Will the Lesser of Two Evils Prevail?

David Pett at the National Post reports that Euro worsens deflation risk:

Since the Great Recession, there have been fears that the U.S. economy would follow in the footsteps of Japan, where economic activity and investment have been stagnant for more than two decades.

More recently, however, prospects for recovery south of the border have improved and it is the European Union, struggling with a growing sovereign debt problem that could be headed for Japanese style deflation.

"The recent string of debt crises in Southern Europe has revealed the true financial frailty of the euro area economy," said Chen Zhao, managing editor, BCA Research Inc. " In fact, the economic snapshot of the eurozone looks very disturbing."

Over the past two months, markets around the world have been rattled by the growing unease surrounding Greece's well-documented debt woes, but also by other eurozone nations, such as Portugal and Spain, also burdened by highly levered balance sheets.

While the past few weeks has seen bond spreads fall and the euro rebound against the greenback on tentative plans for a Greek bailout, Europe's economy remains tenuous. The OECD said growth in gross domestic product in the euro area slowed to 0.1% in the fourth quarter of 2009 and will expand by just 0.9% this year.

Mr. Zhao said the intense debt-deflation pressure being felt in Europe has many similarities to the post-crash environment in Japan in the early 1990s.

Even as the country's very own asset bubble was beginning to burst in 1989, Japan mistakenly believed the biggest risk to the economy was inflation, not deflation, and continued to raise rates until September 1999. Continuing to run a surplus until 1992, its fiscal policy was also a drag on the collapsing economy and it was not until 1995 that Japan's deficit hit 5% of GDP.

Similarly, the European Central Bank was slow to react to the recent global financial crisis, raising rates as late as July 2008 when stock markets had already fallen 30%. The implementation of a fiscal stimulus package was also late in coming.

Since then, Europe's monetary and fiscal policy has been much more aggressive and proactive than Japan's response, but Mr. Zhao said the recent collapse was also much more severe than the slump in the Japanese economy in the early '90s.

"So judging by the severity of the Great Recession, it is not obvious whether the stimulus in the eurozone has been aggressive enough at all," he said.

In addition to parallel policy responses in both episodes, Mr. Zhao said the strong euro has greatly increased the risk of weak economic recovery, price deflation and loss of competitiveness in Europe, as did the strong yen during Japan's post-crash struggles.

To make matters worse, the common currency makes it impossible for member countries struggling with excess debt to devalue their own currency.

Chen Zhao has always been one of the more interesting Managing Editors at BCA Research. When I was working there, I didn't know how he was able to constantly produce so many thought provoking pieces. Chen is a tireless workhorse who never shies away from making big calls.

I saw the slowdown in Europe coming when I visited Greece this past summer. There were hardly any tourists and the strength of the euro didn't reflect strong European fundamentals, but relatively weak US fundamentals at the time. One Greek cab driver told me: "we're going to starve this winter." They're not starving but Greece's fiscal woes are going to require some sacrifices ahead for most Greeks.

And risk of deflation are not just in Europe. In Japan, bonds advanced for a second day as concern deflation will deepen in the world’s second- largest economy boosted demand for government debt.

Bond futures approached the highest level this year as stocks slid worldwide after a U.S. report yesterday showed confidence among consumers declined to the lowest in 10 months. Consumer prices in Japan dropped for an 11th month in January, according to a Bloomberg News survey of economists before the government report this week.

“Given the huge slack in supply and demand conditions, Japan will be mired in deflation,” said Akitsugu Bandou, a senior economist at Okasan Securities Co. in Tokyo. “This will make it easier for investors to keep spending money on bonds.”

The yield on the benchmark 10-year bond fell 1.5 basis points to 1.315 percent as of the 11:05 a.m. morning close in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The 1.3 percent security due December 2019 gained 0.130 yen to 99.869 yen.

Ten year bond yields at 1.35%! As bad as that sounds, it's better than the ravages of deflation, which wipes away returns from risk assets like stocks and corporate bonds.

In England, Gov. Mervyn King said on Wednesday that the Bank of England may still have to pump more money into Britain's fragile economy after the central bank forecast inflation standing well below target in two years' time.

Finally, the jury is out on whether the US will escape deflation. Some people feel that deflation risks still exist in the US while others see bond trading reflecting two views on US inflation:

Bond markets are jittery and investors have reasons to be nervous.

The decision last week by the U.S. Federal Reserve Board to raise the discount rate - the interest it charges on the emergency loans it makes to banks - suggests the days of easy money marked by the Fed's zero-interest rate policy are numbered.

The Fed raised the discount rate by one-quarter of a percentage point, to 0.75 per cent.

While that signals another step in the return of financial markets to a more normal state, given the weak economy it will likely be some time before the Fed begins to raise its key federal funds rate. That is the rate that helps to hold short-term interest rates down in order to stimulate economic growth.

And it is that policy that has bond investors antsy. The worry is that the continuing low interest rate and loose monetary policies of the Fed will fuel inflation.

So far, inflation pressures as measured by the consumer price index have been relatively tame, if rising gasoline and food prices are excluded. The U.S. core consumer price index (excluding food and energy) on a year-over-year basis was 1.6 per cent in January, compared with 1.8 per cent in December.

However, overall the annual inflation rate is 2.6 per cent, reflecting higher gasoline prices and the beginning of higher food prices resulting from the impact of the Florida freeze on fruit and vegetables, according to BMO Nesbitt Burns Inc.

Bond investors are being torn between the safety of holding U.S. Treasuries and the risk of seeing their savings eroded by inflation. Recent action in the bond markets illustrates the forces at work.

The short-term action has been dramatic.

The U.S. Treasury Inflation-Protected Securities bonds, or TIPs, are securities that provide a return tied to the CPI data, including food and energy. TIPs have experienced a sharp selloff during the past few weeks, after a year in which they outperformed conventional Treasuries by more than 10 per cent. The recent drop has lowered the out-performance to about 7.6 per cent.

"I have been aggressively selling TIPs during the past month, and have been selling since some time last year," said Mihir Worah, a managing director and head of the real return bond desk for Pacific Investment Management Co., or Pimco, the world's largest fixed-income manager.

A year ago, Pimco saw TIPs as an excellent investment opportunity because they were priced as if there would be deflation for six or seven years. "Let's hope this call is right, too," Mr. Worah said.

Let me repeat that given the choice between the lesser of two evils, the Fed will err on the side of inflation. There is a concerted effort to reflate financial assets which they hope will translate into "mild inflation".

Pension funds are betting trillions of dollars that inflation will ultimately prevail. Let's hope they're right on that call because if they're not, millions of pensioners will be feeling the squeeze of reduced pension benefits.