Merk: Beware Quick End To Low Volatility

May 30, 2014

Complacency about low volatility, not Draghi euro debasement, is biggest market risk now.

[This interview originally appeared on our sister site,]

Axel Merk is president and chief investment officer of Merk Investments. Famed for identifying the credit bubble, he is considered an authority on currency investing, gold and macro trends.

He argues that investors should actively manage their currency risk and should do their homework when it comes to buying currency-hedged ETFs.

Rebecca Hampson, European editor at, talks to Merk about his bearish views on asset prices, how he expects gold to do well and that Draghi might be one step ahead of Europe. How will monetary policy impact the euro?

Axel Merk: The monetary policy affects the euro, but not the way most people think. It affects the euro by keeping things a lot stronger.

The ECB is just not capable of debasing the euro. The euro has been very frustrating for Mario Draghi [president of the European Central Bank] because he has not been able to push the euro weaker. The real challenge he faces is that the tools the European central banks are using are not very effective at weakening the euro.

He now wants to lower interest rates, which means imposing negative deposit rates, but the problem with this is that there are no deposits left at the ECB. The facility that is going to be punished with negative rates is almost empty

One of the things people don’t always understand is that you can have lacklustre growth and a strong currency, just look at Japan, and conversely, just because you have a problem somewhere in the Eurozone doesn’t mean that the euro is weak.

The stimulus the ECB is looking for has been coming through lower spreads. The periphery has been paying much less than they were a while ago and that is all in anticipation that Draghi will continue to do ‘whatever it takes’, which is a much stronger message than any policy action.

Sure, there might be another longer-term refinancing operation repayments (LTRO) announced, but the market has already indicated that it is lukewarm about the LTROs.

What is positive in the Eurozone is that there is demand for new credit, it is just that there is old credit is not being rolled over and that is not going to change because the world is this way now.

What they want to do with monetary policy now is introduce an ABS programme and that is not going to happen overnight. What is an ABS programme?

AM: It’s an asset-backed securities programme.

In the US the Federal Reserve had Quantitative Easing (QE) and this is the Fed buying treasury securities and paying for them by making up the money. So, for example, in a few strokes on a keyboard Goldman Sachs suddenly has a billion to use. Instead of holding the security they hold cash and they can go out and induce more economic activity, which of course hasn’t happened, they have just put the cash back at the Fed for deposit.

In Europe that doesn’t work because the credit markets aren’t as developed and what the ECB calls the ‘transmission mechanism’ isn’t working either. This is why we have had to go through the stress tests and what Draghi does differently is say that stress tests are good, but if you do it you have to have a solution for institutions that don’t pass.

What he wants to do is create a programme, which is compatible with how the Eurozone works and that is to facilitate an asset backed securities market. It was a reasonably vibrant market before 2008 and he wants to revive that.

The challenge is that Europe is so fragmented that it isn’t easy to implement something on such a huge scale that is going to help boost growth any time soon.

Draghi is extremely smart, but he might be a step ahead of the market here. How can investors protect themselves against these issues?

AM: The question as an investor is what is your goal and how are you going to implement this?

The first seismic shift that has happened in the euro – which people aren’t all aware of – is risk is generally being priced locally again. This may sound arcane, but it makes the world of difference. When Cyprus blew up, Spain had a treasury auction where they paid the lowest yield since the early 90’s. It means that the next time a crisis flares up, odds are, it is going to be a local crisis and it doesn’t need to swap the currency. So another question is do you want to play the euro or the yields, what’s the play?

We don’t think that it is prudent to chase yield in the current environment where we are seeing complacency as a global theme. Asset prices in general are also very vulnerable, because - in my view - at some point the tide is going to turn and the glass will become half empty. What do you think of currency hedge ETFs?

AM: It is a big theme this year. The Japanese helped to get that market started, because last year if you hedged the Yen out of the Nikkei you had gangbuster returns. Year to date it hasn’t worked.

Generally speaking about 30-50 percent of market returns are due to currency and that can be due to upside or downside. So, if you hedge it out you leave a big chunk of the return on the table. It can reduce the volatility - sure, but you leave the returns on the table.

If you don’t hedge it out you are in for a rough ride. My view is that you should actively manage the currency risk of your portfolio, including your international equity portfolio. We live in a world where asset prices don’t reflect fundamentals, because we have active policy makers, on the policy side, the fiscal side and the regulatory side. The currency market often expresses the next policy action and therefore it’s important to manage this and by hedging it out – in my view – you don’t get much of an advantage. Enough tools for investors to know how to manage currency risk?

AM: Not really. Part of the reason is that most people stay away from currencies because they think they don’t understand them, so there hasn’t been much demand for them.

The currency space is one market people can get true diversification, but people don’t understand it and don’t take the effort to get to know it, so a lot of people are just listening to the pundits and they come up with some ideas that we have a rising interest rate environment, so the dollar has to go up. This is historically that is bogus.

People are just not very critical when it comes to currency and it is why these currency hedge ETFs have become very popular without people actually doing their homework or analysis.

I am not saying that people shouldn’t use them, but if you do then you have to take another sleeve of your portfolio that focuses on that currency risk. Are these appropriate for retail investors?

AM: Well, we think so.

People always say currencies are speculative and volatile. The reason people think currencies are so volatile is because a lot of people use leverage in the currency space. But you don’t have to use leverage. What are the key risks for European investors?

AM: Draghi is going to unleash some bazooka to try and debase the euro, but odds are that a lot of it will have been priced in by the time it happens.

I think the biggest risk to market is complacency. Volatility is down in just about every asset class and this invites people to use leverage. It invites people to engage in investing habits that they will regret as soon as volatility flares back up. Volatility is going to come back up and that is bad for all risky assets, they are the most vulnerable. You have launched a Gold ETF recently, why?

AM: Our Gold ETF (Merk Gold Trust ETF (OUNZ)) is a direct competitor to some of the leading gold products out there. The ETF is trading relative to the spot price to gold with a tight spread. The physical gold is held in London and the key differentiator is that investors can take delivery of the gold, knowing that at the time they take delivery they can have the gold converted to coins. Also, from a U.S. investor perspective taking delivery is not a taxable event.

European investors can buy stocks on the NYSE like everyone else and we can facilitate delivery anywhere in the world, but it is not listed in Europe. Is this the right time to launch a gold ETF?

AM: We think gold is going to do just fine.

Draghi and the Eurozone have said that interest rates are negative and will become more negative over time. In the U.S. they can afford positive real rates, so we are going to have a bias toward negative real interest rates as far as the eye can see.

There is also going to be a price to pay for the amount of debt in the world and I think this price is going to be reflected in the price of gold. If nothing else the risk that the dollar will continue to be debased means gold should do just fine. What are your views on sterling?

AM: We are fairly positive in sterling. When Carney came on board he continued with the easing policies. The BoE have been the ones tapering, the Fed has not. It means that because of the tail winds and the economy in the UK, the Brits are going to be one of the earlier ones mopping up some of the liquidity and that is being reflected in a much stronger sterling.

In the short term - for the full year - I wouldn’t be surprised is sterling outperforms the euro. I also think the euro will outperform the dollar.

The only reason I am not fully on board with this is because I think Draghi has overplayed his hand a bit and is more likely to under deliver on weakening the euro.

Axel Merk will talk more about macro trends at the Inside ETFs Europe conference next month in Amsterdam.


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