Something momentous happened this week. The U.S. Federal Reserve changed its optimistic tone and expressed concern about the slowdown in Europe & the explosive rise in the U.S. Dollar. Big deal, most would say. After all, every central bank talks about its currency & discusses global conditions, right?
Wrong. The U.S. Federal Reserve (Fed) has virtually been a closed system so far. Their mandate is the U.S. economy and they resolutely focus on it. They have had the luxury because the U.S. economy is so large, so developed and so diversified that it is normally impervious to global drivers. Even the price of oil is no longer a major factor for America, thanks to the shale revolution. The Fed has always maintained that the U.S. Dollar is a topic for the U.S. Treasury Department and not for the Fed.
So why the 180 degree turn by the Fed? Because the European economy is virtually falling off the proverbial cliff. Germany, Europe’s dominant economy & linchpin, posted horrific industrial & export numbers this week. S&P downgraded its rating for France on Friday evening to AA. “We are reaching the end game in Europe … :” warned Andrew Roberts, credit chief at RBS, the Telegraph reported.
What end game? The dreaded D-word – Deflation.
Deflation is what Japan has experienced since 1989. A vicious cycle of rising debt and deflation feeding off each other in an economy stuck in mud. When could this happen to Europe? “Deflation is already knocking on the door. We think it could happen as soon as next month given the latest fall in food prices,” said Mr Roberts according to the Telegraph.
The best gauge of deflation fears are sovereign bond markets and they are literally screaming in fear right now. The annual yield on the German 5-year note has dropped to 0.155%, even lower than yield on the Japanese 5-year note of 0.158%.
Europe has been a sick continent for the past few years but, thanks to the assurances of the European Central Bank, it seemed to have regained stability. And, Germany, its core economy, was doing relatively well thanks to its dominant export machine. Now Germany looks sick with its factory orders falling 5.7% & exports falling 5.8% in August alone. What brought this on? Two words – Russia-Ukraine
The German industry is forecasting a fall of 20-25% in German exports to Russia, a huge figure given that German-Russian trade was 76 billion euros in 2013. The precipitating factor for Germany & Europe falling off of the proverbial cliff has been the sanctions imposed by Europe on Russia & counter-sanctions imposed by Russia on Europe. And the worst may be yet to come. Winter comes soon and Europe needs Russian natural gas to survive through winter. Russia has been hurt badly by European sanctions and Putin may well want to exact financial revenge. Russia is already talking about seizing Western financial assets in response to Western freeze of Russian assets. The impact of such seizures on German-European industrial sector and European banks could be large enough to plunge Europe into a recession.
How is this impacting the US? A picture is worth 1,000 words, isn’t it?
(Screaming rally in the U.S. Dollar)
This is not Netflix, GoPro or any internet stock. This is the chart of the U.S. Dollar. The parabolic rise of the Dollar in the past three months is a scary reflection of the fear in financial markets. The fear is now global and money is rushing out of the rest of the world into America. Look at the fall in Asian currencies in the last 3 months in the graph below from GaveKal Capital.
How do you spell financial contagion in 2014? – Sanctions on Russia. As we wrote on April 26, 2014:
- “Frankly, we are far more afraid of the consequences of a financial war than a military war. The American physical homeland is secure from any non-nuclear invasion. But the American financial homeland is not. An integrated financial system is subject to fast & systemic contagion that can cause havoc even in a strong economy. The American economy is improving but it is far from being impervious to a financial contagion.”
Want to see what fast contagion in an integrated global financial system looks like?
(courtesy GaveKal Capital via Advisor Perspectives)
This is a nightmare for the U.S. Federal Reserve. Deflation is their arch-enemy. And a viciously strong Dollar is the conduit for Europe’s deflation to enter America. The Fed has tried to do everything it can to create inflation in America, to regenerate a self-standing strong economy that can create jobs & deliver higher wages. They have been exceptionally bold, even recklessly bold in the eyes of some, in delivering stimulus to the U.S. economy. Now, just as they are about to withdraw their stimulus, they are faced with the specter of financial contagion from Europe and the rest of the world.
Look at Oil. This indicator of world’s economic health is falling hard. Normally that would translate into a rally in transportation stocks. Instead, the Dow Jones Transportation fell by 7% this week. The financial markets are smelling something malignant and they are running scared. And what can anyone do about it? Japan is still in its economic coma; China is slowing down either in a steady mandated manner or in an unruly credit bust. And China cannot grow or even stabilize without economic stability in its largest customer – Europe. Latin America and Asian countries cannot grow without exporting to China. So Europe has to be stabilized for this economic contagion to end.
The financial sector is calling for monetary measures to stem the contagion:
- “We are reaching the end game in Europe. If they don’t launch real QE and start reflation by the end of the year or soon after, the consequences are too awful to contemplate” – Andrew Roberts, credit chief RBS
We disagree. Monetary measures like Quantitative Easing (QE) only buy time. They don’t cure the disease. Europe’s structural disease will take years to cure. What is needed is an immediate jolt to European economies, especially to the German economy. Such a jolt is delivered when wars end and peace reigns.
It is time to end the financial war with Russia and bring economic peace to Europe. This can be done quickly, rationally and without unnecessary rhetoric. If not, the current contagion is likely to continue & get worse with the onset of winter. Neither the FED nor the European Central Bank can do this. It is up to President Obama and Chancellor Merkel.
They should remember that medical science knows how to cure contagions like Ebola. But economic science has never been able to cure a deflationary contagion.
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