(Source: Bloomberg - link)
The Davos forum was seized upon by global policy makers as an opportunity to stop the rot in capital markets, and also to use the crisis as an opportunity to accelerate policy solutions. Focus moved from the Euro currency to the Eurozone banking system. The Eurozone banking sector, rather than the currency itself, is the asset class in which opinion over the future of the Eurozone is being discovered through price action. The banking sector's performance has now decoupled from the Euro currency.
It used to be that a weak Euro was associated with the survival of the Eurozone and that this implied that the banking sector was safe also. Now all bets and correlations are off. The Euro's relative strength is all the more interesting given that the Fed is supposed to be tightening. It now seems that Draghi is unable to save and/or weaken the Euro.
Eurozone banks had been enjoying Draghi's halo effect and ECB liquidity. This had allowed them to sit on their bad loans and avoid addressing the issue with either write-downs or capital buffer increases. The halo effect is now over and the banks are being nudged towards dealing with their bad debt issues.
Current price discovery in the banking sector, combined with Euro resilience, suggests that the currency will survive but that many banks will not. The banking sector is moving towards the creative destruction phase discussed in the report entitled, "'Paneuropa' Re-Emerges".
The importance of the Eurozone banking sector issue was highlighted by the argument between Blackstone CEO Steven Schwarzman and Jeroen Dijjselbloem at Davos. According to Schwarzmann, the Eurozone banks were under-regulated going into the Credit Crunch and have been over-regulated coming out of it. Consequently, they got themselves into the kind of trouble that they cannot grow out of by resorting to old lending practices.
Dijsselbloem begged to differ that the banks were now over-regulated. He tried to frame the debate by saying that the Eurozone banks are just emerging from their own specific crisis later than their American peers. He was plausible but unconvincing.
What both interlocutors were careful to avoid was the drawing of audience's attention to the fact that the Eurozone banks have been hiding behind a sea of ECB liquidity which has allowed them to hide their problems until now. The market discounting mechanism clearly says that the Eurozone banks are back in a crisis and that QE only hid the symptoms without treating the causes.
The last report highlighted the hurdles preventing the progress of European banking union. In spite of these difficulties, the ECB bravely pressed on with nudging the banks to come clean about the situation in relation to their bad debts and non-performing loans. Italian banks, in an economy which had been identified in the last report as the biggest winner from QE, seem to be where the biggest problems are to be found.
The ECB's nudge of the banks towards the day of reckoning received an added push from the Bundesbank. The Bundesbank's specific nudge was in the direction of the sovereign debt issue that plagues the banks. Andreas Dombret, the Bundesbank's supervision Czar, opined that although Basel IV is not on the cards, that the details of Basel III have still to be written.
The last report explained how national governments and their bank regulators were stalling on implementing current supervisory and capital adequacy rules. They had all hoped that by removing the threat of Basel IV that they can still evade the current rules. Dombret has just reminded them that they are expected to fulfill their duties. He has also reminded them that the issue of sovereign debt will be on the agenda, even in the absence of Basel IV. According to him, "it has become more than obvious that sovereign paper is not risk-free".
Germany clearly intends to address the issue of sovereign debt in the near future. Under current regulations, all sovereign debt is given a zero risk weighting. Germany intends to remove this blanket zero risk weighting and enforce a more specific credit weighting process to each nation. This has obvious implications for the balance sheets of Eurozone banks that have played the carry trade to rebuild their balance sheets.
Balance sheets have been loaded with alleged zero risk weighted sovereign debt, often of the highest yield. This has then been financed with easy money from the ECB. The banks have had a free ride on earnings because they have not had to raise expensive risk capital against this sovereign carry trade. To boost earnings and share prices, they have leveraged this carry trade up with no adjusted risk weighting on the assets purchased.
When there was a yield premium in weaker sovereign bonds, the banks had some kind of risk cushion. Once the ECB got heavily involved in QE, the yield premium vanished and hence the risk for the leveraged banks became egregious. The performance of bank shares recently suggests that there is now some price discovery in relation to this looming end of sovereign carry trade getting discounted.
If the implication of Dombret's signal is bad for the banks, then it is even worse for the ECB. The ECB enabled the leveraged carry trade at the banks. It also put the banks at greater risk by collapsing yield premiums with its own massive QE buying. The ECB, therefore, has credit risk to the banks that it enabled to leverage up. In addition, the ECB also has direct credit risk to the sovereign nations that do not all deserve the highest credit rating.
The ECB is therefore looking at losses from Eurozone banks that it has extended credit to. In the absence of the European banking union, these losses are a systemic problem for the ECB. The ECB is also looking at taking a capital loss on its sovereign QE operations. In the absence of a political and fiscal union, this loss is unsustainable for not only the ECB but the whole Eurozone.
The current wave of populism suggests that momentum towards political and fiscal union is now in reverse. The requirement for recapitalization of the ECB is therefore a significant probability. Only Germany, which has surpluses with all its trading and investing neighbours, could raise the equity. Germany is, however, not immune because failure by any of its neighbours to honour their obligations would mean a significant loss for the nation.
Andreas Dombret is therefore signalling that the first installment of the real Eurozone sovereign debt crisis is imminent. The solution will by definition be political. There will appear to be winners and losers, but in fact, all those involved will lose something in a giant political compromise. There will thus only be losers and even bigger losers. If the Europeans can pull this off without resorting to the kind of violence that they have repeatedly used before, then this will be the only victory.
Dombret's signal was reinforced by the supporting action of the German government itself. In its latest initiative, the government has proposed some new Eurozone Stability Mechanism (ESM) tweaks aimed at de-mutualising the sovereign debt burden. Under the new proposals, Eurozone nations will automatically have their debt maturities extended in order to buy them some breathing space to get their finances in order. Ostensibly this sounds like a positive step.
Drilling through the headline, this is clearly a signal that Germany is moving in the opposite direction from Jean-Claude Juncker's mutualisation drive. In addition, it suggests that Germany sees a new crisis unfolding and is moving to mitigate its impacts by kicking the can down the road. This suggests that even the Germans are not sure that they have the ability to break the current Eurozone and recreate it in a more sustainable form. In fact, kicking the can down the road simply allows the debt transgressors to continue transgressing in the meantime. Germany sees that there is no Plan B. The slow death of the Eurozone is clearly more palatable than the current accelerating rate of decay.
(Source: The Daily Shot - link)
The Italian bank bond market is sending a signal that Dombret's threat has substance. Italians themselves have shown their faux European credentials by dumping their own banks' debt, whilst the ECB has been trying to save it. This pecuniary behaviour is reminiscent of the Greek approach to Eurozone solidarity.
(Source - Seeking Alpha: Nudge Theory: Ground Zero For "Paneuropa" - link)
Italy is the least likely to help the Eurozone make any progress towards banking union or resolution of the sovereign debt issue. The country is an outsize borrower, at sovereign and private level, by Stability Pact standards. QE and the low interest rates that it has enabled have, therefore, allowed Italy to carry its debt superstructure. Indeed, Italy seems the least likely to support any scaling back of QE and the current monetary policy status quo in the Eurozone. Politically speaking, however, all is not well, and Silvio Berlusconi's announcement that he intends to return to politics signals trouble on the horizon.
The latest Italian shenanigans with the interconnected banking union and sovereign debt issues show clearly why the Germans are moving away from the mutualisation drive. Italian Finance Minister Padoan vaguely reported that Italy was solving its non-performing loan issues. Allegedly, an initiative is being taken to get these loans off the Italian banks' books. What he did not explain is that this initiative will involve the Italian government guaranteeing the loans.
The Italian banking crisis is therefore morphing into a sovereign debt crisis via the sovereign guarantee amendment. Germany has no intention of sharing this burden, either through mutual bank deposit insurance or sovereign debt mutualisation. Germany expects the Italians to deal with the crisis themselves in addition to any lenders foolish enough to have lending exposure to either Italian banks or the government.
(Source: Bloomberg - link)
Spanish banks are now trading at crisis levels, thanks to the inconclusive election results and the potential for Podemos to become involved in government. So tenuous is the position of the incumbent Prime Minister Rajoy that the King was forced into trying to build a government. The result of this action is that Podemos is now motivated to act as kingmaker in a coalition government led by the Socialists.
The power of Podemos is all the more palpable because would-be Socialist Prime Minister Pedro Sanchez is himself under threat from within his own ranks. Having polled his worst share of the vote in his leadership, Sanchez may be thrown out by his own party. He will therefore have to be careful how much power he seeds to Podemos for fear of looking weak to his own party followers.
Podemos, on the other hand, can exert control over him and also look to attract Socialists over to its cause. Any new government will now have an official anti-austerity agenda which puts it on a collision course with Germany.
Spain's debt profile is lower than Italy's; however, it has also been a great beneficiary of the QE process. The low interest cost of Spanish borrowing has not yielded political stability either. In fact, the inconclusive recent election result could be said to be the outcome of the economic stasis brought about by QE. This economic stasis has unfortunately created a political situation where there is no democratic majority to govern the nation.
Oxfam recently issued a report which concluded that Spain is the second OECD nation after Cyprus with the most inequalities. The threat from these inequalities is amplified by the lack of a rational political consensus on how to deal with them. In the lack of rationality, an irrational process will therefore deal with these inequalities in ways that may be undemocratic, and may therefore risk national unity further.
(Source: Bloomberg - link)
In neighbouring Portugal, a similar political vacuum, into which Socialists are advancing an anti-Austerity agenda, has now pushed yields back above levels at which Draghi expanded QE last January. German critics of QE can say with some justification that QE is not working in countries that allegedly need it the most. In the latest twist in the Portuguese tale, a Social Democrat now leads the polls to become President. The Prime Minister who sets economic policy is Socialist. Portugal, therefore, has the gridlock of partisanship developing.
A pattern is developing in Southern Europe. Economic stasis as a result of QE has produced a lack of political consensus. Under previous circumstances, Southern Europe would have looked to Brussels and the EU for political leadership. This time around, populism has eroded the political franchise in Brussels so that Southern Europe will have to solve its own political problems. The Southern Eurozone at the supranational level is facing a political leadership vacuum that is degenerating into populism at the national level.
Meanwhile, parts of Baltic Northern Europe are also feeling the need for expanded QE to prolong the easy money status quo and avoid dealing with the inevitable. Latvian ECB policy maker Ilmars Rimsevics believes that the ECB is underestimating the force of the headwinds blowing from China. He has therefore provided one name to the faceless recently released Governing Council Minutes, which showed significantly differing opinions on this issue. This change is interesting because until now Baltic Northern Europe had been a staunch defender of German monetary and fiscal orthodoxy. This change of heart signals that contagion is spreading and that the Eurozone is fracturing.
(Source: Bloomberg - link)
Last but by no means least, the upcoming Irish national elections will be seen as a referendum on austerity. Ireland has been framed as the poster child of success through the embrace of austerity measures. It will now be seen if this success has permeated the whole of Irish society.
France has also reached a political tipping point. With eyes on the Presidential elections next year, President Hollande reached for his Socialist playbook. The pro-business legislation that he previously enacted has not borne the desired fruits. His latest economic plan is interventionist and provides direct state subsidies for job creation and training. French commitment to the national agenda has taken priority over its rather vague commitments to meet EU Stability Pact guidelines.
There is, however, a question mark over Hollande's continued leadership. The fact that Economy Minister Emmanuel Macron was obliged to deny that he would resign from government only serves to underline the question mark over Hollande's head. Macron arrived at Davos ostensibly to make the case for Hollande's new economic policies. It is, however, known that Macron does not agree that the original supply side economic reforms went far enough to stimulate the economy.
Macron was therefore scrutinised more to see if he would throw his hat into the ring and challenge Hollande, rather than to be a spokesman for the new change in French economic policy. He played his cards so close to his chest at Davos that the observers concluded that he is a stalking horse for Hollande's job after all. His demand for Hollande to expand and accelerate reforms, to stand a chance of winning in the 2017 elections, was his little tell signal. Whilst Hollande turns left to fight against populism and the extreme right, Macron is staking out some territory centre-middle.
Prime Minister Manuel Valls, also under scrutiny to see if he will be Hollande's ouster, was under the spotlight at Davos. His analysis implied that the European Project as it now stands is over. He opined that unless the immigration and security issue is solved, at the supranational level, that the European Project will finish. Since the issue is currently being dealt with at the national level, his framing of the subject therefore signals that the project has ended prematurely by his own assessment.
A pattern is also discernible in the coordinated German action. At the political and economic levels, Germany is nudging the Eurozone to a point at which it must radically change its structure and modus operandi. One nudge came from the German transport minister, who advised Angela Merkel that it is now time for Germany to close its borders in order to keep out refugees.
This nudge was reinforced by the custodian of the German constitution President Joachim Gauck, who made the moral and political justification for limiting refugee numbers. Chancellor Merkel's hands are now tied and she must limit refugee numbers, either via EU burden sharing or closing Germany's borders. If Germany closes its borders, it will then have effectively destroyed the European Union's prime directive of borderless movement of people.
German Vice Chancellor Sigmar Gabriel made a very curious reference to the current border crisis. In his words, "Austria, Sweden and Germany can't master the refugee crisis alone". Taken at face value, his words suggest an ultimatum for other EU nations to take their share of refugees. His reference to these three countries should also be put into the context of the four nations, suggested by Jeroen Dijsselbloem, to set up an alternative "Mini -Schengen Zone". Only Belgium was missing from Gabriel's comments. Three out of four is significant enough to suggest that the "Mini-Schengen Zone" will come next, if the rest of the Eurozone does not respond with alacrity.
(Source: Bloomberg - link)
Belgium is by no means out of the running. Dijsselbloem's prescience in envisaging a "Mini Schengen Zone", including Belgium, has been validated by the stirrings of the New Flemish Alliance (NVA). The NVA is now openly moving for independence from Francophone Wallonia to the South.
Citigroup has become the latest financial institution to embrace the global macro zeitgeist that there is a confluence of dangerous geopolitical and economic forces driving up risk premiums in asset prices. European Union (EU) President Donald Tusk's semi-joking threat to send in the tanks to make European leaders honour their joint commitments on immigration underlines just how clear the present danger in Citi's thesis is for the Eurozone. Deeper context was provided by the Austrian finance minister, who opined that the immigration crisis eclipses the Greek bailout crisis. This sounded more like code for saying that it could actually split the Eurozone.
According to Citi, the withdrawal of accommodative monetary policy by the Fed has removed the cohesive glue that was holding the global economy together. This should be music to the ears of policy makers who like fiscal stimulus stimulus and central bankers who believed that QE was a force for good. Markets should, therefore, expect varying combinations of these two going forwards, as policy makers seek to justify their positions with actions.
According to Citi, since Pax-Americana is also waning in global influence in this new multi-polar world that globalization created, one can no longer look to America to provide the traditional geopolitical solutions of the past. The future is therefore even more uncertain. According to its Chief Economist Willem Buiter, America followed by Europe are the least likely to be able to adapt to the new global macro dialectic. He attributes this to the growth of partisanship, fiscal austerity and populism. What he sees required is bipartisanship and a coordinated fiscal and monetary stimulus. He is basically talking about a New Deal.
There is some evidence that this solution is in its infancy in America, based on Congress's recent wealth confiscation of dividends paid by the Fed to commercial banks in order to finance infrastructure spending. What Citi seems to have missed is the fact that America has been pursuing a far greater unilateral course of policy making ever since President Obama took office.
To be fair to Buiter, however, it is correct to say that Obama's attempts at a New Deal under the banner headline of "Change" have been thwarted by the intensification of partisanship. The penny does not yet seem to have dropped on unilateralist behaviour, even after the President opined that "the United States of America is the most powerful nation on Earth… Period…", during his final SOTU address. There was indeed a "Change" that was evident for almost eight years and that Citi now believes has been overruled by partisanship.
America it would seem is in need of an enemy (or another Pearl Harbour moment) that can unite its disparate internal communities. The Credit Crunch and QE have only intensified divisions and weakened the nation. Europe is no way near a concerted fiscal and monetary response; in fact, it is headed in the opposite direction. According to Buiter, there is no chance of a New Deal in Europe any time soon, although he may just be wrong. There is, however, a Pearl Harbour moment in Europe in the form of the refugee crisis.
The last report opined the death of supranational solutions to the EU's collective problems. It was said that "what can therefore be expected are several ad hoc initiatives by nations with aligned interests going forward". German Finance Minister Wolfgang Schaeuble opened up the inter-nation floor to such ad hoc solutions, when he called for a "coalition of the willing" to address the immigration crisis. This move confirms that the EU has no ability to create a solution and is therefore a failing institution. It also confirms that German pragmatism is replacing the EU with a new institutional framework between nations with aligned political agendas. As explained in the last report, the German agenda is not totally confluent with American national security interests in Europe.
Ironically, unable to achieve a New Deal at home, America is trying to enforce one onto the Eurozone in order to preserve its national security interests in retaining the EU's integrity. This initiative can be observed through the prism of Christine Lagarde's attempts to get re-elected as the Managing Director of the IMF.
Having received the vote of the Europeans, Lagarde was then able to position America back at the heart of the Eurozone by way of the Greek bailout negotiations. The IMF's position is that the Eurogroup must grant significant debt relief to Greece, if IMF participation is required. This view directly contradicts with Germany's position that Greece should not be given further concessions. If Germany now campaigns against the IMF on Greece, it will be signalling a direct conflict with America. Since Europe has already voted in support of Lagarde, such behaviour by Germany would also signal its direct conflict with the rest of Europe. The ball is now in Germany's court.
(Source: Bloomberg - link)
As the great and the good in global policy making met at Davos, the mood was gloomy. The mood of the time is that there is a collective lack of intentions and capabilities to solve the global issues at the leadership level. The absence of the Fed and the current ECB pause on QE has clearly undermined all hope that this leadership vacuum can be lived through with easy money until true political leaders emerge.
The ECB is in search of consensus since it is only through consensus that leadership can be created. In search of the middle ground that will placate the German resistance to expanding QE and Draghi's nudges towards it, Ewald Nowotny put his own summation of the contested issue out there. According to him, QE is working yet there are limits to what it can achieve.
He was clearly signalling that it is time for the elected leaders to create a fiscal policy framework for growth so that the ECB is not forced to continue to do the contentious heavy lifting. He may also have signalled that the ECB has reached the limits of what it can do for growth and inflation creation with QE. With no more QE and the prospect of some kind of fiscal stimulus, the Euro can therefore sustain its recent gains.
Nowotny is often seen as the market for Draghi's invisible hand, so his smoke signal may have been in anticipation of what Draghi is going to announce in March. In respect to inflation, he opined that he expects inflation to go negative in H1/2016 because of collapsing oil prices.
He also sees the exporting of deflation from China, magnified through a declining Yuan, as contributing the negative inflation print. This is presumably what he was referring to as a limit to what QE can achieve. Nowotny would like to see governments have a swing at creating inflation, with expansionary fiscal policies.
Nowotny's view was echoed by Lithuanian ECB Governing Council member Vitas Vasiliauskas, with the qualification that a significant fall in inflation expectations would prompt a further expansion of QE.
Draghi's press conference statement concurred with his two colleagues, but also raised the prospects for a QE expansion at the March meeting. He sees that QE is working, but also that the downside risks to growth and inflation from the global economy have increased. This was enough to put the short covering bid in for oversold European equities between now and the March meeting. It was not however good enough for a convincing sell-off in the Euro against the US Dollar. The Fed is expected to do nothing in March, so Draghi will really have to overwhelm at the next meeting to move this currency cross.
(Source: Seeking Alpha - Draghi Should Know His Limits Rather Than Say He Has No Limits - link)
Draghi re-opened the previous round of debate with his German ECB colleagues when he resorted to his latest established default line, observed in the previous report entitled, "Draghi Should Know His Limits Rather Than Say He Has No Limit". His line states that he has "no limit" to the policy tools available to hit his inflation target. Draghi felt the need to increase expectations further of something new and interesting, whilst refraining from giving any clues as to what this will be. In his own words, "We have plenty of instruments. We have the determination, and the willingness of the governing council to act and deploy these instruments".
This implies that he has indeed departed from "doing whatever it takes" to weaken the Euro in order to hit his inflation target. This previous report observed that the Euro was now in a process of being hardened to survive any breakup of the Eurozone. Draghi chose the forum of Davos to repeat this "no limit" message. It is therefore logical to assume that a new phase is beginning in the survival of the Eurozone and its currency in some new shape or form.
His use of the word "We" in place of "I", signals that he is playing hard and fast with the lack of consensus to expand QE at the ECB. He implies that even if there is no consensus to expand QE, based on his replacement of "do whatever it takes" with "no limit", there is agreement in principle to apply different "instruments". Observers should now look at what these "instruments" are and what the German led response to the debate over them is like.
The other problem with Draghi's line of guidance is that it implies that he will not have to rely on expanding QE to hit his inflation target and will instead resort to some other policy "instrument". The selling pressure in the Euro is therefore contained.
Furthermore, since it remains unclear as to what these "instruments" are, speculation through buying Eurozone risk asset prices looks premature. In fact, the risk is that Draghi's bluff gets called in March and the "instruments" he pulls out of the box are deemed to be growth neutral, even if they do stimulate inflation. He already dramatically upstaged himself at his last press conference in 2015, so it would be unwise not to take what he says with a large pinch of salt until he acts.
Perhaps more interestingly, Draghi is using the passive aggressive tactic of turning the German nudge towards the creative destruction phase of Eurozone debt liquidation against the instigators. The more Germany pushes, the more Draghi will use the market chaos and volatility as the excuse for expanding QE. A giant game of brinksmanship is now being played between Draghi and the German faction within the ECB. In such a game, nobody wins, however.
Draghi's bold assertions were then put into context by his shadow voice Nowotny. According to Nowotny, the Governing Council has not yet identified if and what new tools will be needed. They will, however, review the situation at the March meeting. This does not sound exactly like Draghi's apparent commitment to expand QE in March, which sent the global equity markets into paroxysms of short covering.
(Source: euObserver - link)
Confluent with the thesis that a new phase is opening in the Eurozone, some early observers are now openly suggesting that the Euro currency can survive even if the Eurozone disintegrates. "There is no practical or economic link between Schengen and the euro," Daniel Gros, director of the Brussels-based Centre for European Policy Studies, is on the record for saying.
The powerful Breugel Institute which is brain, heart and soul of the European Project is now focusing more on currency survival first; and then extension of this currency to a new political and economic grouping of nations around this lowest common denominator by default. "There is no link between the common currency and how much you have to wait at the border to cross," Zsolt Darvas, a senior fellow at Bruegel opined. "Within the single market the dismantling of Schengen could raise transaction costs and transportation costs, but since there is no talk of introducing tariffs or other duties, it would not have an impact on the functioning of the single market," he added.
Whilst the architects of European economic and political integration (such as Jean-Claude Juncker and Angela Merkel) argue that the dissolution of Schengen will destroy the Euro, the technocrats are far more pragmatic. In fact, the technocrats are now positioning for survival of the Euro after the demise of the current Eurozone polity. In theory the survival of the currency is the key to the survival of the whole European Project. There is no legal mechanism for the Euro's dissolution; and in theory it will be more acceptable than any national currencies from weak nations governed by populist governments with massive deficits in their own currencies.
Purely as a medium of exchange, it can be argued that the Euro would be the ideal currency if there were no populist governments (and central bankers) capable of influencing how it was minted. What once seemed heresy, a Euro without a Eurozone, is now openly debated and accepted by the technocrats. Bureaucracies have an innate ability to survive and outlive politicians. The ruler's head may be removed from notes and coins in circulation, from time to time, but someone must still control the supply of the currency.
At Davos, Draghi also chose to use the simplistic analysis that spending on immigration was actually a beneficial fiscal stimulus. This will inflame the populists and opposition to the European Project further. It will also inflate budget deficits beyond what some nations can't even sustain. He seems keen to embrace the New Deal solution of combined monetary and fiscal expansion that Willem Buiter has opined. Draghi's positioning, of himself and the ECB, at the heart of an elite globalist agenda forum is not helpful for the survival of the European Project.
In the absence of any economic growth and with immigrants in receipt of welfare rather than job offers, his simplistic view may be totally inaccurate also. His awarding of an A+ to Janet Yellen, for beginning to normalise, verged on over-confidence and excessive self-belief. The audience was not fooled that a continued ECB QE expansion and a Fed normalization are part of the Trans-Atlantic plan. Strictly speaking, though, Draghi only said of Yellen's move that "it was perfectly communicated and flawlessly executed". He was therefore only commenting on the actions and not the intent.
Jens Weidmann immediately responded to this New Deal opining, by stating that the lines between monetary and fiscal policy in the Eurozone have become too blurred. He thus hopes to switch attention back to the upcoming German Constitutional Court re-hearing of the case for the legality of the QE process. Draghi may have a won a battle, but the war is still on.
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