Monday, December 06, 2004

While housing bubble deflation hits Australia and the UK, and looms in parts of the US, our favorite ignis fatuus may be ready to migrate to the eurozone, according to Morgan Stanley's Joachim Fels.
A weaker dollar spells stagflation for the euro area. However, it is a new kind of stagflation. While the �stag� continues to stand for economic stagnation, �flation� is no longer short for consumer price inflation: in type-II stagflation, it stands for asset price inflation. Why? A stronger euro puts a damper on growth and lowers import prices, both of which tend to be disinflationary. But a stronger euro also cements the ECB�s negative real interest rate policy, which continues to fuel liquidity growth. In search of yield, investors will push equity and real estate prices higher and bond yields and corporate spreads lower. . . .

Euro area markets are already awash with liquidity, stemming from more than three years of excessive money supply growth. Record-low short-term interest rates, coupled with the prospect that they are likely to remain low for an extended period of time, provide a huge incentive for investors to extend along the government bond yield curve and to venture into riskier assets such as corporate bonds, derivatives, and equities. It is no coincidence that bonds and equities have both rallied in recent weeks -- excess liquidity is the only rational explanation, in my view. Moreover, favorable financing conditions have led to a surge in mortgage borrowing and a rally in house prices in many parts of the euro area. The longer the ECB keeps rates low in response to a strong euro, the bigger these bubbles will get.
In Fels' view, the ECB has two choices if it is going to head off asset bubbles at the pass: [1] cut interest rates; or [2] intervene massively in currency markets to push down the euro, and sterilize. With the ECB's fanatical irrational fear of inflation, there is little chance of [1] coming to pass. The chances of [2] are quite good for not simply asset bubble reasons but export reasons as well. Yet the question remains how much more debt the European governments can absorb via sterilization. Perhaps the ECB cannot fend off asset bubbles as easily as Fels thinks.

Other areas with rising currencies and negative real interest rates may be ripe for similar asset bubble threats. One that comes immediately to mind is Canada. The Bank of Canada overnight rate now stands at 2.5%, Canadian CPI is 2.3%, the loonie is up over 5% against the USD in the last eight weeks, and housing markets in Canada are surging. All the pieces are not quite in place, but early 2005 could be a bubbly time of year for the red and the white (and the bleu).

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