Eurozone - Caveat Venditor

Includes: DIA, FXE, IWM, QQQ, SPY
by: Adam Whitehead


Attention is shifting from the scope for more unconventional monetary policy to fiscal stimulus.

The Bank of France Governor has taken up sponsorship of the fiscal integration project.

Germany has evaded a Eurozone targeted fiscal stimulus.

The BIS has nudged the Eurozone banks closer to crisis mode.

High yield lenders are seeking more protection as a new credit crunch unfolds.

The growing question mark over the ability of unconventional monetary policy to stimulate economic growth significantly from current levels in the Eurozone, has switched the debate back to the potential for fiscal stimulus. The deficit situation in many Eurozone nations sets limits to the scope for fiscal stimulus, under the current rules of the Maastricht Treaty and Stability Pact. Nations that need the fiscal stimulus the most, are the most limited by the fiscal rules of the Eurozone. Attempts to broaden the scope for fiscal stimulus, by mutualising the debt obligations of all nations, are meeting significant resistance from core nations.

Private investors hunting for yield, in the world of negative interest rates, find that the latest risk-adjusted returns on offer are prohibitive. Private investors are therefore demanding greater transparency over the status of indebted borrowers, before taking on more risk. With greater scrutiny by private lenders, the ECB is being nudged towards taking on more credit risk. The ECB is thus drifting further into the moral hazard zone. Indebted nations considering a fiscal stimulus should therefore understand the new consequences of the emerging "Caveat Venditor" political, economic and legal landscape.

The last report observed how the ECB's process of recycling its provision of emergency liquidity, from the surplus core nations to the deficit periphery, was a de facto debt mutualisation project. Against the backdrop of negative interest rates, this process systematically undermines the banking system; so that its sole function is to enable the mutualisation rather than to stimulate credit creation.

In the absence of a genuine monetary stimulus therefore, policy makers are under increasing pressure to enact fiscal stimulus. This pressure to enact fiscal stimulus, however, encounters strong German resistance in the form of recommendations to adhere to the Stability Pact fiscal limits. Germany therefore has become the focus of all attempts to proceed with fiscal stimulus and debt mutualisation initiatives.

It was suggested in the last report that an opportunity to further the process of fiscal integration had been lost, as a consequence of Angela Merkel avoiding what appeared to be a trap at recent summit in Portugal. At this summit, the Portuguese hosts had asked Germany to engage in an explicit drafting of the rules for fiscal integration in June this year. Merkel remains transfixed by domestic issues and here re-election campaign; so it is highly unlikely that she will fully engage in this process.

After Merkel's escape, it was left to the French to take up sponsorship of the fiscal integration issue. This was boldly done by Bank of France Governor Francois Villeroy de Galhau. Alluding to mutual suspicions between France and Germany, over their desires for the future of the European project, de Galhau opined that it is time to bury the hatchet or risk the breakup of the Eurozone.

Rather than attempt a full-blown timetable and plan for fiscal integration; he advocated setting up the rules of engagement between nations at the finance minister level. Each nation in theory will then have some binding rules on its obligations to fiscal reform that can serve as the basis for a common advance of a wider fiscal integration plan. A cynic (probably German) would argue with some justification that these guidelines are already covered by the existing Maastricht Treaty and Stability Pact. The French attempt at restarting the dialogue is therefore an attempt to commit Germany to a fiscal integration process that is already broken by nature of transgressions at the national level.

(Source: Bloomberg)

The ECB recently got in on the act of nudging Germany towards the desired mutualised outcome. Under the disguise of a study with the general heading "Public Investment In Europe", the ECB tried to nudge the policy maker debate towards a German fiscal stimulus. This alleged stimulus will be aimed at infrastructure projects within Germany. By investing in infrastructure, economic growth and the removal of bottlenecks and barriers will allegedly occur. Economic stimulus is therefore created within a context of economic reform.

(Source: Bloomberg)

The ECB disingenuously shows its real intentions and capabilities, when it addresses the financial underpinnings of the strategy. The ECB advocates that Germany should finance the fiscal stimulus through borrowing and monetary policy expansion. In practice, what this means is that the ECB therefore has more German bonds to buy as collateral for its QE process. The ECB will by default therefore have more emergency liquidity available to recycle from Germany to the periphery. The process of debt mutualisation through this recycling process is thus enhanced.

Germany is ostensibly being asked to underwrite the ECB's plans for debt mutualisation and further QE expansion; using the notion of an infrastructure investment programme as the excuse. To understand just how well this campaign to nudge German is being orchestrated, articles in the press about the crumbling state of German infrastructure were nudged deeper into the public domain. What appears to be a "New Deal" fiscal policy, is in fact a new deal for monetary policy and further economic integration at the expense of the German taxpayer.

(Source: Bloomberg)

Germany responded with alacrity. The government will increase fiscal spending on specific German economic and geopolitical priorities. The money will go to building more houses to deflate the developing bubble; and also to increase military spending as Germany weaponizes its geopolitical footprint. The biggest slice will go to social spending, as Germany is forced to balance its open door immigration policy with social projects aimed at the indigenous population; so as to avoid the developing wave of xenophobia.

More importantly for the rest of the Eurozone, Finance Minister Schaeuble seemed to take great pride in announcing that the new budget will not require an increase in borrowing. There is very little that the ECB could say is aimed at the Eurozone in general therefore. It is a budget aimed at getting Merkel re-elected rather than at saving the Eurozone per se.

If the German position may be regrettable for some periphery nations, the behaviour of France in relation to its own fiscal deficit is perhaps more worrisome. The French deficit hit its lowest level since 2008, yet still 50 basis points away from the Stability Pact guidelines.

France is clearly following Germany's example of preparing for life after the Eurozone, by moving itself towards a surplus position. The fact that it is now paid to borrow, through the negative interest rate process, has not tempted France to stray further into the moral hazard zone. Evidently budget discipline and the economic independence it creates are eagerly being sought after by French policy makers.

Despite a failure to respond, in the way that the ECB desires, the Germans are trying to reframe perceptions of them. In Draghi's own words they are a "nein zu allem" (no to everything) cadre. They are therefore in need of a makeover, before they get the blame for the collapse of the Eurozone.

Jens Weidmann appears to have undergone a makeover. Whilst the rotation voting mechanism precluded him from voting, on the ECB's last policy move, he did at least say that he agreed with the need to expand the monetary stimulus.

Having shifted from a position of outright resistance, he then pushed back against internal ECB pressure to increase the monetary policy stimulus in order to hit the 2% inflation target at all costs. In his opinion, the ECB must simply accept that it is going to take longer to hit the target, rather than scrap it or boost monetary stimulus to hit it on schedule. In relation to the impact of negative interest rates, on the banking sector, he was careful to draw the line between monetary policy and bank profitability.

In his opinion, there is a risk that negative interest rates undermine the monetary policy transmission mechanism through the banking system. For this reason, he is therefore antipathetic towards negative interest rates. He also touched briefly and lightly on the moral hazard issue implicit in Mario Draghi's strategy.

Bubbles and the misallocation of capital are the direct consequences that he sees from Draghi's current policy moves. He was also very swift to point out that in his opinion the current calls for Helicopter Money are absurd; and that recent unconventional measures have gone too far. What he is looking for is fiscal reform. It is no coincidence that Germany has just presented a fiscally neutral budget therefore. Anyone looking for Weidmann's example of fiscal reform, will be directed to the latest German budget.

ECB Executive Board member Sabine Lautenschlaeger followed the same German measured conciliatory tone as Weidmann. She seems to accept that negative interest rates are a fact of life. Banks must therefore adopt their business models to this new landscape in order to survive.

It is also her belief that the workout of the Eurozone banks' bad debts and non-performing loans will take years to accomplish. The term of negative interest rates is therefore likely to drag on as a consequence of this workout period also.

Interestingly, Lautenschlaeger suggested that the process of rescuing indebted sovereigns may serve as a template for how the bank workout process will go. Creditors and equity investors in Eurozone banks, should be prepared to take hits going forward. A full-blown banking system bailout is not on the Lautenschlaeger's cards.

In the absence of traditional German resistance, the Dutch have taken up the mantle. Dutch Governing Council member Klaas Knot felt less constrained to directly criticize the growing sense of moral hazard inherent in the ECB's policy.

In his opinion: "A further expansion of the buying program will lead to increased tensions with the prohibition of monetary financing." Knot is therefore trying to draw the line to prevent a further expansion of monetary policy, with the implicit threat that the moral hazard criticism will be raised in the future.

The feeling of moral hazard is growing in the fixed income analyst community. As the wording of the ECB's latest directive to follow QQE through buying investment grade corporate bonds is dissected for meaning, the moral hazard issue has appeared.

The ECB's vague wording, that it will in general follow the Eurosystem's existing collateral framework, has created room for a liberal interpretation of what constitutes investment grade. Analysts at Barclays have concluded that the ECB only needs to get an investment grade rating from one ratings agency in order to make a purchase. This would then see some junk bonds creeping into the universe of eligible collateral for the ECB's Corporate Sector Purchase Program (CSPP).

The Bank for International Settlements (BIS) then administered the catalyst to trigger the next phase of the Eurozone banking crisis. The Basel Committee on Banking Supervision recently proposed radical changes on how capital adequacy requirements are assessed.

The BIS proposes to remove the ability lenders to use their own models to determine how much capital they need to fund exposures to risk counterparties and assets; requiring them instead to use a standard model and process set by the regulator itself.

The plan also proposes a floor to be set, to limit how far risk assessments using the legacy models still allowed for assets such as mortgages and small-business loans can diverge from those calculated with the standardized approach. The wiggle room for the Eurozone banks and their national regulators, to subjectively play with capital adequacy rules, has just been constricted.

(Source: Association for Financial Markets In Europe [AFME])

Eurozone junk bond investors have been on a state of high alert, since it has become clear that a credit crisis is unfolding. In a move to get ahead of the game, to protect their position within the eroding capital structure of Eurozone balance sheets, the high yield investment industry issued its own demands.

These demands specifically address issues of transparency on reporting; in addition to capital and interest payment adjustments in conditions of financial stress. These demands should be viewed as collateral evidence that may form the basis of some heavy lawsuits during the next Credit Crunch in Europe.

Investment managers need yield, especially in a negative interest rate environment, hence they are forced to buy junk bonds. The BIS has just made it harder for high yield assets to be dissociated from their inherent credit risks. Investment managers therefore need to be protected from lawsuits that their fiduciaries will hit them with, for failing to pay adequate attention to credit risks as they stampede into high yield product to earn fees.

The investment managers therefore want their high yield cake and eat it, with the confidence that they can keep their fees and avoid being sued when the bubble bursts. It is a not so subtle shift from "caveat emptor" to "caveat venditor"; based on the thesis that the lack of borrower transparency and good faith precludes all forms of investor due diligence.

It also implies that borrowers are lying about their true financial health. It is Europe's Subprime moment. The behaviour of investment managers should therefore be viewed as a key signal that a risky bubble landscape is emerging in the spread product asset class. This bubble is being inflated by the ECB. It is therefore no coincidence that, as Europe's Subprime moment unfolds, those in the policy making fraternity are already framing market expectations about the solution. One such solution is Helicopter Money.

(Source: Bloomberg)

The spectre of Helicopter Money was raised by Peter Praet in the last report. The debate over its efficacy and imminence is now ongoing in the public domain. Controversy remains as to whether this tool is in the ECB's toolbox or not. Governing Council member Erkki Liikanen reiterated the ECB's commitment to keep interest rates negative for longer; and also intimated that there are other tools in the toolbox if negative rates fail to elicit the desired response. He did not specify if Helicopter Money is one of those tools.

The application of Helicopter Money would have to be something that is referred back to G20 for review and comment before it can be executed. It is almost certainly going to be viewed as something that is being applied to deliberately weaken the Euro; even though its intended recipients are European consumers. A fall in the Euro and a boost in consumption is the mechanism whereby the inflation target is supposed to get hit.

Convincing the rest of G20, that Helicopter Money is not aimed at weakening the Euro, can only be achieved if it is applied by all G20 members. Managing the sequence of the application of Helicopter Money will then become the global agenda of policy makers.

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.