ECB QQE Means Mo' Money Mo' Problems

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Includes: ADRU, DBEU, DBEZ, DRR, EEA, EPV, ERO, EUFX, EUO, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEU, FXE, FXF, HEDJ, HEGE, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, SBEU, ULE, UPV, URR, VGK
by: Adam Whitehead

Summary

The generic assault on the Euro's value continues with the assault on the 500 Euro note.

Larry Summers signaled that the generic assault on cash as a store of value is a global process.

The special deal between the EU and Britain to avoid the Brexit threatens to derail the EU's plan for centralized bank capital adequacy regulations.

Ewald Nowotny tries to cover up the ECB's hand in creating the equity market reversal and threat to the global economy.

The Eurozone banking crisis is degenerating into a protracted legal process.

Click to enlargeThe last report observed the characteristic road to serfdom, through currency debasement, being trodden in the Eurozone with the ECB's assault on the five hundred Euro note. This assault received the political blessing of the Eurogroup's president Jeroen Dijsselbloem. Dijsselbloem went even further than Mario Draghi and asked the ECB to look into the role of the five hundred Euro note "and cash money" in relation to the "useful idiots" of organised crime who are being framed as the excuse for this exercise. According to him: "We are going to ask the ECB to look at cash money and the accessibility of the 500 euro note".

Dijsselbloem therefore signaled that he intends to sanction the removal of cash in circulation, in addition to the large denomination bills. Residents of the Eurozone will not be able to hide their money under the bed, since there will be no money. Any money they hold will therefore be in digital form at the bank. The bank will then charge them negative interest rates for holding such digital cash, and the Eurozone sovereign nations will then confiscate wealth from the banks with even more negative interest rates. The liquidity preference of consumers, much feared by Keynesian central bankers, is therefore now officially under attack from the European Union (EU).

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(Source: Bloomberg)

The facts surrounding the velocity of money, in relation to the note that has been affectionately nicknamed the "Bin Laden", suggest that Dijsselbloem (and Draghi) are being disingenuous at best or lying at worst in their framing of the issue. Supply of this note leads demand, and there has actually been no increase in demand for some time. The reference to organised crime as a reason for removing the note from circulation does not therefore stand up to real scrutiny.

In the absence of a competing hypothesis, as all policemen know, the only remaining one becomes the main line of inquiry by default. Rational deduction therefore suggests that the assault on cash is a systemic attempt to attack consumer liquidity preference. This assault comes in the form of common debasement, through printing combined with a tax on the fiat currency through negative interest rates. With no cash in circulation this assault becomes digital and a simple matter of spreadsheet manipulation rather than the grand larceny at the printing press.

On the subject of grand larceny at the printing press, there seems to have been a very curious jump in the volume of Bin Laden's in circulation, just as the Eurozone crisis was unfolding. Could this have had anything to do with a serious attempt at a printing press solution to stimulate the Eurozone economy? At this time the Fed was also pumping US Dollars into the financial system, through swap lines with all the major central banks. The ECB would therefore have had plenty of US IOU's to use as the collateral to create its own Euro IOU's.

Or was it simply a case of investors dumping everything and literally moving into physical cash? Since the volume of notes in circulation is demand driven, the identity of this source of demand would provide the answer. Either possibility cannot be ruled out; especially given that the ECB and EU are very eager to remove the evidence from the potential crime scene. The removal of the forensic evidence from circulation does not mean that the money created back in the crisis has been destroyed however. The money created simply got washed into something else.

Click to enlarge

(Source: Bloomberg)

The counterfactual supporting evidence comes from the Swiss Franc and behaviour of the Swiss central bank. The bump up in Euro Bin Laden's during the Credit Crunch is mirrored in the Swiss equivalent 1000 Swiss Franc Bills. These have however risen in circulation, as the Swiss have adopted negative interest rates in response to the voodoo economics being undertaken in the neighbouring Eurozone. Evidently the alleged drug dealers have expressed their liquidity preference in cash in a hard currency.

There also seems to have been a jump in 1000 Swiss Franc notes circa 2012, when Greece was threatening the survival of the Eurozone, and Draghi was doing "whatever it takes" to save the Eurozone with his OMT programme. In fact there have been subsequent jumps in the 1000 Swiss Franc circulation at times that can be linked to the Fed, the BOJ and also the ECB unconventional monetary expansions. The central banking cartel that influences the gold price has been unable to influence the 1000 Swiss Franc note, which has become a currency in its own right; possible the only real one in circulation today. It is in fact easier to equate the jumps in the 1000 Swiss Franc note with central bank QE actions than with narcotics production.

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The whole subject of the disinformation campaign, surrounding high denomination notes in circulation, took on a sinister global dimension with the appearance of Larry Summers President Obama's go to economics guy. Summers would go as low as the $50 bill in his classification of high denomination, and he wants this globally adopted by G-20. This suggests that the issue is coming to America after it has been accepted as common practice in Europe. Summers plans for hyperinflation creation are therefore far more ambitious than those in Europe. Classifying a $50 bill as a high denomination note signals a far greater capacity to steal wealth through QE and negative interest rates. It should also put all Americans on alert that they face further losses in their civil liberties, if they are caught in possession of such weapons of mass destruction.

Jeroen Dijsselbloem also confirmed that the current Eurozone banking crisis, is all part of a bigger scheme known generically as a bank bailout process and euphemistically in Europe as the Bank Resolution and Recovery Directive (BRRD). He affirmed that he sees no need to water down the BRRD rules, thus setting the banks and their national regulators on a collision course with the EU. Nation states are now expected to yield their taxpayers' wealth in order to recapitalize their banks. If this then triggers a sovereign debt crisis, the wider question will be asked on how to restructure the Eurozone financially. Jean-Claude Juncker would like this reconstruction financed by Northern European taxpayers.

Northern European taxpayers are currently flirting with the fantasy of populism, which will ostensibly let them off the hook for their feckless Southern neighbours' borrowings. Southern Europeans think that they can renegotiate their debt terms and their social contract with Brussels, under an equal and opposite expression of populism to that found in the North.

Policy makers, who see the bigger picture, understand that since the Northern Europeans effectively own the debts of their Southern neighbours there can be no populist solution that does not harm all involved. Those who see the bigger picture also understand that Europeans ultimately resort to violence when they can't resolve their indebtedness issues in a civilized or legalistic manner. The current EU occupation of the Greek coastline and territorial waters, to prevent the Greeks from threatening their creditors with waves of migrants instead of interest payments, looks suspiciously reminiscent of the Allied occupation of the Rhineland for failure to pay war reparations during the last period of European historic unpleasantness. One could easily argue that European history is rhyming again.

Currently, this tendency towards violence is being channeled towards the "useful idiots" from conflict zones in the MENA region. The Central Powers in Brussels and at the ECB therefore wish to satisfy both the domestic populist agendas and the creeping move towards a collective final solution, by eroding the value of debts through monetary inflation aka the 2% inflation target. This also looks suspiciously reminiscent of the attempt to monetise debts in the Weimar Republic at the same time its Rhineland was being occupied. The significant difference is that Germany is a creditor these days and unwilling to allow other national central banks or the ECB to repeat its own past attempts at populist monetary inflation.

Dijsselbloem also renewed the case for the EU "Central Powers" to prevail with a final solution, when he pushed back against the special deal being negotiated between Britain and the EU in relation to fiscal and political subsidiarity. The British deal clearly opens the way for all nations to break the Eurozone by renegotiating their own deals and destroying the Maastricht Treaty. David Cameron has thus become the "useful idiot" who has furthered the ambitions for European political integration whilst ostensibly appearing to end them.

ECB Governing Council member Ewald Nowotny like Dijsselbloem is emerging as another of the Eurozone's more self-effacing heralds of the assault on the Euro and its liberty. Perhaps the two gentlemen have been chosen because their professional and un-alarmist demeanours are far more seductive than the emotional hyperbole employed by the likes of Juncker and Draghi. Nowotny's most recent mission was to prepare the markets and the people of Europe for what he euphemistically called "negative inflation". His elaboration, on the difference between "negative inflation" and deflation, was an interesting spectacle to behold.

According to him: "I wouldn't speak of a deflationary risk, per se. It could be the case in certain months but that is not deflation. I think it was the success of the previous policy of the ECB that we prevented a deflationary scenario in Europe."

Having dropped this bombshell, in his consummately perfunctory manner, he swiftly moved on to the glorious day in the near future when the success of the ECB in presenting an inflationary scenario will occur. Many observers are now left scratching their heads about when the previous successful deflationary policy was started and when it ended. Is the ECB now actually taking credit for the fall in oil prices?

It would seem that Draghi's predilection for "positive obfuscation", outlined in the previous report, is contagious. It would also seem that Nowotny is preparing the markets for something from the ECB in March. This something may not however be what the markets want, which is more QE. Like Draghi therefore, Nowotny is nudging observers to accept that something is better than nothing under the circumstances, so that another disappointment does not occur post-ECB announcement, as it did in December last year.

Click to enlargeThere is unfortunately a dark side to Nowotny's obfuscation, which needs closer painful scrutiny. In an amazing moment of clarity that he may soon regret, Nowotny dropped his guard and pulled back the curtain to reveal the magic of ECB guidance. His reference to the magic of the period surrounding the last ECB meeting was most enlightening. In his own words: "In December, in the midst of visits to London, I was confronted with almost ludicrous considerations that were divorced from reality. Now, this is not the case. We're having relatively serious discussions. There is still time until March, however, so it's important that we don't get lost in 'mind games' that are simply institutionally and technically impossible".

One suspects that he was addressing the issue of the meeting that was held between the ECB and an elite cadre of hedge funds, prop-traders and CTA's before the disastrous December meeting. This inglorious period of ECB history is clouded in controversy. It represents a bold attempt by the ECB to control the behaviour of the investment community in order to amplify the effect of incremental QE policy. This bold gambit spectacularly blew up and is now coming back to haunt the ECB and the global economy.

The elite audience came away with the impression that "shock and awe" expansion of QE was imminent, and promptly went short Euros and long Eurozone sovereign bonds and risk assets in size. When Draghi then underwhelmed at the meeting, the pain trades as these positions were unwound swiftly became existential questions about the ECB's credibility. Nowotny obviously doesn't want a repeat performance. He is now trying to under-promise in order for Draghi to overwhelm. He is also trying his hand at plausible denial that the ECB led these speculators down the garden path.

His problem is that the elite cadre of traders lost money and their own credibility because the ECB representatives failed to disabuse them of their P&L fantasies about Draghi's ability to "do whatever it takes". They will never forgive or forget Draghi and the ECB, and in fact they will now be looking for payback with the added bonus of wrecking the ECB's plans. Revenge is a dish best eaten cold and the traders want their just desserts. More alarmingly as a consequence of the ECB's spectacular fumble in December, global equity markets reversed and the correction that is now being called a bear market began. Draghi and the ECB therefore have more than a few Masters of the Universe to answer to. The global economy is now at risk thanks to them.

Deutsche Bank was observed in the last report to be arbitraging the diverse Eurozone and national rules on capital adequacy and disclosure. The arbitrage involves the bank buying back tranches of its debt capital structure at a deep discount, in order to window dress the reported capital adequacy position. The bank will then be able to issue more shares at a premium to where the debt was bought back, in order to appropriately address the true risk capital deficit.

(Source: Bloomberg)

The conditions for the arbitrage have recently been identified. Deutsche trails its Eurozone competitors, because it uses more leverage on its balance sheet. The bank must either shed assets or sell more shares or cut leverage, or a combination of all three. The bank has elected to cut leverage first through buying back debt. This is expected to raise the share price, so that it can then issue more shares at a higher price.

It should be noted that the bank is not shedding assets, from which it can be inferred that some of these assets are unprofitable. The bank still has a hedge fund structure, even though the new CEO preaches the mantra of transforming the bank away from this business model and culture. One has to put this hedge fund structure into the context of a wholesale funding model and deposit base of negative interest rates in the Eurozone. Presumably Deutsche believes that investors and depositors will pay it through negative interest rates to operate as a hedge fund.

The fact that its own national regulator has not forced it to clean its disclosure and capital position up also speaks volumes. The indulgence and protectionist instincts shown by its regulator, suggests that neither the bank nor the regulator think that the global rules on capital adequacy apply in Germany. This assumption is now being tested by the capital markets and looks set to get tested in the law courts. If Deutsche bank does get sued, it will most certainly not be in a German legal jurisdiction based on perceptions of the relationship between the bank and its regulators held outside of Germany.

Speculators who chased yield, in the ECB's negative yield environment in 2015, through purchasing Deutsche Bank's bonds are now in revolt. They have noted that the bank may have breached rules on disclosure in failing to report the bank's true financial position, before issuing these bonds to them. The bank then reported its poor financial earnings, less than two weeks after placing the bonds. This would be fraudulent misrepresentation, if it were proven to be the case. If it could be shown that regulators had signed off on such disclosure then the fraud becomes systemic. This is therefore the tip of an iceberg.

This ugly episode alone justifies the European Banking Authority's (EBA) noble pursuit of the banks and their national regulators to clean up their act on disclosure in relation to liquidity events which impact the contingent capital structure of the banks' balance sheets. It is noteworthy that Germany is as guilty as any other Eurozone nation, which undermines its own attempts to clean up the finances of the Eurozone in general. The appearance of lawsuits, from plaintiffs who claim to have been defrauded, serves to illustrate the fraudulent abuse of the opaque and diverse Eurozone rules on bank capital adequacy and disclosure.

Banks and their regulators are now even more likely to remain opaque and protectionist in order to protect themselves against financial claims and lawsuits. The Eurozone banking crisis is therefore degenerating into a legalistic process, that by its very nature does not lend itself to a swift resolution. In fact it is in the banks' self-interest of preservation to keep things as dark and opaque as ever. It will be interesting to see how the national regulators interpret their own mandates in relation to disclosure versus supporting their banks.

(Source: Bloomberg)

An example of this protracted legal war of attrition can be found in the case of the Austrian bank Hypo Alpe-Adria-Bank International AG or rather what remains of it. This bank was a casualty of the 2008 crisis, after it had over-extended its franchise in emerging eastern Europe and the Balkans. The banks problems were "resolved" using the good bank/bad bank model, similar to that being advocated by the Eurozone. Once it sold its good assets, the rest was turned into Heta Asset Resolution AG, with the intention to be wound down. The Austrian regulator FMA took custody in March 2015, after an asset review revealed a larger hole in Heta's finances. Bond payments were halted. Creditors, including Pimco, German banks and some hedge funds have now joined a class action suit to reject what they believe is a derisory offer to pay them out on their bond holdings by the regulator. Opining for the Austrian central bank, Ewald Nowotny said that: "We're now in a period of psychological warfare …… In a purely economic view, everybody would be well advised to take the offer. I think it's a fair offer, and it's an adequate offer."

This Austrian legal stasis therefore represents a microcosm of what the whole of the Eurozone banking system is facing. Once the ECB is engaged, by nature of the fact that it owns covered bank bonds, the whole process will become even murkier. In effect, the whole Eurozone banking system including its national central banks and the ECB will require a recapitalization.

Negative interest rates have effectively weakened the banking system even further and triggered further liquidity and solvency issues down the line. The transmission mechanism for economic stimulus has therefore been shut down. The Eurozone of the future will therefore require a completely new banking system.

What is certain, is that no northern Eurozone nation will accept a sovereign debt mutualization solution, until each southern nation's taxpayers have first bailed out their own banks. What is almost as certain, is that private creditors are going to get bailed in by the national bank regulators. Trust in the Eurozone banks will evaporate and with it their ability to raise funding. Since interest rates are negative, depositors are unlikely to fund them either. A Eurozone bank run could easily occur on a grand scale, as this scenario becomes widely understood by the people. Based on this bleak outlook, it is thus no surprise that Eurozone policy makers and central bankers are preparing for a cashless future. In a cashless future, there can be no runs on a bank.

German Finance Minister Wolgang Schaeuble's acerbic response, to questioning on the Deutsche Bank situation, illustrates the level to which things have degenerated at the leadership within the Eurozone. Schaeuble tried to defend Deutsche Bank by opining that the state of debt problems and disclosure are far worse in Portugal. It was not so much a case of comparing apples with oranges, as comparing rotten apples with even more rotten apples.

The ECB signaled that it has the intentions and capabilities to enable the Eurozone banking crisis to become a sovereign debt crisis. Italy has recently received the green light to provide state aid to its banks, in the forms of bank guarantees that the European Commission will not classify as state aid. According to a rumour, the ECB is now discussing how to buy non-performing Italian loans repackaged as bank bonds. Thanks to the Commission's ruling, the ECB can safely say that it is not monetising Italy's sovereign debt, because the guaranteed bank bonds are not classified as state aid. This rumour was denied by Mario Draghi, but as readers will see later in this article in relation to proposed changes in QE guidelines there is no smoke without a fire.

The ECB therefore intends to bail out the Italian banking system, by transferring the Italian taxpayers' risk to its own balance sheet. This is reminiscent of the tactics deployed in the first unsuccessful attempt at bailing out the Greek banking system. A much bigger sovereign debt can is under construction that the ECB is endeavouring to kick down the road. The consequence is that the ECB will now be at risk to capital losses, which will require it to be recapitalised. The ECB has therefore signaled its intention to embark on QQE, similar to that being followed by the BOJ. A cursory look at Japan should not reassure the observer that this will end well. To mitigate this risk, the ECB hopes that Jean-Claude Juncker's plan to mutualise debt across the Eurozone will come to its rescue.

The first challenge to the ECB's strategy comes from the current guideline limits set on its QE bond buying process. The current rules mean that national central banks can only buy 33% of an outstanding sovereign bond issue. The ECB is currently running up against these limits in its recent expanded buying programme.

The second challenge comes from negative interest rates. The current rules only allow the ECB to buy a bond if its yield is higher than the deposit facility rate which is currently -0.3%. As the universe of eligible collateral converges on this rate, the buying programme will get choked off. This is one reason the ECB is so keen to start buying corporate debt and other credit spread product.

The third challenge to the ECB's strategy comes in the form of the German Constitutional Court re-hearing of the case for the Outright Monetary Transactions (OMT) programme. OMT should not be confused with QE in legal terms, however the two are inextricably linked.

OMT should be associated with Mario Draghi's declaration to "do whatever it takes". This programme was scheduled to target speculation against a Eurozone member, by driving its yields to levels at which it could no longer sustain Eurozone membership. It was dreamed up by Draghi in 2012, when the Greek crisis threatened to become contagious and break up the Eurozone.

Quantitative Easing (QE) is something else. Although it also involves sovereign bond buying, the objective is to stimulate inflation and thus avoid a depression. There is a suspicion that Draghi has been using the QE programme as a kind of OMT programme, by keeping sovereign yields depressed in order to prevent contagion. Like all good Jesuits, Draghi has been able to talk his way out of the hole in this regard, but it has only increased suspicion of his motives rather than his method. If one believes that deflation will lead to a Eurozone breakup, then QE should be seen as a proxy for OMT.

It should be noted that Jens Weidmann has no issues with QE under current conditions. For some strange reason, which should be understood as pecuniary German self-interest, he is happy to play along with QE currently. Presumably he is happy to play along with it, since the current rules governing it give it a finite lifespan. Once national central banks own 33%, of all the sovereign issues in circulation, the QE programme ends. Since Germany is in budget surplus, it will soon hit its QE limits so that the programme will become academic. He does however have serious issues with the OMT, which he equates with verboten deficit financing. This is why Draghi wishes to change the rules governing QE in order to introduce QQE.

The Eurozone has now reached the point at which the clear line between OMT and QE has become grey and fuzzy. If the German courts deal a blow to OMT, this will effectively mean that Draghi cannot "do whatever it takes" to save the Eurozone. He will then have to focus on doing whatever it takes to create inflation, within the constraints placed upon him by the current rules governing QE. Since he has spent much of the allotted QE, by using it as a proxy for OMT, he has little room for manoeuvre. By introducing QQE he hopes to effectively do more OMT under the guise of QE inflation targeting. QQE in principle combines QE with the OMT, so Draghi is going to struggle to get it past Germany.

(Source: Bloomberg)

The live case of Portugal will show just how capable Draghi is of getting QQE through. Portugal currently is on its way out of the Eurozone, based on its deteriorating debt and political fundamentals. It is therefore an ideal candidate for some OMT. It will therefore become the pawn in the game between Draghi and Germany.

To create the intellectual and "independent" opinion necessary to generate public acceptance that the ECB should have its QE rules expanded, to give it the capabilities to do QQE along with its intentions, the Breugel group published its "independent" opinion. It should be remembered that the Breugel group is headed by Jean-Claude Trichet. The agenda of the Breugel group is therefore to preserve the existence of the Euro and the Eurozone at any cost to the peoples of Europe.

According to Breugel: "We recommend that the ECB further alter the program guidelines…. especially if the ECB decides to increase its monthly purchases…Distributing the purchases across countries according to their outstanding debt instead of distributing them according to the ECB capital keys would lead to limits being reached in every country at roughly the same time." It should be remembered that Germany has a fiscal surplus, so effectively Breugel is giving the green light to the ECB to buy more of the debts of the nations with the greatest debts. Breugel is therefore overturning the Maastricht Treaty and Stability Pact in order to enable the ECB to engage in QQE.

Draghi orally framed the debate in an attempt to nudge it along in the direction required to achieve the QQE outcome. He told the European parliament that, "in the light of the recent financial turmoil, we will analyze the state of transmission of our monetary impulses by the financial system and in particular by banks," and "if either of these two factors entail downward risks to price stability, we will not hesitate to act". He may as well have been speaking in the past tense, since all the triggers and conditions that he has listed for action have been met. The ECB will therefore deliver more QE in March. This is not yet however QQE in the Japanese sense of the word, but the debate leading towards it or expressly against it has begun.

The Qualitative "Q" in QQE was outlined by his specific reference in the words "the state of transmission of our monetary impulses by the financial system and in particular by banks". Draghi will say that, to address the transmission mechanism, credit risk should now be taken onto the ECB's balance sheet. It will be interesting to see if any bright-eyed journalists ask him if negative interest rates and QE have in any way impacted the financial position of the banks. This will however be a career ending move for any journalist, so these questions will have to remain in the domain of the blogs.

In order to try and prevent the banking crisis from prematurely triggering a sovereign debt crisis that will undermine his QQE objectives, Draghi then opined that the capital adequacy of the Eurozone banking system is healthy.

Danielle Nouy the chair of the ECB's bank supervisory arm reiterated Draghi's opinion on the health of the banking system. To emphasize this she reported that the ECB will not seek tighter capital requirements going forwards. This could however be interpreted as saying that the ECB does not wish to trigger a collapse in bank share prices, by demanding that more equity capital is issued.

Nouy also indirectly addressed the regulatory disclosure issue highlighted by the EBA, when she concluded that further clarity of disclosure is required to remove uncertainty. It now remains to be seen if the Eurozone banks will come clean about their real capital adequacy positions. One suspects not, because one also suspects that the mark to market rules applied in valuations of their assets may be works of fiction rather than fact. An accurate mark to market of the illiquid spread product on their books, may indeed require additional capital to be raised.

The ultimate challenge to the ECB's QQE strategy comes from the unresolved Eurozone debt mutualisation issue. If the northern Europeans head off Juncker's plan to transfer their wealth to their southern neighbours, through the mutualisation process, all bets on QQE are ultimately off. 2016 looks like being the year in which the go/no-go decision on QQE will be made.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.