Eurozone policy makers are trying to put things on hold for the summer recess and deal with the situation in September, when they have had a better chance to evaluate the impact of the recent Brexit vote. The ECB's recent decision not to change policy, was accompanied by hints that there is no urgency to expand the monetary stimulus. This reflects the wider view now being taken by developed nation central banks including the Bank of England, Fed and the BOJ. If the global economy deteriorates from here, they will then by default all have fallen behind the curve. This fall will then require them to overcompensate with looser monetary conditions.
In this hiatus some observers have concluded that the central banks have run out of tools, rather than having become afraid to apply the available ones with even greater force. Any future overcompensation therefore, may be viewed as highly risky by those who believe that the central banks have run out of ammunition. Any future monetary easing will therefore meet the same stubborn resistance rather than create the animal spirits in the real economy that the central bankers hope to unleash. Central banks are failing with their management of market perceptions.
(Source: The ECB)
Evidently the ECB is aware of this assertion of failure; hence it has recently produced a mendacious report that asserts the contrary. Its latest findings conclusively report that: "the ECB's expanded asset purchase program has been important in preventing a potential de-anchoring of inflation expectations" and "this, in turn, is vital in order to prevent a further prolongation of the period of low inflation outcomes through second-round effects." QE to date has therefore been justified and the door has been left open for more should inflation expectations face another de-anchoring.
The last report noted that the ECB may have changed its modus operandi in favour of buying sovereign debt based on the volume of debt outstanding, rather than by respective national GDP. Evidently this is bothering Governing Council member Jens Weidmann. In his latest take on the ECB's need for reflective pause on the Brexit outcome, he said that the composition of sovereign debt purchases should also be reviewed. Weidmann expects all said reviews to take place over the summer recess, before any further decision is made on expanding the purchase programme.
ECB Governing Council member Ignazio Visco was more disingenuous with his take on the process. In his view there is currently no scarcity in available collateral, that will prompt a shift in policy; but should one occur the ECB will address it. When questioned specifically on whether the "capital key", linking purchases to size of country GDP, would be dropped he equivocally said that: "It depends. We will have to see." Clearly some official change in the QE purchase programme is coming, but this may have to wait for due process and debate after the summer recess.
The last report discussed the process by which the Eurozone sovereign debt and related banking crises will be addressed. This process involves the transfer of sovereign debt risk, especially that of deficit rule breaking nations, from bank balance sheets to the ECB's. Empirical evidence suggests that this process was actually well under way in June. The ECB increased its purchases of Italian and Spanish debt, relative to that of other sovereign issuers. This observation also suggests that the ECB is now deliberately contravening the "capital key" limit rules on sovereign bond purchases. Under the original rule, sovereign debt can only be bought in relation to the size of the economy. The ECB has however run out of bonds to buy through applying this rule, since these eligible nations have got lower outstanding debts. The ECB is now aggressively buying the debt of the deficit rule breaking nations, because by default they have got more bonds outstanding. The ECB is therefore monetising the deficits of the deficit rule breaking nations more aggressively than that of the more fiscally disciplined.
(Source: The Daily Shot)
Mario Draghi has stated that some kind of state support, sanctioned by the European Commission (EC), would be most welcome in solving the banking crisis. This will push the deficit rule breaking nations even further beyond the mandatory limits. Since the ECB has switched to buying more sovereign debt of these nations, Draghi is signalling that the ECB advocates state intervention to support its own QE programme. He is therefore linking the solutions to the sovereign debt crisis and banking sector crisis with the ECB's balance sheet.
Draghi's analysis of the problem is a little disingenuous; but this is necessary to obscure the reasons for his actions. According to him, the growing non-performing loan issue is halting the credit creation process. Draghi conveniently left out the fact that negative interest rates are undermining the health of the banking sector; and thus also weakening the credit creation process. Draghi is focussed on the sovereign debt issue and the deficit monetization process that is part of its solution, above the health of the banking sector. With sanctioned state aid, the sovereign debt that the ECB is going to accumulate as part of the monetising process gets underwritten by Eurozone taxpayers. Just as in the case with the Greek bailout, Draghi has taken a position which protects the ECB's balance sheet at the expense of the taxpayer. In return, he creates negative interest rates so that taxpayers are compensated by the ECB's willingness to pay their own countries for borrowing from it.
First, the taxpayers bail out the banks. Second the ECB bails out the taxpayers. As a consequence of this process, the banks must be disintermediated from the lending to sovereigns which requires them to pay the sovereigns negative interest rates. The sovereigns compensate the banks for this disintermediation by bailing them out. After this exchange of consideration for services rendered, the banks will be expected to go about their business of taking private credit risk again rather than buying sovereign debt. To encourage them to make this transition, risk weightings will be attached to sovereign debt that will make it expensive to continue to hold it. This process directly unwinds the tortuous political process that has created the crisis.
During the initial stages of the sovereign debt crisis, sovereign nations needed the banks to hold their debt to avoid them applying EU austerity measures. Zero capital risk weightings on sovereign debt incentivised the banks to play along with this game. The banks were used to avoid austerity. By avoiding fiscal austerity a banking crisis was created. The ECB has now concluded that the only solution to the austerity avoidance issue is through debt monetization. The sovereign debt must therefore be transferred from the banking sector to the ECB's balance sheet. The solution requires the linking of the banking and sovereign debt crisis. The ECB's balance sheet is the place where these two crises get resolved.
Whilst the ECB's role in the process is clear, the rules and institutions that will apply it at the European Union (EU) are anything but clear. In fact, as stated in the last report, the institutionalization of the process may lead to great friction between France and Germany as its principal architects and enforcers. The last report suggested that after Angela Merkel's call to address the matter, that German policy makers would be working flat out over the summer to fulfil her demands. It would seem that they have already finished the job, before she spoke out.
The last report also noted that the ECB's Vitor Constancio suggested progressing on a case by case basis given the heterogeneous environment of the Eurozone banking system. He also advocated the use of some state aid where and when required. Each country will therefore require a specific solution within the general process outline. The Italian banking crisis is an immediate concern for Merkel, because it is linked to the survival of Prime Minister Renzi against the populist Five Star party. Renzi has staked his survival on the evasion of the need for bank creditor bail-ins through the requirement of state aid. Initially Germany had resisted, but now there are signs that Merkel is relenting and adopting Constancio's suggestions as Renzi slides in the polls and the banking crisis gets worse.
A further contribution to the German design for the process was recently put on the table by the Bundesbank. This contribution envisages the European Stability Mechanism (ESM) as the vehicle that drives the fiscal deficit resolution process. The German central bank suggests turning the ESM into the region's leading fiscal authority, armed with core competences including those currently carried out by the European Commission and the European Central Bank.
The Bundesbank also wants a change in the terms of new government-debt issues; that will allow easier restructuring and a maturity extension should the country enter an aid program. The Bundesbank also suggested terms for newly issued bonds that would automatically extend their maturities for the duration of an assistance program without triggering a credit event.
Such a change would make it easier to determine whether a country suffers from a short-term liquidity squeeze or a more fundamental debt-sustainability problem, while maintaining the liabilities of investors. At the same time, the firepower of the ESM would be increased -- bailout programs could be smaller in size as aid wouldn't be used to repay maturing debt.
The Bundesbank has therefore neatly addressed the problem of the requirement and conditionality of state aid for the banking sector; that could then possibly create even further deficit rule breaking. The Bundesbank solution involves sovereign debt restructuring without the calling of it as credit event, that could then trigger the bail-ins that blow deficits out even further. Whilst the ECB is not involved in the restructuring and governance process, it is still on hand as the ultimate receptacle of the sovereign debt restructured by the ESM. The ECB will buy ESM restructured debt, so that it does not appear to be monetising deficits. The deficits have been restructured and kicked into the future before said monetization. It is only semantics, but it is necessary to baffle the various courts which will be asked to opine on whether it is monetization or not. Eurozone debt is going to get rolled out into the future and creditors are going to be forced to accept it. The ECB will gladly accept it. Creditors who do not accept it will therefore sell to the ECB.
Despite its pro-active stance on the Eurozone banking crisis Germany still remains divided over the political outcome for the Eurozone. This division is reflected in the split within the coalition government. The SPD wishes to see deeper political unity and the creation of a Eurozone Government, whilst Merkel's CDU wishes to consolidate and reform the current stage of the European Project without deeper integration. This division is destined to become an election issue in 2017. It is important to understand that neither side wishes to see a dissolution of the Eurozone however, so they are both united in their resistance to populism. This common ground therefore offers the foundations for a new coalition after the elections.
The one thing standing between the Eurozone policy makers and their summer recess was the European Banking Authority (EBA) stress tests. As the results of the tests loomed, noises began to be made about how the ensuing resolution process will occur. Italy was of specific interest, because it represents the kind of heterogeneous problem that will require a specific solution. Italian depositors have already been bailed in by stealth.
To avert a run on the banks, domestic depositors were offered attractive yields on bank subordinated debt as an alternative to their deposits. The noises being made are that these subordinated bond holders are about to get bailed in as part of the resolution mechanism. The fact that these bonds still trade around par, implies that they owners still do not expect this. This can only mean that they expect the state to step in and bail the banks out. The noises being made however suggest that state aid will only be allowed after some kind of bail-in has occurred. Any such bail-in would make it difficult for Prime Minister Renzi to survive his intended no confidence vote to force through the political reforms that he needs to bring about further economic reform. As the Eurozone policy makers packed their bags for the holidays, it became clear that a political crisis in Italy will await them on their return.
This hardening of attitudes in relation to the banking crisis and sovereign debt crisis in Italy was also mirrored by a spectacular U-turn by Commission President Juncker in relation to Portugal and Spain. In the last report he was observed to be playing to the gallery in these indebted nations by insisting that they should not be fined for breaking deficit rules. In the space of a week his attitude has changed for some reason; and he is now alleged to believe that they should be fined. Juncker is a political survivor and has recently been under threat from Germany, with its wholesale plan for European reform. The timing of his U-turn corresponded with a statement of indignation, from Eurogroup chief Jeroen Dijsselbloem, about the lack of follow through at the EU level after these two nations have been officially named as deficit rule breakers. Evidently there are moves behind the scenes to address the matter more forcefully and Juncker is trying to appear to be leading the process.
The Germans would like to make the EU more politically representative of the member nations. This implies that each nation should also take responsibility for its fiscal position. Juncker is therefore going with the flow, yet showing that indebted nations like Spain and Portugal should be careful what they wish for if they want greater political autonomy. He is showing all member nations who are seduced by these notions of autonomy, that there is a fiscal price to pay for it. It will be interesting to see just how much autonomy Italy, Spain and Portugal will demand going forward, when faced with this cost.
The hardening of attitudes, to sovereign debt and state aid for the banking sector, demonstrates evidence of the willingness to address the problems; and the signs of a process in place to deal with them which were noted in the last report. There is a growing certainty that the sovereign debt crisis and related banking sector crisis are now being addressed. This translates into positive sentiment towards the banking sector, despite the headline risks. This improving sentiment is evident in the price-action of Co-Co bonds, which are now breaking out to new highs. The corollary of this trend is that the ECB will have no fear of pushing interest rates even more negative. ECB Executive Board member Benoit Coeure took this message on the road in America, to prepare his hosts (and the Fed) for a protracted period of addressing the sovereign debt and banking sector crisis, that may involve further cuts in negative interest rates. According to him: "It is difficult to know how long these low interest rates will persist …..But it seems possible that they will be low for quite some time."
From the ECB's perspective, negative interest rates are part of the solution to the sovereign debt crisis. Now that damage to the banking sector is being addressed, the path is open for the ECB to concentrate even further on the sovereign debt crisis. The damage to the banking sector from negative interest rates is now being mitigated. The banking sector will however have to respond to the new NIRP/ZIRP interest rate environment. One such response will be the scaling up of merged banking entities, which can then perform the lending functions in an environment with low lending margins.
Speaking at G20 Chengdu, with his Bank of Italy Governor's hat on, what Ignazio Visco had to say about the Italian bank non-performing loan situation was of great interest. In his view most of the writedowns have now taken place, so that the global systemic risk has been overstated. This view was underlined by Finance Minister Padoan. If this analysis is correct, then this is as bad as it gets for the Italian banks; so that the upcoming stress tests can serve as a basis for the resolution phase involving mergers, private creditor bail-ins and state bailouts.
(Source: The Telegraph)
The EBA banking stress test results came and went with no major surprise. Perhaps the major surprise was the ease with which most of the banks passed the tests. With the exception of the basket case Monti dei Paschi di Siena, which conveniently is having its problems resolved at this moment, everything went smoothly. The last hurdle to boosting the bull trend in Co-Con bonds was therefore cleared; and policy makers could pack their beach towels.
The last report observed that France has not been fully involved in the latest process of Eurozone reform and restructuring post- Brexit vote. Germany has been pro-active about the Brexit and has used it as a tool for reform of the Eurozone. It has also been pro- Britain. Wolfgang Schaeuble's opinion that Britain can reasonably demand single market access post-Brexit was boosted when Angela Merkel came out in support of Britain delaying triggering its exit until next year. France was less engaging with Britain as Theresa May made her tour of the capitals, demanding more details on the British plan for exit.
France has waited and watched Anglo-German manoeuvring before making its coup de main, which ostensibly hits the centre of gravity of their joint manoeuvres. This coup de main was spelled out by President Hollande in no uncertain terms to the hapless Theresa May. Quite simply if Britain wants access to the Eurozone single market, the quid pro quo is that it must accept unlimited access of Eurozone personnel to its own economy. Hollande sweetened the deal by agreeing that the non-desirable immigrants from outside the Eurozone will be prevented from getting to Britain. If Theresa May accepts Hollande's deal then she will overturn the fundamental principle of the Brexit vote; and may swiftly be joining David Cameron on the has-been list of former Conservative Prime Ministers unless Germany intervenes further for Britain. German intervention would be in direct contravention of what the Eurozone stands for, so it is unlikely to happen.
Despite the hard French negotiating baseline, there is enough evidence to suggest that this is not the EU's default position. Rumours have emerged which suggest that Britain may be offered a seven-year period of controlled access to the British economy, in return for reciprocal single market access, after which it must accept the free movement of labour. This new offer has wider unforeseen implications. The precedent set would allow other EU nations considering EU exit to avail themselves of the same deal. By default therefore, controlled movement of labour is already becoming an implicit EU directive, thus changing the original free movement principle. It is easy to make the small leap to assume that, in the event of a larger potential breakup of the EU, the seven-year rule becomes a new basis for a looser affiliation of nations. The Brexit is thus being used a tool to reform the EU. Looking at Britain's position, if the EU changes enough, over the seven-year timeframe, then it could easily hold a new referendum to join again or simply reverse the decision in Parliament.
Theresa May therefore has to return home with Boris Johnson to try and convince the Brexit voting half of the country to accept EU immigrants in return for retaining access to the single market. Convincing the majority in Parliament should be easy but convincing the Brexit voters will be impossible. Her best shot, will be if Britain undergoes the kind of economic contraction that frightens even the most ardent Brexit voter into submission. Unfortunately, this recession could cause the Conservative government to lose its majority in Parliament however. As May is swiftly finding out, there is no free lunch in Europe or in Britain.
The Hollande government has had its own problems at home, pushing through economic reform, which have precluded it from greater engagement at the Eurozone level. The resistance to reform has increasingly forced the government to deploy tactical sleight of hand, in order to get it passed, which totally avoids the parliament. This lack of democratic process, will have severe repercussions that strengthen the populists' hands. In the latest tactical manoeuvre, labour law reform passed its final parliamentary hurdle after the government used special constitutional powers to push the bill through the legislature in the face of sustained opposition from Hollande's own Socialist lawmakers and labour unions.
Prime Minister Manuel Valls used article 49-3 of the constitution to avoid a vote -- the third time he will have used the special power during the bill's passage through parliament. This does not auger well for French involvement in the Eurozone restructuring process. By attacking Britain on the principle of the free movement of people and goods within the Eurozone, Hollande has gone out on a limb to test French citizens' commitment to the single market itself.
Some readers have privately questioned why a "cloak and dagger" geostrategic discussion of EU-NATO ties has been included with all the Eurozone "global-macro stuff" that is currently going on in these reports; and also why America has a national security interest in the outcome of the Eurozone sovereign debt crisis. If it is understood that NATO membership obliges a member to spend 2% of GDP on NATO related defence commitments, then this factoid should hopefully provide the wider context and answer. Recession and fiscal austerity have an impact on NATO, just as the corollary of sovereign insolvency does; since all put pressure on a nation to meet its 2% of GDP NATO commitment. The Eurozone banking sectors' enabling of the Eurozone to avoid austerity, was therefore a NATO issue even if it wasn't presented as such. The ECB's solution to the deficit and banking crisis is also a NATO issue therefore by default, since the ECB will be in effect contributing to NATO coffers.
America currently subsidizes the NATO nations that can't pay their membership fee, especially those on the border with Russia; which automatically buys America a seat at the table when the European Project is being discussed. This is something that some Europeans loathe; and it is also apparently something that Donald Trump and many Americans cannot tolerate either. Trump's recent threat to NATO, carried a more potent degree of associated risk, because it was made after he received the Republican nomination. It should however be noted that his words, whilst threatening were less inflammatory than in the past; suggesting something more in the way of coercive negotiation than existential challenge. Trump is after all a dealmaker, so his invective should be put into this context.
One of the first things that Britain said after the Brexit vote, was that it is still committed to its NATO military spending target. Parliament also voted overwhelmingly to keep the Trident nuclear deterrent, despite the fact that Britain can hardly afford it. Britain's priorities should thus underline the significance of the NATO issue in the current Eurozone economic environment. NATO is existentially challenged by the European debt and growth crisis; ergo global political and economic security are at risk. It doesn't get any more global macro than this. The Fed, the ECB and the Bank of England no doubt conduct monetary policy in this wider context, even though they just claim to be data dependent.
The growing global military role of Germany was discussed in the last report. In a purely economic sense, this can be understood in terms of Germany's growing economy and its fiscal surplus. The question now is how Germany uses its fiscal and military clout within the NATO context. Germany may assume a greater burden of subsidising other European nations' NATO membership fees. Presumably, Germany will demand something in return, such as greater economic and political control of said subsidised nations. Pax-Americana thus becomes Pax-Germanica for these nations. Twentieth Century history however teaches that Pax-Germanica is not a pleasant experience for European nations.
Suddenly a return to the awkward World War II status quo in Europe appears on the horizon. Since Germany is the neighbour of Russia, American antipathy towards Russia is curbed by Germany within the NATO framework; especially as Germany is literally calling the shots in Europe and may ultimately have to pay for all of them. Potentially another Russian-German non-aggression pact looms on the horizon. Continental Europe it seems is still fighting World War II.
Given that continental Europe has growing issues with an indigenous Semitic community within its wider Christian polity this time around, which have been euphemistically framed under the general headline of Immigration, the alarming historical parallels start to run even closer. Perhaps the European Project is just an extension of World War II after all. Whatever the case, apparently Donald Trump doesn't buy into it; and won't pay for it if he is elected President either. So to complete the historical picture, there is potential for an isolationist America to go with a Britain that is trying to recreate its empire of old post Brexit. If one believes the analysis that President Putin wishes to restore Russia's Imperial territory, then everything neatly falls into place. The audible worry in European capitals at the prospect of Donald Trump should be clearly understood in this historical context, given Trump's inflammatory remarks about America's NATO allies and what he will do to them if he is elected.
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.