Euro, yen gains heighten central banks' low-rate conundrum

* Low rates, inflation tend to deliver strong currencies

* Euro rise since ECB easings:

* Yen rise since BOJ went negative:

LONDON, April 5 (Reuters) - The harder the European Central Bank and the Bank of Japan push, the less they seem able to subdue their currencies.

Fearful of deflation, both central banks have this year surpassed expectations with the scale and depth of their extraordinary monetary easing.

But far from weakening, the euro and yen -- key avenues through which this easing affects the underlying economy and inflation outlook -- have strengthened significantly.

The euro last week rose above $1.14 for the first time in almost six months while the yen is at a 17-month high against the dollar, chalking up its biggest quarterly gain since 2009.

(Euro rise since December:

Yen rise this year:

Their resilience demonstrates that, if inflation gradually erodes the purchasing power of a currency then the reverse theory must also hold up. It’s also a reminder that, in the longer run, currencies with low inflation and low interest rates are typically those with strong exchange rates.

Euro zone inflation is mildly negative and unlikely to return to the European Central Bank’s target of just under 2 percent for years, while Japan has spent the best part of the last 20 years fighting deflation.

Short-term speculative flows have also contributed, amid a broad recalibration of the U.S. interest rate outlook for fewer - if any - rate hikes this year.

According to popular wisdom among the currency trading fraternity embodied in the “carry trade”, low-yielding currencies should be sold for higher-yielding alternatives.

But evidence suggests that currencies of developed economies boasting high levels of GDP growth per capita and productivity, a balance of payments surplus and high savings rates tend to fare better over the longer-term.

Research by Cass Business School, Germany’s DIW think tank and the Bank for International Settlements shows that a country’s interest rate only has an 18 percent weighting in determining a currency’s real exchange rate value.

That is marginally higher than inflation (16 percent) and slightly lower than productivity (20 percent) but is well behind the differentials in the quality of a country’s exported goods, which accounts for nearly 50 percent of real exchange rate variation across countries.

“We see with regularity that low inflation and low interest rate currencies typically have strong real exchange rates,” said an economist at a central bank in Europe.


For all the euro zone’s and Japan’s economic difficulties, their currencies still receive support from in-built structural foundations of high savings rates, surpluses and productivity.

The euro zone ran a seasonally-adjusted current account surplus last year of 320 billion euros, meaning that sum needed to exit the region just to prevent the exchange rate from rising.

This large amount of savings is the “Euroglut” theory advanced by Deutsche Bank that, with nominal returns on euro zone assets so low - thanks to sub-zero deposit rates and bond yields - investors will seek higher returns abroad.

But a fragile global economic outlook has instead diminished investors’ risk appetite, keeping much of that cash pile at home and putting Deutsche’s forecast of the euro at $0.85 next year under increasing scrutiny.

The composition of capital flows has changed since the global crisis of 2008, which has diminished the influence interest rate differentials play in setting exchange rates.

Portfolio flows in and out of bond and equity markets -- the most sensitive to those differentials -- fell and have yet to recover.

Meanwhile foreign direct investment (FDI), less sensitive to central bank policy actions, has held up fairly well and is playing an increasingly important role in determining exchange rates.

Research by investment bank UBS shows that nominal capital flows as a percentage of global GDP collapsed to around 6 percent last year from just over 20 percent in 2007, mostly due to lower portfolio flows.

“The influence of central bank policy on currencies, in particular the role of the interest rate differential, is likely to be less than has been the case in the past,” said Paul Donovan, Managing Director, Global Economics at UBS.

“Central banks seeking to influence the value of their currency may also need to reflect on the changes this implies.”

With global interest rates at all-time lows, the exchange rate is one of the few levers central bank policymakers have left to boost competitiveness and growth.

It’s a race to the bottom that, as long ago as 2010, then Brazilian finance minister Guido Mantega dubbed a “currency war”.

As the ECB and BOJ are discovering, winning it remains as hard as ever.

Reporting by Jamie McGeever; editing by John Stonestreet