An interesting survey from Central Banking shows central bank reserve managers have apparently lost faith in the euro, with the stability of the Eurozone supposedly this year’s greatest fear. Apparently concerns over political instability, weak growth, and the European Central Bank’s (ECB) negative interest rate policy have led central banks to cut euro exposure, with some eliminating it completely. This strikes me as very strange timing.
Now, there is of course uncertainty about the Eurozone. But it seems odd to me that these reserve managers have chosen this year to start worrying. Where have these guys been for the last 9 years? There has been uncertainty surrounding the Eurozone since the financial crisis (and before). Greece’s woes have hardly been a secret – they have had two debt restructurings in the last 5 years. Yields in the Eurozone periphery blew out to extreme levels when the Greek crisis was at its height, reflecting concerns about Eurozone break-up. Back then, concerns were not confined to Greece either – Spain and Portugal were also very much in the firing line. By comparison, the current bond market spreads show very little evidence of worry about Eurozone break-up. So why are the central bankers in a tizzy all of a sudden?
One of the reasons they give is the negative interest rate policy from the ECB. It is understandable that investors aren’t happy with this, but it is hardly a new phenomenon. The deposit rate went negative in mid-2014. Furthermore, concern on this issue shows a worrying degree of money illusion. Using the OECD’s forecasts for 2018 inflation, the table below shows real interest rates across the G10.
Source: FX Economics, OECD, national central banks
On this basis, the real policy rate and real 10 year yield for the Eurozone (using France as a proxy for the 10 year yield) aren’t really that low by international standards. In fact, the real policy rate is higher than in both the UK and US. I have ranted about money illusion many times before, so I won’t bore on, but you would have hoped that international reserve managers were a little bit more savvy than to look just at nominal rates.
So maybe they are worried about politics. I find this ironic. The UK votes for Brexit and the US votes for Trump and reserve managers are worried about politics in the Eurozone? It’s true that the Eurozone is existentially more vulnerable, and therefore you can regard political instability as more dangerous. But in reality the chance of a Le Pen victory in France is tiny, and even if she did win, the chance of France leaving the EUR given she has no parliamentary support is similarly tiny. The bigger danger is Italy, but again, despite the anti-euro lead in the polls, there is unlikely to be an election this year, and forming a coalition that would genuinely be prepared to take Italy out of the EU would be extremely difficult. Of course, Italy leaving would be disastrous (for Italy but also for the EU) so this is not a scenario that can be taken lightly. For this reason it is also extremely unlikely to happen, but that doesn’t mean there wouldn’t be major market concerns if the possibility started to look more real. Nevertheless, it is surprising that yield spreads haven’t blown out much further is this was a genuine concern.
As for weak growth, this has been an endemic problem in Europe, but it is again strange to worry about it now when Eurozone growth is picking up and looks set to record its fastest rate since 2010.
There is no doubt that the EUR has suffered from a lack of foreign capital in the last year. In 2016 there was a reduction in Eurozone portfolio liabilities of EUR66bn – foreigners sold a net EUR66bn of Eurozone assets – compared to net buying of nearly EUR400bn in 2014 and Eur300bn in 2015. As long as this continues – the net portfolio and direct investment outflow more than offsetting the current account surplus – investor concerns about the EUR are likely to be self-fulfilling. But I am not sure how long this attitude can last. The EUR is already very cheap by long term measures, and the economy appears to be picking up. If Le Pen loses – as seems very likely – I suspect it will be hard for the markets to maintain this negative attitude indefinitely. But then I don’t really understand why reserve managers have turned so negative in the first place.