Draghi's Clarity Fails Just When He Is Needed Again

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Summary

Eurozone commentators are talking about an ECB tapering just as the ECB is running out of eligible bonds to purchase.

Coincident with the ECB taper discussion, a discussion over deficit target breaches has also begun.

The ECB has become trapped by the perception that a taper is a tightening of monetary policy in the ZIRP/NIRP world.

The ECB is on hold awaiting a global macro catalyst for further monetary policy expansion.

The deteriorating Brexit negotiations may eventually become the ECB's global macro catalyst for further action.

(Source: Bloomberg)

Recent commentary in the press has suggested that the ECB may be considering tapering. This legend was observed to be challenged by various ECB spokesmen in the last report, leading to the conclusion that the central bank has become data dependent. It may also be the case that the ECB's QQE buying programme in relation to corporate bonds has become a victim of its own success, thus necessitating a backup in yields in order for it to re-engage. Yields on some corporate bonds are now so negative that they fall outside the ECB's own buying criteria. A rise in yields or alternatively a loosening and broadening of the criteria must now occur to enable further buying. Interestingly a loosening/broadening of the criteria would require a further deterioration in economic conditions, thus confirming further rational for the data dependency hypothesis. The taper discussion should therefore be understood in the context of diminishing available QE bonds and the lack of further economic deterioration.

Just as the question mark appears over QE eligibility and scope, the eurozone lawmakers have started to make noises about the undesirability of nations breaking their 3 percent deficit to GDP guidelines. This apparent coincidence may in fact be more than that and may reflect the acceptance that the ECB is going to be the future buyer of first and last resort of eurozone debt. In order to enable this process and even to remove the capital key limit on ECB sovereign debt purchases, the eligible nations will have to appear to be sincerely going through the motions of fiscal rectitude in relation to borrowing. By appearing to take care of the numerator in the debt/GDP equation, policy makers and the ECB can thus blame the denominator as limits get broken. By framing the denominator as the problem, it then becomes a simple process of rhetoric for Mario Draghi to say that in buying more debt and breaking the capital key rules, he is trying to address the GDP denominator to support his law making colleagues who are doing their bit to address the numerator.

European Commission Vice President Valdis Dombrovskis thus began the process of addressing the debt numerator by politely asking France to adhere to the guidelines which it is currently breaching. In an election year, where populism is the main threat to the EU, his polite request is unlikely to be met with alacrity by France. His comment therefore just serves to tick the box that due process is being followed for the record. France will then acknowledge the guideline and then focus attention on the weakening GDP denominator to move the process further on to where the ECB's balance sheet kicks in.

Having warned the French, Dombrovskis then went on to warn the Spanish. Spain is unique in that it still doesn't have a government, yet its economy is arguably growing faster than the rest of the eurozone. His words of warning therefore cannot be officially responded to or followed by the parliament with any direct policy action. Once again, the rhetoric just conforms to the due process of ticking the box for Spain.

Italy was also warned by Dombrovskis. Once again, unique mitigating circumstances in Italy in regard to Renzi's upcoming confidence referendum preclude it from responding with alacrity, thus ticking the due process box for Italy whilst avoiding any serious intent to do anything about its debt situation. To highlight the absurdity of the situation, Prime Minister Renzi, with his eyes on the referendum and not Brussels, passed a budget with a fiscal stimulus and corporate tax cuts in the package.

The wave of bank mergers suggested in these articles and confirmed by Mario Draghi in an earlier report is more of a trickle in Italy. The combination of cooperative lenders Banco Popolare SC and Banca Popolare di Milano Scarl, recently approved by shareholders, is being framed as a one-off for now. The hurdles faced are the referendum politics, tougher capital standards and a growing mountain of bad debt on Italian banks' balance sheets. Further consolidation may therefore require the invisible hand of government intervention and the visible hand of state bailouts, combined with the ECB's debt monetizing balance sheet, to enable the process further. This process may then become the model for eurozone banking consolidation in general.

In spite of the hurdles to banking sector consolidation, central bankers are clearly in favor of it. The latest proselytizing for the consolidation solution came from the Bundesbank's Andreas Dombret. Defaulting to Mario Draghi's baseline that the banks must adapt to the new economic environment that they and not the ECB are responsible for creating, Dombret reinforced the case by invoking the taboo of central bank independence to prevent the ECB from being taken hostage by the banking sector. In his opinion, consolidation is one specific means of adaptation to the new ZIRP/NIRP environment.

Mario Draghi provided the final word on the ECB tapering story. In doing so, he left the taper on the table as an option to be applied in 2017 when the current QE programme ends. He provided certainty that the end of the QE phase will not involve an automatic tightening of monetary policy. His problem is that observers do not see the difference between tapering and tightening, especially when they have become accustomed to a lengthy period of ZIRP/NIRP. As the Fed is finding out, a tapering is viewed as a monetary tightening in the current climate of weak economic growth and anemic inflation. Draghi's clarity in outlining the future course of ECB policy has thus been negated by the current weak economic environment and negative term structure of interest rates. Observers cannot perceive of any future economic scenario in which a tapering is not an outright tightening of monetary policy.

The ECB has thus entered the zone of central banking currently occupied by the BOJ. Clarity of guidance is no use in this situation, because inflation and growth expectations have become anchored into a new normal that is converging upon what John Williams is opining as the lower new natural rate of interest. The problem for the ECB (and the BOJ) is that this new natural rate of interest is negative!

The ECB and global central bankers in general will therefore start contemplating some kind of shock and awe to shake economic observers out of their pessimism. Indeed they may already be contemplating this and waiting for their opportunity to strike. To trigger their response, a new global macro catalyst is required however.

(Source: Seeking Alpha)

In Europe, this new catalyst has been associated with the Brexit negotiations, which, as suggested in a previous report, have the innate redundancy to become toxic. Evidence of this growing toxicity came last week when Prime Minister May hardened her attitude to both the EU and her domestic critics who would like to get the parliament to engineer some kind of second vote to reverse the first outcome.

(Source: The Daily Shot)

It is in the interest of the Eurocracy to see Britain fail on its own in order to kill off populism in Europe and also to make the polity of the eurozone believe that it cannot survive without the EU superstructure. No quarter will therefore be given on either side of the negotiations. This adversarial position adopted means that both sides will do the maximum damage to each other, thus achieving a sub-optimal outcome for all involved. The first glimpses of the toxic adversaries became visible when it was rumoured that the ritual humiliation of Britain during the Brexit negotiations would be carried out in French. It is early days, so there is great scope for things to deteriorate much further to become a true catalyst for the ECB to act again.

ECB Governing Council member Ewald Nowotny appeared to call time-out on further monetary policy stimulus for the time being. He also called for a policy mix of structural economic reform and fiscal stimulus to complement the ECB's actions thus far. Faced with the Brexit negotiations, the referendum in Italy and the elections in France and Germany just where this fiscal stimulus and structural reform will come from is open to question. The ECB like the EU is also ticking the due process boxes. In the absence of said reforms, the ECB is expected to be on hold, awaiting further economic deterioration to trigger its next monetary policy expansion.

So Draghi is thus viewed as running on autopilot with no further easing until March 2017, and then tapering (tightening) against a deteriorating Brexit political backdrop, a referendum in Italy and general elections in Germany and France. The Fed and the BOJ show no signs of coming to the rescue with easier policy during this period, and the Bank of England is now the enemy of the ECB. There is also a hint that Draghi has understood that further easing only plays into the hands of the populists during the French and German elections. He has therefore signaled tapering to accommodate the Europhiles on the ballot boxes in these two countries. The ECB's hands are thus tied and intervention to address an unfolding crisis would come as a late reaction rather than in early anticipation. Market uncertainty thus faces the certainty that the ECB is stuck in neutral gear. Suddenly there is a question mark over how swiftly Mario Draghi can step in to "do whatever it takes" again.

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