro.
We answer the outflows question by modeling the Euro-area’s net international investment position (NIIP). We argue that Europeans now have to become net creditors to the rest of the world and that the NIIP needs to rise from -10% of GDP to at least 30%. We estimate that this adjustment requires net capital outflows of at least 4 trillion euros.
No ‘net capital inflow’ is needed for the EU to lend euro. As always, it’s a matter of ‘loans create deposits’. That is, the euro borrowings as I described create euro deposits as I described. The notion that borrowing comes from ‘available funds’ is entirely inapplicable with the floating exchange rate policies of the dollar and the euro.
This conclusion leads to three investment implications.
First, we continue to expect broad-based euro weakness.
They were right about that!
I say it’s from portfolio shifting and speculation desires exceeding the trade flows, even as restrictive fiscal policy and now currency depreciation from portfolio shifting and speculation has caused an acceleration of net exports.
They say it’s from a pool of ‘excess savings’.
European outflows have been even bigger than our initial (high) expectations, so we are revising our EUR/USD forecasts lower. We now foresee a move down to 1.00 by the end of the year, 90cents by 2016 and a new cycle low of 85cents by 2017.
It’s very possible, if the portfolio shifting and speculation continues to grow faster than the EU’s current account surplus grows. However, should the growing current account surplus ‘overtake’ the desired portfolio shifting and speculation, the euro will reverse and appreciate continuously until it gets high enough for the current account surplus to fall to desired portfolio and speculative fx weightings.
Second, we expect continued European inflows into foreign assets, particularly fixed income. Our earlier work demonstrated that the primary destination of European outflows will be core fixed income markets in the rest of the world, and evidence over the last few months supports these trends: most European outflows have gone to the US, UK and Canada. These flows should keep global yield curves low and flat.
Yes, to the extent that euro portfolios desire to shift to dollar financial assets due to the interest rate differential the shift can continue. However, history and theory tells us this is limited as the desire to take exchange rate risk is limited. Euro portfolios are most often matched with euro liabilities, and so shifting to dollar financial assets can result in substantial euro shortfalls should the exchange rate shift adversely. In fact, many portfolios, if not most, including the banking system, are in some way legally prohibited from exchange rate risk exposure.
Finally, we see Euroglut as continuing to constrain monetary policy across the European continent for the foreseeable future. Since our paper in September central banks in Switzerland, Norway, Sweden, Denmark, the Czech Republic and Poland have all eased.
Except this ‘easing’ is in the form of lower interest rates, which is effectively a fiscal tightening as govts pay less interest to the non govt sectors, which in fact works to make the euro stronger. Likewise, the deflationary forces unleashed by restrictive fiscal policy likewise imparts a strong euro bias.
These countries run large current account surpluses.
Yes, a force that generates currency appreciation as previously described.
This is why, once the shifting and speculation has run its course, I expect the euro to appreciate continuously until it gets high enough to again reverse the trade flows from surplus to deficit.
Feel free to distribute.
Through a unique mix of huge excess savings and structurally low yields, the entire European continent will continue to be a major source of global imbalances for the rest of this decade.