The ECB Faces A Mandatory Contradiction

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The ECB's political stance is contradicted by current incoming economic data.

The state bailouts of the banking sector may be followed by mutualization of the sovereign debt risk this creates through "Safe Bonds".

In the presence of the 2017 election year political vacuum, the ECB may monetize the mutualized deficit "Safe Bonds".

The ECB may face criticism for breaking its inflation mandate for political reasons.

Softening long-term inflation expectations have taken some pressure off the ECB in the near term.

Having injected a monetary insurance policy into the financial system in anticipation of the expected political headwinds from a banking sector crisis, national elections, the Brexit and President Trump at its last meeting, the ECB has been confronted by economic conditions that contradict this politically inspired decision. The central bank may thus be perversely hoping for the worst, in order to subvert these signals of the best of times ahead, at the start of 2017.

(Source: Bloomberg)

The last report observed Italy shuffling towards a state bailout of the banking system that would usher in the next phase of government deficit monetization in the eurozone. This shuffle was given a big push recently by the Italian government seeking permission from parliament to increase the nation's public debt by as much as 20 billion euros ($21 billion) to create a backstop fund for future bank bailouts. This sum falls well short of the estimated 52 billion euros required. Perhaps the excess will require further Italian government involvement, which will then push its fiscal deficit further into the red zone as far as the Stability Pact is concerned. There is also the elevated probability that the EU will then step in with its own support. At this point, the collateral for the eurozone "Safe Bonds" discussed in earlier reports, which were identified with mutualization of fiscal deficits, could be deployed in this EU support for the Italian banking system by the Italian government.

After the big push of seeking national support, a little nudge towards full nationalization was made by sources close to the Monte dei Paschi (OTCPK:BMDPY) situation, who leaked that there was no appetite from any private investor to bail out the bank. The bank then promptly dropped all pretences that a private sector bailout solution was on the table, thus triggering the mechanism through which a state bailout will be engineered.

(Source: Seeking Alpha)

The issue of "Safe Bonds" was anticipated by Mario Draghi way back in the October 2016 report, so it is plausible to assume that he foresaw the festering problems in the Italian banking system at this time. Back then, he tasked Governing Council member Philip Lane with investigating the idea of eurozone bonds collateralized with the sovereign bonds of eurozone member nations. The election of President Trump and the failure of Prime Minister Renzi's referendum since then may have accelerated the timetable. Lane recently gave an update on his progress in this endeavor. The European Systemic Risk Board (ESRB), under his aegis, was to begin its study at the end of December 2016 and complete it on January 27th, 2017. The ESRB study will have to be careful not to uncover the seedier side of eurozone finances as it prepares the groundwork for the acceptance of "Safe Bonds" fait accompli.

In Italy as with Greece, there is an element of criminality associated with the privileged elite who have benefit from a process of debt creation, distribution of proceeds, failure to repay said proceeds and, finally, the bailout process. This process has contributed to the rise of populism in part throughout the eurozone and has been a contributor towards the Brexit vote in Britain. The element of moral hazard associated with the process therefore has an elitist connotation that may anger the populists, and create a further backlash, if it is not managed and spun well in the media.

Banca Monte dei Paschi may be getting all the headlines, but the headlines associated with Bank Etruria have the potential to upset the pork barrel. Recently, it was revealed that the bank's executive and board were under investigation for the fraudulent practice of making loans that were never intended to be paid back. Some of these loans went to favoured individuals, and possibly some to organized crime figures also. The tip of a potentially large iceberg has thus become visible in relation to this case. If it scales across the whole of the Italian banking landscape, any kind of EU participation in a bailout will face the wrath of populists in the countries doing the bailing. Any attempt by the EU to sweep the element of fraudulence associated with the moral hazard of bailing out the Italian banking system will need to tread carefully in the press.

The situation in the Italian banking sector contrasts with that which is in the process of being addressed in Spain. In Spain, the legal system intervened early and ruled many of the sharp practices adopted by banks to maximise their margins at the expense of their borrowers to be illegal. The banks and their officials were punished, and the borrowers were compensated at the expense of bank creditors and shareholders. The losses to creditors and shareholders then paved the way for early state intervention and, ultimately, EU support. The Spanish banking sector therefore remains toxic for the fiscal deficit and is in need of EU support, which is a precedent that serves to guide how the Italian banking sector may try and resolve its own issues. This precedent is, however, not a panacea for the eurozone. It must also be said that the festering issue of loans to privileged persons with no intention to pay back was addressed in some cases, even going as far as the Spanish monarchy. Spanish banks may appear to be better value than Italian ones because they seem to have taken their pain and medicine early. In reality, they are just closer to the real medicine of an EU bailout, which therefore makes them appear less risky, assuming that a bailout is forthcoming.

The Spanish and Italian banking sector resolution pits populists who are on the side of the borrowers against populists in other EU nations who do not wish to pay for the sins of bankers in the other EU countries. German taxpayers, with their own banking sector issues, are unlikely to vote for a German government that wishes to bail out Spanish and Italian borrowers, especially if this rewards criminals who can just walk away from the damage inflicted on the banks. Populism is a national movement that is antipathetic to the notion of European integration. To avoid this clash of nationalist populist agendas, the EU and the sovereign nations are attempting to weaken the bank capital adequacy rules within their jurisdictions in order to allow the banks to limp on as zombies.

The banks' zombie status will then be underwritten by their national governments, who are then underwritten at the EU level by being allowed to break deficit limits in order to bail out their respective banking sectors. The EU then limps on, as the banking sector limps on with systemic weakness and baked in moral hazard as a consequence of political expediency.

Bundesbank head Jens Weidmann signaled that there is a movement within Germany that intends to strongly resist any drift towards weaker fiscal guidelines in 2017 and their further watering down through weak bank capital adequacy regulations. In the last report, he was observed leading the northern European resistance to the weakening of fiscal and bank capital adequacy rules that have become correlated by the drift towards national bailouts of the banking sector. His classification of the eurozone's problems as slow growth because of structural inefficiency rather than weak aggregate demand was identified as his principle objection to the ECB's latest extenuation of its QE programme. Weidmann made the case for structural economic reform to stimulate growth rather than apply more QE aimed at boosting aggregate demand. In his latest speech, he called upon his neighbors to show greater respect for Stability Pact guidelines, in addition to a removal of the ECB's monetary stimulus based on his view that the oil price will stick at higher levels in 2017. In relation to the timing of removal of the monetary stimulus, Weidmann opined that the ECB should not be too slow to do this, implying that he will be pushing for this in 2017.

Specifically addressing the issue of the state bailouts of the Italian banks, Weidmann demanded that as a rule, aid should only be given to those banks that are healthy at "their core." He thus sought to avoid the moral hazard of simply using taxpayers' funds to keep alive zombie (potentially criminally fraudulent) banking operations. His attack was followed up in the political executive branch of Germany by Deputy Finance Minister Jens Spahn. Supporting Weidmann's call for ending QE , Spahn opined that the improving economic growth and rising inflation throughout the eurozone now dictate that the ECB should start to exit the QE process.

Since Germans go to polls in 2017, it would have been unlikely for Weidmann and Spahn to have spoken in any other way. Their position comprehensively articulates the stand that Merkel's CDU is going to make in 2017 as other EU nations attempt to apply softer options to get them through an election year in which the debt crisis and the banking sector crisis weigh on voters' minds. This position may not, however, be taken by Merkel's coalition partner, the SPD.

The SPD is still forming its position and remains leaderless at this point going into the elections. Deputy Finance Minister Sigmar Gabriel tested the waters with an alternative German position and also his potential SPD leadership credentials. Gabriel tested public opinion to see if there is any tolerance out there amongst Germans for a more relaxed approach to fiscal austerity within the EU. Testing this thesis, he opined that it is "absurd" to expect France and Italy to adhere to fiscal austerity rules under the current challenging political and economic environment. There is no clear-cut winner emerging in Germany, so another coalition is widely expected. The strategy amongst the coalition partners is thus to try and gain the upper hand in the coalition.

Merkel's CDU appeared to have shot itself in the foot with its European partners through its choice to become the new EU Budget Commissioner. The switch of this position to become potentially occupied by a German provides greater scope for the country to influence eurozone budget discipline in addition to Brexit negotiations. Unfortunately, the choice of Guenther Oettinger for this position was an own goal in EU terms after his hallmark chauvinist comments about Chinese people, quotas for women and gay people. Oettinger's rhetoric may, however, play well with the German electorate; so if he makes it through the EU's screening process, he could well become an inspired choice to evince the face of populism that attracts votes to Merkel's party.

Northern European resistance fell into line behind Merkel's party doctrine recently in the form of ECB Governing Council member Ilmars Rimsevics. He proselytized for structural economic reform almost verbatim of Weidmann's words. The strong resistance from Northern Europe ensured that the rolling state bailout of the Italian banks got off to the messiest start possible. By making this mess appear worse, however, the Northern Europeans may have simply brought the inevitable moral hazard response from a combined ECB and EU solution closer in time.

It transpires that Monte dei Paschi's bailout requirements are larger than initial estimates. These estimates were based upon the 2016 stress test by the ECB, which was basically an exercise in staving off a run on the banks at the time. The run, however, came later and with consequences now visible. The scale of the bailout required clearly frightened away any private investor. It is therefore clear that any clean-up of the banking system in Italy can only be done at the state level. Italian Finance Minister Padoan wasted little time blaming the failure of the private bailout of Monte dei Paschi on the ECB for lowballing the initial size of the funding required. By inference, therefore, the ECB is also culpable for an inevitable state bailout of the whole banking sector, at a cost which pushes Italy well beyond its Stability Pact limits. By blaming the ECB, Padoan also tried to exonerate his government from breaking its Stability Pact guidelines as it comes to grips with the situation across the whole Italian banking sector. He implies that had the ECB initially informed him of the size of the state bailout required, he could have factored this into his budget so that the Stability Pact guidelines will not be broken. Since he was not correctly informed, by default he must now break these guidelines, and it is the ECB's fault not Italy's. Such casuistry is the stock in trade of the eurozone's creep towards debt mutualization by stealth. Like an alcoholic being treated with more alcohol, the patient and the doctor both remain in denial about their own complicity in institutionalizing the illness. The Northern Europeans have tried manfully to take the bottle away, but only for a larger one to reappear later that they must all fill.

This latest tactical victory for the Northern Europeans may thus lead to another strategic loss, as the more ugly the state bailouts become, the more the ECB will be inclined to respond with easier monetary policy. Since the ECB requires collateral to expand its monetary policy, the sovereign debt of the nations doing the bank bailouts become the desired lower fruits on the branch that it will try and pick. Since the tightly enforced capital key rules preclude it from buying these indebted nations' bonds directly, the obvious solution is for the creation of "Safe Bonds" to accommodate the ECB's bond buying wishes. The Northern Europeans have therefore triggered a new banking crisis that will lead to a sovereign debt crisis in 2017. Since the politicians will be engaged in fighting populism in the 2017 European election year, the vacuum of leadership will have to be filled by the ECB as it was in 2016.

The recent Northern European initiative to address the rise of populism may also prove to be an own goal. This initiative is being led by Dutch Finance Minister Jeroen Dijsselbloem. In a reflexive act of populism, he has suggested raising corporate taxes to fund wealth distribution to the disenfranchised. The Netherlands will deal with its own issues by raising fiscal revenues from companies rather than from Dutch voters or voters in other EU nations. Fiscal austerity didn't work, and now corporate austerity is being tried out. Evidently, making policy that spurs investment and employment creation is either no longer Dijsselbloem's business or is beyond his abilities. If and when voters pause to reflect on these possibilities, especially when the corporate cutbacks on jobs and investment to fund the wealth transfer occur, Dijsselbloem's credibility and career will take a severe knock.

The signals out of the banking sector in France suggest that the wagons are being corralled into a defensive ring to repel all invaders, including Northern Europeans. In yet another signal of politically motivated monetary policy strategy, the French banks have decided to fight the populist threat from Marine Le Pen by refusing to lend her party the money it needs to run in the presidential elections this year. Since Le Pen is antipathetic towards the ECB and EU membership, the French banks have decided that they are antipathetic towards her. In return for their allegiance, the ECB will be expected to return the political favor with cheap funding and the real promise to support any French banks that get into trouble. In addition, the EU will be expected to waive any penalties or resistance to the French budget breaking Stability Pact rules in this election year as the pro-EU membership parties buy their votes with fiscal gifts.

The big question mark hanging over the European banking sector became a highly visible risk for 2017 when it was announced that this year's scheduled meeting on the adoption of Basel III rules on January 8th would be cancelled - without any rescheduled announcement date. This crisis now appears set to rumble along with no direct solution throughout the eurozone election year of 2017.

(Source: Bloomberg)

In addition to the banking sector crisis, the issue of latent economic growth and inflation outlined by German Deputy Finance Minister Spahn is a looming threat to Mario Draghi's position for 2017. The improving data and German commentary elicited a swift response from Governing Council members who wish to preserve the status quo of an expanded ECB balance sheet.

ECB Governing member Council Ewald Nowotny was the first central bank speaker to set the baseline for policy expectations in 2017. Whilst talking up the oil price and its impact on inflation, he still expects this to fall below the ECB's target. The baseline scenario set out by Mario Draghi at his last press conference, of an aggregate expansion of monetary policy achieved through smaller monthly increments, was thus preserved by Nowotny's remedial guidance.

The situation is rapidly becoming absurd, as the inflation and growth that the ECB aggressively sought to stimulate have now become unwelcome arrivals that the central bank now wishes to swiftly discount. The process of discounting these unwelcome positive developments was continued by Executive Board member Yves Mersch. According to him, these arrivals are not strong enough to warrant any scaling back of the monetary stimulus extended at the last Governing Council meeting.

Nowotny's emphatic predictions about sub-target inflation show where the risk for the ECB and Draghi lies. Having committed to anticipate a political doomsday scenario in 2017, the ECB is now faced with a eurozone recovery which is sending inflation back to target somewhat faster than anticipated in the political decision. The criticism will soon be pouring in from all sides, especially the German one, this year. The latest German unemployment data showed a strengthening in economic activity going into year-end; and the latest inflation data also spiked with oil. German economic strength, despite the oil price headwind, directly contradicts Nowotny's logic and justification for the current ECB policy stance.

(Source: Bloomberg)

The ECB is now dangerously contradicting its monetary policy mandate, with a politically motivated expansionary policy that risks moral hazard by breaking the taboo of deficit monetization. This is the big theme for eurozone capital markets in early 2017. The circumstances may be extenuating in political terms, but this should not be a concern of the ECB under its current mandate guidelines. The situation has not become critical for the ECB just yet. Long-term inflation expectations, whilst elevated, have recently begun to cool. Inflation expectations have thus not started to get away from the ECB, so that it is falling behind the curve. Things are therefore delicately poised, but the ECB does not have the breathing room it once had to pursue an expansionist monetary policy with impunity.

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

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