If deflation is ahead should I fix for 10 years?

[Gervan]

We are warned that the Eurozone could be facing a long period of deflation. Negative interest rates have been suggested.
Every time I see a new posting in the deposit thread my heart sinks as interest rates drop lower and lower.

In a deflationary scenario is it correct that the longer I hold on to money the more it will buy? Does it make sense to put any funds I don't see myself needing in the next 5 or 10 years into a very long term deposit, even at the current pitiful rates?

 

[Lightning]

If a period of deflation is to occur, or ever very low inflation, then is obviously more likely that the ECB will cut rates further.

Negative rates on deposits at the ECB will hurt banks who have excess cash deposits with the ECB by encouraging them to park money elsewhere or lend it. Irish banks have liquidity 'loans' from the ECB rather than sizeable excess deposits. The trickle down effect to retail consumer deposit rates should be minimal, albeit, a negative ECB deposit rate is sure to reduce the already low Euribor and Eonia rates, ever so slightly, which has its own trickle down effects. In a nutshell, I think a negative ECB deposit rate will have a very minor effect on retail deposit rates.

However, the general direction of deposit rates, going downwards, is sure to continue as Irish banks seek to build greater net interest margins. However, the scope for further retail deposit cuts is starting to get limited.

In a deflationary scenario is it correct that the longer I hold on to money the more it will buy?

Yes because your purchasing power increases for the duration of a deflationary period.

Does it make sense to put any funds I don't see myself needing in the next 5 or 10 years into a very long term deposit, even at the current pitiful rates?

If deflation occurs in a prolonged and meaningful manner then long duration term deposits, if they pay well, are normally the most sensible option. However, given that rates are so pitiful, even for 5 or 10 year terms, it is difficult to justify locking your money away for such a long period. Also, if deflation / low inflation does not stick around, and rates in the medium term increase, then it is not the best strategy.

 

[The Ghoul]

10 year national solidarity bond pays 2.66% AER if you leave it for the full term, if you don't leave it for the full term it's zero or really pitiful interest. I think for someone that has other shorter term investments it is not a bad idea now to buy 10 year SBs. If we get a few years of very low inflation and then inflation rises to say 3-4% (well above 2.66% and well above ECB target) you might still make a real return on this product.

My own situation is I have:
-3 year savings bonds (issue 12) maturing 2014-2015
-5.5 year savings certs (issue 17) maturing 2017
-prize bonds which I regard as a 7 day notice account
-10 year SBs, mostly issue 3 and 4.

I am happy that I have the savings bonds and certs but when the bonds start maturing this year I'm not sure what I'll do with the money. Probably PBs or 10 year SBs. I'm also getting an inheritance this year (a low six figure sum) and thinking something similar for it.

Re: fixing for 10 years and predicting the future, had my crystal ball been operating correctly I would have filled my boots with the 10 year SB when it was in issue 1 (as well as buying Greek bonds and BOI shares!)

 

[dub_nerd]

If Eurozone deflation occurs and lasts for several years, I'd have concerns for the euro. Also, the problem with locking money away for many years is you don't know what the government's going to do to your returns (or even your capital!). I was happy to lock my money away for a few years while the rates justified it, but as it matures over the next few years I think I'd prefer to keep my money mobile and forego the current measly returns on term deposits.

 

[Jim2007]

If Eurozone deflation occurs and lasts for several years

Why would deflation occur? If such a situation was on the offings, you can assume that the ECB would move very quickly to convert it to inflation, for the simple reason that we know how to handle inflation, where as we do not know how to handle deflation!

I'd have concerns for the euro.

The Euro has gone through an incredible period and the Euro countries have shown not only that they have faith their currency, but that they willing and capable of defending their currency and that surprised the City (London) no end.

I'd prefer to keep my money mobile and forego the current measly returns on term deposits

And what then is going to be your alternative. How are you going to grow your wealth? How are you going to ensure that your savings at least keep up with inflation - because that is far more likely than an other outcome...

 

[dub_nerd]

Why would deflation occur?

By carving my statement into clauses you've missed my point. Yes, of course the ECB will attempt to bring about moderate inflation (or rather, to stimulate demand through looser monetary policy, which causes inflation). Therefore, if they were to fail, it would signal a deep malaise in the European economy -- I'm not speculating as to how or why that might happen, just that if it did I would worry for the euro. The pertinence of this to the OP's question is that their reason for locking themselves into long term rates is unlikely to come to pass and indeed might be just the reason not to commit long term to the currency.

And what then is going to be your alternative. How are you going to grow your wealth? How are you going to ensure that your savings at least keep up with inflation - because that is far more likely than an other outcome...

That's the $64 question. I wish I knew. All I know is that my savings are keeping well ahead of inflation right now, but that will all end in the next couple of years. I also know that when government policy is doing its damnedest to try to entice your money out into the open, it might be just the time to sit tight and accept an effective negative interest rate (after tax and inflation), with a view to capital conservation.

 

[mcriot29]

There is a chance the ECb will hike up rates
http://mobile.reuters.com/article/idUSBREA2T09O20140330?irpc=932

 

[dub_nerd]

However, Draghi has intimated in recent pronouncements and at a press conference yesterday that the ECB is very aware that something needs to be done about low inflation:

http://www.theguardian.com/business/2014/may/08/mario-draghi-may-move-to-tackle-risk-of-deflation

On the other hand, as reported on the BBC today and elsewhere, the ECB has little room to manoeuvre with rates already at 0.25%, plus they are not allowed buy government bonds directly and the banks don't have a lot of worthwhile assets, so US Fed style easing is not an easy prospect. Nevertheless, I wouldn't be locking my money away for ten years in the hope of continued low inflation.

Just another thought -- with the euro at nearly 1.40 to the US dollar, I've considered whether it would be sensible to convert money to dollars or dollar-denominated assets now in the expectation of the ECB acting to weaken the euro (which has been as low as $1.25 in the last two years). Does anyone know how the average punter could achieve this? Is it as simple as buying US shares? (I don't dabble in any of this sort of stuff, but plan to learn about it sometime).

 

[North Star]

Hi dub nerd
If you are looking to try to take advantage of a weker Euro verus US Dollar, you have a couple of options;

1) You can simply buy US Dollars and then convert back to Euro if/when the exchange rate falls. Given the price spreads charged by banks you will probably lose about 8 or 9% of your funds in doing these 2 exchange deals - so this is clearly not recommended

2) As you say you can buy assets denominated in USD e.g U.S shares where you then have both exposure to the exchange rate and the currency , however please check the price spreads being charged on the currency element

3) if you already have unit linked assets e.g private pension, Buy Out Bond, PRSA or ARFs in life company unit linked funds, then you probably have the option to switch at zero or very minimimal costs into Euro denominated funds but with underlying assets in US Dolars e.g U.S equity fund. The advantage here is that these investments are already in USD and the unit price will rise or fall in Euro terms depending on both the currency movements and the underlying asset price movements. So you or the fund manager dont have the cost of doing an fx transaction its just a daily translation re the current fx rate

4) You can purchase an ETF which tracks the Euro Dollar exchange rate, just make sure you buy the ETF that is short the Euro. You can get ETFs which are leveraged i.e the payoff is 2 times the change in the exchange rate, or an even higher multiple if you wish. As with any investment leverage is/can be very dangerous. Transaction costs on an ETF are much lower and if you select a liquid ETF there are very narrow price spreads and low transaction charges - via a stockbroker. An example of an ETF to achieve this would be the Pro Shares Short Euro ETF EUFX

generally option 4 and 3 would be our preference

I hope this helps.

Regards Vincent

 

[dub_nerd]

Thanks Vincent, that's extremely helpful!

 

[Jim2007]

Just another thought -- with the euro at nearly 1.40 to the US dollar, I've considered whether it would be sensible to convert money to dollars or dollar-denominated assets now in the expectation of the ECB acting to weaken the euro (which has been as low as $1.25 in the last two years). Does anyone know how the average punter could achieve this? Is it as simple as buying US shares? (I don't dabble in any of this sort of stuff, but plan to learn about it sometime).

You are talking about a country that has run a massive trade deficit for over 15 years and a projected debt level of about $21 trillion by year end... What would it take for their currency to appreciate??? Or what would the ECB need to do in order to devalue the Euro against the Dollar to a level that you would benefit from???

To try and put it into perspective, we have the Franc pegged to the Euro for the past while... but to do so the SNB has had to hose up Euro bonds to such an extent that it now holds bonds equivalent to the national deficits of the 7 biggest Euroland nations!

 

[dub_nerd]

You are talking about a country that has run a massive trade deficit for over 15 years and a projected debt level of about $21 trillion by year end... What would it take for their currency to appreciate??? Or what would the ECB need to do in order to devalue the Euro against the Dollar to a level that you would benefit from???

To try and put it into perspective, we have the Franc pegged to the Euro for the past while... but to do so the SNB has had to hose up Euro bonds to such an extent that it now holds bonds equivalent to the national deficits of the 7 biggest Euroland nations!

Endless possibilities spring to mind -- the markets turn on Ireland and Portugal and they end up back in bailout programmes; Greece needs a third bailout; the upcoming stress tests show up large numbers of Eurozone banks for the busted flush they are; the European electorates return a large number of Eurosceptic MEPS which shakes confidence in the institutions; peripheral countries facing austerity begin to see their future as outside the Eurozone; France fails to operate within the strictures of Euro budgetary controls and its government falls; the German public tire of their perception of paying for other countries' extravagance or support for anti-deflationary measures is lacking.

If not a single one of those things happens, I would consider it a minor miracle. "Those who say the European economy is recovering are smoking something" ... it's not the ravings of a Eurosceptic doom monger, but the chief economist of Citigroup quoted in the Financial Times. And as the same FT article observes, it's no longer just an economic question, but one of whether monetary union is politically sustainable.

 

[Jim2007]

Endless possibilities spring to mind -- the markets turn on Ireland and Portugal and they end up back in bailout programmes; Greece needs a third bailout; the upcoming stress tests show up large numbers of Eurozone banks for the busted flush they are; the European electorates return a large number of Eurosceptic MEPS which shakes confidence in the institutions; peripheral countries facing austerity begin to see their future as outside the Eurozone; France fails to operate within the strictures of Euro budgetary controls and its government falls; the German public tire of their perception of paying for other countries' extravagance or support for anti-deflationary measures is lacking.

Without quantification, possibilities are just that and making financial decisions based on possibilities amounts to speculation, which is a great way of loosing money! Take for instance your comment on Euroland banks, most of their 'to big to fail' banks have T1 ratios of around 6% to 8% and for those banks to be come problematic their T1 ratios would need to fall to about 2% to 3%. For that 'possibility' to work out for you, asset values would need to decline by about 70% (including a decline in gold prices). Now as far as I'm concerned, I would not be willing to invest on those kind of odds!

If not a single one of those things happens, I would consider it a minor miracle. "Those who say the European economy is recovering are smoking something" ... it's not the ravings of a Eurosceptic doom monger, but the chief economist of Citigroup quoted in the Financial Times. And as the same FT article observes, it's no longer just an economic question, but one of whether monetary union is politically sustainable.

Well the CITI economist and the FT have one thing in common, they both have advised traders to bet against the EURO, so talking down the EURO is the objective! And of course the fact that FT needs to sell newspapers should not be overlooked. Unless an author can back up their claims with hard statistical analysis I tend not to pay them much attention.

This idea of monetary union being unsustainable is interesting though, since it is usually presented as being 'obvious', while the examples we have would seem to suggest the opposite.... Funny that!