Germany First, Europe Later Perhaps

by: Adam Whitehead


There is no further pecuniary or political advantage for Germany in maintaining a negative interest rate term structure.

The Bundesbank is positioning for a recapitalization of the ECB.

The ECB's prioritising of Eurozone survival is in direct conflict with President Trump’s global trade agenda.

A Germany First movement is growing in opposition to President Trump.

Multi-speed Eurozone integration is now suggested as way of keeping the European Project alive.

Germany has begun to position itself in anticipation of economic and political changes this year that will have an impact in 2019.

In a previous report, the year 2017 was noted as being pivotal for the survival and structure of the Eurozone in 2019 assuming that it survives. This was then followed by the last report, which observed the widening schism between the German contingent within the ECB's governance structure and Mario Draghi's control of the monetary policy agenda for the Governing Council. The German antithesis is based on its assertion that the current incoming growth and inflation data determine that the Governing Council should no longer be expanding monetary policy in the current countercyclical fashion that it has adopted. Mario Draghi's thesis is based upon his own politically motivated subjective framing of the same evidence, to support his position of monetizing the deficits of the highly indebted sovereigns.

Mario Draghi's thesis, that oil price driven inflation is a transient phenomenon, for maintaining an expansive monetary policy is now undergoing a vigorous test. The latest Eurozone inflation data came in just below his 2% target at 1.8%, so he appears to be vindicated. The fact that it jumped from 1.1% the previous month should not give him any room for complacency however.

The "few good men" identified in the last report ,on the lack of best governance practice at the ECB, have started to come forward in support of Draghi; to confirm that the central bank is in fact making unprecedented political decisions when framing its monetary policy. Their political comments are aimed squarely at the threat of populism. Executive Board member Peter Praet recently opined in criticism of this rhetorical populist nemesis that: "It's kind of dishonest to say 'I can regain control' in a globally interconnected world". Praet ignores the fact that President Trump and Brexit are making this globally interconnected world obsolete.

Praet was then followed by Governing Council member Francois Villeroy de Galhau; who opined that "taken separately" every Eurozone nation would lose its collective voice and bargaining power through the triumph of populism. Villeroy signaled that the ECB intends to fight, what it sees as the perfidious Anglo-Saxon attempt to destroy the European Project, at the venue of the next G20 meeting. His battle cry resonated with a further signal about the intended direction of the European Project. He said: "When the ECB president speaks at the G-20, the whole world listens to Europe carefully," and that "We need the asset of European sovereignty." According to Villeroy the ECB President will be the spokesman, of a combined European sovereign that does not even legally exist yet. What could be more overtly political can this?

A glimpse under the hood of the perfidious Anglo-Saxon machine, was recently provided by an expose of the invisible hands behind the UK Leave campaign and President Trump's campaign. The hands involved in both are apparently connected to the same body. The figure of hedge fund manager Robert Mercer and his formidable computing power was found to be the winning common denominator in both campaigns, along with the outbreak of fake news that influenced the voting behavior in these two campaigns. A foul has been called by the election committee in Britain, because Mr. Mercer's support was not declared. In America where the electoral process does not hide the fact that it is heavily influenced by financing he is feted as a genius.

The new battle cry of "European Sovereignty" is in fact a code for deeper fiscal and political integration to fight off the Anglo-Saxons. Evidently, the ECB intends to enable this through a combination of further sovereign debt buying which breaks the current capital key guidelines. The creation of this pile of debt on the ECB's balance sheet will then mitigate for a central fiscal agency to underwrite, it in order to prevent the Target 2 system that is supposed to settle it from failing to settle.

Governing Council member Ewald Nowotny then joined his brothers in talking politically. His choice of political commentary showed where the ECB's fears are focused and the fallout that may come in the future as it clashes with its American populist nemesis. Opining on US fiscal policy, Nowotny forecast that it would lead to a rise in US interest rates that would strengthen the US Dollar and undermine the stimulus. Evidently, the ECB understands that President Trump is an existential threat and the battlefield is the foreign exchange market. President Trump could and no doubt will respond by saying that lower European interest rates will have the same negative impact on America through weakening the Euro. A war between the President and the ECB, into which the Fed gets dragged, looms large for the remainder of the year. Nowotny has drawn first blood by talking about American domestic economic policy, so President Trump is well within his rights to respond for America.

The rhetorical style drift, away from the strict discipline implied by the ECB's inflation mandate, into the realms of geopolitics by the latest ECB speakers was egregious. This style drift was made all the more striking, by the dropping of all pretensions to link the political rhetoric with any implied forecasts for the inflation and growth impacts of populism. The ECB has dropped all pretense to economic discipline and embraced the strongest emotive rhetoric available in the behavioral finance textbooks that it can find.

(Source: Bloomberg)

The pushback from Germany against Mario Draghi's adherence to a continued monetary easing was seen to be gaining strength in the last report. Undeterred by Draghi's vigorous denial of its contrary assertions, German preparations for an ending of QE and a rise in interests rates have continued at the Bundesbank. These preparations were made in the provisioning for losses on the Bundesbank's holdings of German government bonds, which have been bought at negative yields and will lose value by accreting to par. Bundesbank Executive Board member Andreas Dombret then urged the German banks to follow suit, in order to prepare for the negative marks-to-market of their own asset books when interest rates rise.

From a German pecuniary perspective, QE and NIRP have lost their utility. The Bundesbank stoically accepts the capital loss associated with the end of its utility and provisions for it. The Bundesbank is also lucky in that there is no limit on the losses it can take by German law. The ECB on the other hand is facing insolvency, yet remains in denial, because it is limited to only taking losses up to the value of its paid up capital. In the event of insolvency, a new round of capital would have to be raised from all Eurozone national bank members; that is assuming that they have enough capital themselves. It is moot whether the nations that are already breaking Stability Pact guidelines, whose bonds the ECB is bending capital key rules through buying, will be in any position to finance an increased capital subscription to the ECB. The Bundesbank is thus in a position to outlast the ECB in a war of attrition, should rising yields threaten the solvency of both.

The Bundesbank has therefore signaled that it is now adopting a position that assumes rising interest rates and the threat of insolvency for both itself and the ECB. Mario Draghi on the other hand has adopted a different strategy to deal with this threat of insolvency. The Bundesbank's losses have been amplified because it is forced to buy more negative yielding German bonds under the capital key rules on sovereign debt buying which govern the QE process. The ECB has recently bent these rules deliberately, by buying higher yielding bonds of more indebted Eurozone nations such as Italy and Spain. Rising interest rates threaten both the ECB and Bundesbank, with the latter able to outlast the former.

The Bundesbank is still solvent, because is pays less negative interest rates on the deposits it borrows from the German banks. This yield curve arbitrage is hated by the German banks and their depositors. Depositors have raised their physical cash holdings and sought alternative asset investments. The German banking system is in distress, as its margins are compressed by the Bundesbank and its depositors pushing in opposing directions. Depositors have now also become angry voters. The Bundesbank understands that its license to steal from these depositors/voters, via the yield curve arbitrage, may get revoked.

The Bundesbank has noted how the yield curve arbitrage of borrowing at greater negative interest rates than it lends to the German government through bund purchases is over in any case. In its latest report the Bundesbank posted a distributable profit of 399 million euros for the 2016 financial year, compared to 2015's figure of 3.2 billion. The Bundesbank is now facing a capital loss as yields rise, that the German government will have to pay through recapitalization, rather than receive its profits from the central bank's playing of the yield curve arbitrage. The Bundesbank has therefore decided to provision for losses that cannot get passed on to bank depositors through even more negative interest rates. There is therefore no more absolute pecuniary advantage for the Germans in maintaining a negative interest rate regime. Negative interest rates in Germany now have a real financial cost. Since there is no political advantage and in fact political capital is being eroded through maintaining negative interest rates, it is logical to assume that the Germans now wish to end this monetary experiment.

The ECB pays less negative interest on its deposits from Eurozone national central banks than it earns on its holdings of sovereign bonds. The ECB also thinks that it is unaccountable to bank depositors, taxpayers and voters because it is a politically independent central bank of sovereign central banks; despite the rise of populism which clearly says the opposite. By bending the rules and buying sovereign spread product, Mario Draghi hopes to stay in the game long enough to avoid insolvency through the adoption of fiscal union within the Eurozone. Fiscal union would then make all sovereign bonds equal and would force the Northern European taxpayers to bail out the high yielders.

Bundesbank President Jens Weidmann recently brought the whole debate into the open with his carefully-chosen words about the direction of interest rates, as he elaborated his position in relation to the ECB's Governing Council strategy. In his opinion, a further prolonging of low interest rates is being driven by highly indebted Eurozone nations' unwillingness to create growth and reform policies of their own. In effect, they have subcontracted economic growth policy to the ECB's loose monetary policy. In doing so, they have created the dependency that has increased moral hazard. The Eurozone is thus on the cusp of moral hazard, which probably also speaks to Weidmann's view of the ECB's bending of capital key rules on its asset purchases. Whilst sounding the alarm bell however, he does not believe that the ECB will suddenly end its buying program in the near future.

Whilst reiterating his objection to the Governing Council's latest monetary expansion, Weidmann's words also appear to be apocryphal in choosing 2019 as a point in the future at which the ECB needs to be raising interest rates. Evidently, the Bundesbank is looking through the chaos of the current election year in the Eurozone and the potential fallout from any populist surprises, in addition to the sketchy Brexit timetable and President Trump's stormy impact on the global economy. The period between now and 2019 is therefore viewed as conducive to a continued low interest rate environment. 2019 however marks the point at which interest rates should start to rise.

Showing that he has also adopted the ECB's habit of political commentary, Weidmann hoisted his own political colors up the Bundesbank's flagpole. Commenting on SPD leader Martin Schulz's plans to reverse labor market reforms, he opined that these reforms had been instrumental in turning Germany from "the sick man of Europe" into the "economic powerhouse" of today. Weidmann is in fact trying to kill two birds with one stone here. The political death of Schulz is obvious. The death of President Trump's worldview of the weak Euro and Germany's advance, from "sick man" to "powerhouse" because of this currency weakness, is a less obvious yet equally powerful objective. What is clear is that the writing is on the wall for the German advantage of weak Euro membership now that President Trump is in office. Comparative analysis shows that Germany's economy grew the strongest of all the developed economies in 2016. Whilst this may have been due to spending on immigrants, it is highly unlikely that President Trump will accept this explanation. His latest blanket assessment, that every trade relationship which America has is in deficit, has already framed the debate with a negative halo that will be impossible to shift with real evidence.

The above discussion highlights the diverging positions now being taken up by the Bundesbank and the ECB. The Bundesbank has got a rising yield divergence trade on, whereas the ECB has got a low yield convergence trade on. The fact that the Bundesbank is part of the ECB system makes this divergence of positioning a source of friction and systemic risk. As noted above, there is no limit to the losses that the Bundesbank can take but the ECB's are finite. In theory therefore the Bundesbank has a trade on that will ultimately lead to it increasing its shareholding in the ECB, if and when the latter needs recapitalizing. If nations leave the Eurozone, this recapitalization event will be even more necessary; and will give Germany with its Euro trade and fiscal surpluses the upper hand in controlling the recapitalized ECB.

The recent comments from the Lithuanian ECB Governing Council member not only illustrate the ECB-Bundesbank divergence, but also put the ECB's strategy and its outcome into a worrying global context in the new era of President Trump. Vitas Vasiliauskas lately signaled that the ECB is brushing the dust of an old tried and tested crisis liquidity measure to save the banking system. This measure is called the Targeted Long-Term Refinancing Operation (TLTRO). According to him, it may swiftly come back into play in the near future just after it is scheduled to expire at the end of next month.

Under this TLTRO facility, the ECB lends money to the commercial banks at zero per cent and in some cases may even pay them to take money for periods of up to four years. Rather disingenuously a re-ignition of the TLTRO was presented as an opportunity for the ECB to signal that it intends to exit QE without destabilizing markets! The TLTRO was thus positioned as an insurance policy, rather like the latest expansion of QE, to support the banking sector as liquidity is tightened. The ECB has a habit of expanding liquidity under the pretense of tightening liquidity in the future. This expanded liquidity is never withdrawn; and its potential withdrawal is then presented as an excuse to expand liquidity even further. The banking system should be positively responding to the potential for greater profits from rising interest rates. Instead it is being prepared for potential insolvency from the mark-to-market losses on current assets. The real signal is that the removal of emergency cheap liquidity from the banking system is approaching as the program previous TLTRO facility expires; and now the ECB wishes to continue to provide more of because the banking system will collapse without it.

Mario Draghi and those who support him within the Governing Council remain committed to saving the Eurozone and its banking system at all costs. The current growth and inflation data does not however oblige them to do so. By ignoring the data and plunging ahead with its crisis response, the ECB is therefore opening up a trap-door beneath the Euro. The fall in the euro against the US dollar will immediately antagonize and mobilize Donald Trump. It is likely that it will also stall the Fed from continuing with its interest rate rises, for fear of contributing to the global trade tensions. Ironically, President Trump has been labeling the Germans as currency manipulators. On this occasion the Germans are not to blame, despite President Trump identifying them as the problem. In fact the Bundesbank is preparing for the fallout from the trade tensions that the ECB is creating. President Trump will therefore have to move on swiftly to direct criticism of the ECB in due course.

German political action in response President Trump has been recently galvanized in any case, so the country no longer needs to maintain the pretense of fair play in relation to trade. Volker Kauder, a senior political ally of Angela Merkel has effectively spoken on behalf of her; in order to frame public opinion in support of Merkel's own Germany First credentials. The combination of Merkel's Germany First initiative with that of the opposition Alternative for Deutschland part is now promoting nationalism above the European agenda in the German psyche. Speaking to Funke Midiengruppe Kauder opined Merkel's shadow Germany First manifesto for domestic political consumption, whilst she still evinces a pro-European agenda. According to Kauder, Germany should retaliate against any American tariffs with ones of its own. It should also adopt a more muscular military foreign policy, which should be funded by social welfare cuts. The social welfare cuts are simply code for immigration. In many respects, Kauder wishes Germany to mirror President Trump's own policies. Such a mirroring posture would be disastrous for the global economy.

The last report noted that any outcome of the French Presidential campaign will be asymmetrically negative for the global economy. A grand coalition with the SPD in the senior executive position was also seen to be taking shape in Germany. There are two costs associated with this change in German leadership if it becomes the final outcome.

Firstly, the party leader Martin Schulz is financing his political capital building operation at the expense of the German economy. He does this by promising the organized labor movement that he will reverse the labor market reforms that have made the industrial sector competitive. If he is elected therefore he will be relying even more heavily upon a weakened Euro to mitigate the structural economic impediments that he has erected. In effect, the weak Euro will hide Germany's return to "weak man of Europe" status. This will then bring him into immediate conflict with President Trump, who already has an inclination to label the Germans as currency manipulators.

Secondly, Martin Schulz has shown himself to be in favor of Hard Brexit terms and conditions. A Hard Brexit and the reciprocal adversarial reaction from Britain can also be expected from a Schulz victory. A Hard Brexit may be painful for Britain, but this does not make it any less painful for the EU that Britain leaves. This lose-lose thesis was well articulated by a spokesman for Angela Merkel's CSU sister party. "I fear in a certain way that this harsh pressure which is now put from the EU Commission on the UK isn't in Germany's interests," said Stephan Mayer a member of Merkel's CSU ally party. Britons are indeed fond of their Audi's and Beamers! The industrial backers of the CDU/CSU would like to secure access to Britain for their manufactured goods at the same time that Brexit terms are being negotiated. German misgivings over the utility of punishing Britain also extend to the Bundesbank. Andreas Dombret suggested that the approach to Brexit should be "pragmatic" rather than the politically emotive modus operandi being prepared by the EU.

Dombret's pragmatism is born out of a fear of the race to the bottom, in terms of currency and regulatory policy, that a Hard Brexit could unleash through a wave of retaliatory actions. The Bundesbank at least still sees Britain as a partner in preventing President Trump from rolling back the regulations that have strengthened the global financial architecture since the Credit Crunch. A rolling back of regulations, in an environment of predatory trade competition and protectionism, could undermine the stability of the whole global economy. The current behavior of the ECB and EU, in relation to the Eurozone banking sector crisis, is a classic case in point that Dombret can observe as one of the systemic risks that will get amplified by a Hard Brexit.

The crisis response of the EU executive and ECB Governing Council was outlined in a previous report, as the Eurozone faces the twin challenges of President Trump and home-grown populism. The process of addressing the banking sector crisis, through sovereign bailouts of followed by ECB monetization of expanded sovereign deficits, was also observed as laying the foundations for deeper fiscal integration. The European Stability Mechanism (ESM) was seen as a key agency in this process. The ESM was noted as a potential agency through which sovereign debt would be accumulated, mutualized, repackaged and sold (probably back to the ECB!). ESM Chief Klaus Regling has just been re-elected to a new five year position, in order to ensure a smooth transition of this process. Neatly ensconced back in the driving seat, Regling then swiftly moved to smooth over the cracks opening up over the debate about the current Greek bailout. According to him, the country will be able to borrow from the capital markets in 2018. After that, it can then be bought by the ESM and the ECB. It is however hard to see a smooth return for Greece, or any European sovereign borrower, if a Hard Brexit degenerates into a war of economic attrition between the developed nations.

European Commission President Jean-Claude Juncker has finally grudgingly accepted, that Eurozone breakup is possible, by talking about the creation of a process to deal with the fallout; in a way that appears to maintain a commitment to deeper fiscal and political integration in the future. He recently signaled that he will now pursue the strategy of multi-speed political and fiscal union in order to satisfy all the diverse national agendas. His strategy assumes that all Eurozone nations wish to retain the Euro currency at the very least. Juncker may also have seen Germany preparing to split from the Eurozone pack; and may therefore wish to keep it on the same track even if it is pulling away and taking some other nations with it.

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