Eurozone Q3 Events Frame Q4 ECB Developments

|
Includes: FXE, IEV
by: Adam Whitehead

Summary

A new compromise Brexit evasion strategy is on the table.

French and German Brexit negotiating positions are governed by their 2017 election realities.

The ECB has embraced the theme of central bank orthodoxy at Jackson Hole.

The ECB's position is ambiguous because it has lowered its inflation forecasts.

Mario Draghi has begun the process of the next phase of QE aimed specifically at the Eurozone real economy.

(Source: Seeking Alpha)

The summer recess in Europe is most certainly over, so it is useful to refer back to how this was expected to turn out in a previous report as the context going forward. The last report observed the hardening of negotiating positions on either side of the Brexit table, in addition to the possible outcomes being floated by the negotiating parties.

A new proposal to create a Brexit compromise has been floated by an amorphous group, that is indirectly associated with the European Union. The group, which includes Norbert Röttgen, the chairman of the German parliament's foreign affairs committee, and Jean Pisani-Ferry, who heads a think-tank reporting to the French prime minister, is promoting compromise solution; in which Britain would join EU countries in a new, looser, organization known as the "Continental Partnership".

This new proposal is interesting because it gives President Hollande a convenient option to adopt a less hard line attitude towards Britain, than his current baseline negotiating position in which Britain must totally accept the freedom of movement of people or be excluded from the single market.

President Hollande has been the recipient of considerable attempts to dictate the way that he will attempt to be re-elected, now that Britain has informally signaled that Article 50 will be triggered in early 2017. He has had to endure the risk from the stalking horse Emmanuel Macron, from within his own government. Macron has started a new centrist political movement to both lead and threaten the President. Hollande has received support against Macron's threat from Nikolas Sarkozy of all people. Sarkozy appears to have a strategy of polarizing the political debate, or rather leveraging off its polarized nature. Evidently he feels as threatened as Hollande by this new middle ground, so he has elected to destroy it. By recently joining the Burkini ban, not only has he increased the polarization in society but he has also attracted votes away from the Far Right to himself. He then went on to cannibalize the Far Right vote, by jumping into the immigration battle with Britain over Brexit. Taking a populist view, he opined that Britain should deal with its immigration issues on its own soil and pick up the tab. Sarkozy's attack was well informed, as Macron has now resigned from the Hollande government; and is widely expected to run for President next year. It is interesting to observe that Macron's move is coincident with the hardening of the Brexit battle lines; supporting the thesis that the timetable has been coordinated between both sides of the negotiating table.

Unfortunately, Hollande may be unable to avail himself of this opportunity, to destabilize Macron afforded by Sarkozy, because his own political position is under extreme threat. The latest opinion polls show that the any center/left combination, including the new entrant Emanuel Macron, would be eviscerated by Marine Le Pen in the first round of voting. This explains the tactical position taken by Nikolas Sarkozy. Sarkozy destroyed the pretensions of Macron and seized the high ground on immigration occupied by Le Pen. The latest polls show that he is therefore positioned to cannibalize the center/left vote that will use Le Pen as a protest vote in the first round, but may then drop her at the second.

The "Continental Partnership" would leave Britain in control of quotas on EU workers, thus addressing one of the major concerns behind the Brexit vote, while forcing reciprocal concessions in other areas. Significantly, the "Continental Partnership" would also give Britain the option to participate in discussions in single market legislation; and potentially also in key areas such as security and defense. Whilst Britain would lose voting power, and final decisions would still be taken by the EU, this consultative voice is more influential than that for non-EU member Norway which has been suggested as a model for the new configuration of post-Brexit relations by Merkel ally Juergen Hardt. The cost for membership would fall on British taxpayers.

Germany's Brexit negotiating position is anchored around the reality of the upcoming 2017 elections. So far Chancellor Merkel is behind the electoral curve because of populist aversion to immigration, suspicion of the EU and a rejection of ECB monetary policy. Seeking a platform to build on, to overcome these significant hurdles, Finance Minister Schaeuble has tried to frame perceptions of Merkel in an economic history light. Her time at the helm has been one of economic stability and growth, which is the historical foundation of Germany's social contract; the breaking of which has led to the experiences around the Great Wars that have informed future generation of Germans when making political decisions. He has also continued to promote fiscal austerity and balanced budgets, the historic breaching of which has led to said political and economic instabilities of the past that led to said conflagrations. This playing on the race memory of Germany is a smart move by Schaeuble, but risks running into the external problems of a slowing global economy and Brexit; which are now showing up in a rash of German economic data.

Unfortunately for the "Continental Partnership", its initial birth was stillborn thanks to the positioning of Theresa May and her cabinet. In a warning shot, she opined that there would be no "backdoor" remain in initiative. Her cabinet then fell into line, when it opined that there is no need for Parliament to ratify the results of the referendum. Britain's position appeared to harden even further, when the Prime Minister drew the red line on numbers of EU migrants to the UK. The reaction of the European Commission EC was equally and oppositely hard line. There will be no cherry picking by Britain when a deal is thrashed out according to the Commission.

The hard line taken by the Prime Minister however, may only be for specific domestic consumption that is not well-versed in the more nuanced way of political dealing and rhetoric. The "Tudor Monarch" style of the Prime Minister may just be an act for this specific audience. The Prime Minister subsequently became a little more ambiguous and hence open to the "Continental Partnership" when she opined that "I don't want to adopt a particular model, and people use phrases about access to the market, about customs unions and so forth, I prefer to look at it and say let's work out what the best deal for us will be in trade in goods and services, and then let's be ambitious and go out there and find it." Before embarking for the G20 summit, she then said that she foresees "difficult times ahead" for Britain. Her next logical step is therefore to revisit the partnership idea as a means of mitigating this bleak future. Her refusal to give the game away on whether her negotiating position is in or out of the single market gave her greater flexibility to play out this strategy.

Some parts of May's said less-nuanced audience, standing on the far right of the political theater, are however more perspicacious than their brethren. The Prime Minister's little pirouette towards the EU was immediately challenged by the conscience of said audience. Former UKIP leader Nigel Farage immediately seized upon May's backsliding in relation to Boris Johnson's hard quotas for EU migrants initiative. Lady Thatcher often endured rebellions when she was out of the country batting for Britain. Theresa May was facing another one.

(Source: Bloomberg)

The last report noted the theme of conventional monetary policy orthodoxy that was prevalent in the signals from the Jackson Hole summit. Reticence from the ECB to anticipate the Brexit fallout, in the same manner as the Bank of England was also noted. The lowering of the ECB's inflation target well into 2018, signaled that this reticence is a temporary phenomenon; so that once the Fed has done its mandatory tightening the door is wide open for the ECB to address the "Taper Tantrum".

This reticent positioning was recently further underlined by ECB Dove and unconventional policy promoter Peter Praet. Coming from this source, the reticence is more striking. After initially joining his colleague Francois Villeroy de Galhau in defending ECB policy, from the attacks in the banking community led by Deutsche Bank's CEO, Praet then went on to opine that the current strong-ish economic data from the Eurozone merited a wait and see posture. They were ably assisted by Governing Council member Ewald Nowotny; who opined that the ECB's primary job is to fight deflation in this current environment. Despite the evidence to the contrary, he still believes that the ECB has been successful. This all suggested that the ECB would be less likely to expand policy further at its next scheduled September 8th meeting. As it transpired, the ECB did nothing. The ECB is happy to maintain and defend the policy expansion that is currently ongoing, which thus far has created approximately $3,600 in excess liquidity which is not being used in the real economy.

The issue of banking consolidation was raised in this series of reports before the summer. Deutsche Bank's CEO John Cryan provided a timely update on if and how this is progressing. The early days of consolidation are evident in his recent report that negotiations were held with Commerzbank and his forecast that mergers should now occur throughout the sector.

On the issue of indebted nations being let off by the EU, Spain and Portugal were sanctioned but not fined. They were both threatened with the removal of budget support going forward if they do not provide a plan that will get their deficits into line. One can therefore expect that they will provide the necessary documentation, which the EU will then peruse and opine is fit for purpose and the evasion of further sanctions. Italy can be expected to draw up something similar that is also similarly received.

The ECB signaled that it is not going to let Italy off the hook without the semblance of some kind of close scrutiny. Whilst the under siege Renzi government availed itself of the platform of the Ambrosetti Forum in Cernobbio to announce that progress has been made in resolving the non-performing loan situation, the ECB gently pushed back. Opining for the ECB, Yves Mersch said that it would be for the markets to judge if the crisis is being dealt with satisfactorily by the Italian government.

Given the political uncertainty, weak inflation and slow growth in the Eurozone Eurogroup head Jeroen Dijsselbloem stated that he remains confident that interest rates will remain low for some time. He did not however put pressure on the ECB to ease further. He also signalled that the spirit of Eurozone finance ministers is to draw the waggons closer together, after the Brexit vote, in order to keep the momentum of the European Project moving forward.

The Eurozone stars are therefore being institutionally aligned for future business as we move into Q4 and beyond, against the new backdrop of Brexit and the Fed tightening. Mario Draghi has therefore set out his stall for this alignment, at his latest press conference, which disappointed his observers who had been anticipating an expansion of monetary policy. This disappointment then became confusion as the ECB lowered its inflation forecasts; a signal which seemed to conflict with the unchanged policy action. Observers need to step back and look at the bigger picture and context.

The lowered inflation forecast, signals the ECB's intentions and capabilities to deliver more monetary policy expansion. It is however faced with the tactical hurdle of the fact that the end of the current phase of QE is six months away. Ever the consummate technocrat and Jesuit, Draghi positioned for this hurdle. He announced that the ECB will now study ways of making sure that it gets the maximum bang from its asset buying buck. Referring back to the above graph, which shows all the idle liquidity outside the real economy, Draghi wants to find ways of getting it into the real economic arena. To lay out the forensic trail of evidence required for the next phase of monetary policy expansion, the ECB also released a paper which directly addressed the six-month expiry of the current QE programme. This paper concluded the following:

· Buying longer-duration assets brings more economic benefits.

· Forward guidance about future interest-rate increases is critical.

· Clarity about when the QE purchases will end and what will happen to the asset portfolio next is essential.

Joining the dots therefore, the ECB is now in the process of preparing its communications to signal the next phase of monetary policy easing when the current phase ends in six-months' time. The next phase will try to drive liquidity from the capital markets into the real economy(or at least it will be presented as such).

If only the Fed could be so clear!

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.