Game Over Theresa May, Game On United States Of Europe, Gaming Debate Over End Of ECB QE

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Includes: CEE, ESR, EUFL, EUFN, EUFS, GUR, IFEU, TRF
by: Adam Whitehead

Summary

The British election result does not guarantee a softer Brexit outcome.

The ECB is following the Fed’s process of debating the end of QE.

The ECB currently lacks the Fed’s flexibility on ending QE.

The defeat of Populism by economic growth has undermined the Eurozone economic reform process.

The defeat of Populism by economic growth has put deeper European integration on hold until fiscal rules can be enforced.

(Source: Seeking Alpha)

The "Gamed Out Hard Brexit" scenario in the public domain, discussed in the last report, ultimately had a significant impact on the British general election result. British voters remain primarily motivated by fear. Fear of losing jobs and public services to immigrants prompted the Brexit vote. Since then, the Conservative government has made it clear that there will be further austerity and cuts in the provision of public services, in addition to the potential loss of access to the European market after Brexit. Negativity and fear of the Hard Brexit outcome, anticipated in the public domain, was therefore the greatest arbiter on the general election day. There is clearly a desire for economic and political outcomes that do not require pain and sacrifice from Britons.

The original Brexit vote was motivated by a desire to avoid EU nationals taking British jobs and accessing the generous welfare system. The Conservative government and its general election strategy was thus narrowly framed by this referendum result. The default to a Hard Brexit scenario, from the combination of this resulting negotiating strategy and the European reaction to it, has put further fears of the unknown post- Hard Brexit into the minds of British voters.

British voter behavior is symptomatic of the wider disillusionment, with economic policy making and political governance, that is to be seen in varying forms throughout the developed nations. In this environment, central banks have taken it upon themselves to appease voter wishes whilst maintaining the political status quo. This central banking experiment with political and economic policy making has to some degree made the situation worse, by increasing the levels of wealth inequality without creating strong employment and wages as the quid pro quo.

With no obvious trade strategy with the EU or with the rest of the world visible as a Plan-B, the British electorate has had second thoughts. Britons neither want EU nationals taking their jobs, public services and welfare, nor do they want to lose access to the EU common market. They still want to have their cake and eat it, despite the fact that the EU has made it clear that their wishes are mutually exclusive in the framework of the EU. The resultant election outcome, known as a Hung Parliament, delivers the prospect of weak governments with unworkable majorities to get things done and or weak coalitions that have the same fate. The English may not like coalitions, but their pusillanimity and the willingness of their political leaders to follow rather than lead them has created such an outcome. Be careful what you wish for, if you are a British voter!

This great balancing act is symbolized by the new two year term, rather than the traditional one, that has been set for Parliament in order to accommodate the Brexit negotiations and enable greater parliamentary influence in the process. With no mandate for a Hard Brexit, the Prime Minister has been forced to concede more ground to Parliament. Whilst this move logically should lead to a softer Brexit outcome, what it in fact does is allow the Brexit negotiations to become a means of forcing further elections if no consensus can be achieved. MP's are as likely to use this period to engage in partisan warfare as much as they are to seek the best deal for Britain. The best deal for Britain is a subjective matter in any case that is degenerates along partisan party lines. Thus whilst appearing to be the democratic route to consensus on a softer Brexit, in practice this process may lead to mudslinging and gridlock which forces the EU to walk away with no apparent prospect of a Parliamentary solution.

The first obvious casualty will be Prime Minister May. Hindsight will be her jury, judge and executioner. As David Cameron was summarily ejected, because of his perceived mistake in calling for the EU referendum, so May will be removed by making the mistake of calling the general election. May's enforced knee-jerk reaction, to concede ground in her government to her rivals, some of whom still favor a Hard Brexit outcome, signals that she is no longer in control of the negotiated exit process. She is now trying to accommodate both cadres of the Remain and Leave referendum groups, rather than the pure Leave group that was previously headed directly for a Hard Brexit.

British voters who think that they have avoided a Hard Brexit outcome, should take note of the Hard Brexit group within the government that is still asserting influence contrary to expectations. This Hard Brexit group will conflict further with the Remain group, which means that there will not be an agreed negotiating position with the EU. This situation therefore has the potential to be even worse for Britain than a Hard Brexit, since Britain does not have a consensus view on how the talks should proceed. Failure to prepare should be seen as a preparation to fail. All that the EU has to do is isolate itself from the chaos in Britain and then try to avoid the same pitfalls in its own remaining national elections this year. After President Trump's bruising first encounter with Europe, the EU now has a significant Anglo-Saxon tailwind driving its deeper cooperation and rival "EU First" global agenda.

Acting as a proxy spokesman for the EU, European Parliament President Antonio Tajani opined that the British election result was a vote against a Hard Brexit outcome. German Finance Minister Wolfgang Schaeuble and French President Macron, then jointly did their bit to keep hopes of a miracle alive in British voters' minds with some rhetorical goodwill of their own. Schaeuble asked that Britain be given some time to get its Brexit negotiating team together post-election; and said that a return of Britain to the EU would be welcomed if a decision not to leave was now made. Macron even held the "door open" for a return to the EU, if this not to leave decision is made before negotiations begin.

The EU negotiating view of the British election result may not be as positive as those Britons who allegedly thought that they were voting to soften the Brexit terms by voting against the Conservatives believe however. The EU's prime directives are to prevent other nations from leaving and to make membership feel less costly than non-membership to those that don't leave. The combination of the two mitigates for an asymmetrical outcome that by default must be disadvantageous to Britain when it leaves. Any signal that Britain may now wish to soften its own negotiating position, could be read as the green light for the EU to enforce any conditions it likes in order for Britain to retain access to the single market. If Britain is waving the white flag, this does not oblige the EU to offer quarter. The only positive response from the EU will come if Britain decides not to leave. The decision to leave has however already been made, so all Britain can do is negotiate a way to leave. The new situation could therefore see Britain asked to accept terms which would have been unacceptable to Theresa May's original Brexit team. Britain would then have access to the single market but still on Hard Brexit terms.

EU Chief Negotiator Guy Verhofstadt disabused Britain of any notions that a softer Brexit can be achieved, under any negotiated circumstances, when he signaled that the EU that Britain is leaving will not be the same one that it may want to re-join in the future. In his own words, Britain will find that the new EU "would be an EU without special requests, without discounts, without unnecessary complexity, but with more European responsibilities instead." Apparently the EU has moved on since the Brexit vote, so that Britain cannot even have its former conditions on opt-outs and fiscal rebates if it returns. All British voters who thus thought that they could somehow return to the pre-referendum status quo were mistaken. The EU has changed and the price for re-joining the new EU has also gone up. It can therefore be seen that the EU has already moved the goalposts to make EU exit even more onerous and painful.

(Source: Pew Research)

The dynamic interplay of political and economic forces, surrounding the balance of power in the Brexit negotiations, was recently illustrated by Pew Research. Although pollsters are much discredited these days, they still have value in providing a picture of current perceptions of a sample of public opinion even this is not actionable intelligence. The recent Pew research polled EU citizens' views about a referendum on EU membership. The majority polled wished to have a referendum, with the majority within this majority wishing to stay in the EU. Populism has thus been boiled down from outright resistance to a demand for political inclusion. The EU and the ECB will therefore have to be completely inept in order not to be able to nudge such a docile population towards deeper integration. Since the polled majority wish to remain within the EU, by default they accept that Britain must be ostracized for wishing to leave.

The implicit asymmetric outcome therefore is that Britain's experience of a Hard Brexit outcome is actually consistent with a feeling of a positive feeling about this Hard Brexit by remaining EU members. The problem for EU politicians will come later, when they are asked to maintain the soft approach to fiscal austerity which has been applied to make EU voters (with the exception of Germany) feel positive about EU membership. At this point no doubt, the ECB will then be required to quietly monetize the fiscal deficits that European citizens (with the exception of Germans) are unwilling to reduce through the application of austerity.

The UK Conservative party seems to be blissfully ignorant or unwilling to accept that the EU that it triggered exit from no longer exists. The Conservatives have reframed their perceptions and strategy to attempt to replace Hard Brexit with something called Pragmatic Brexit. Allegedly, this pragmatic approach will accept the safeguarding of EU immigrants' rights to work in Britain in exchange for EU single market access. There is however no guarantee that safeguarding immigrant employment rights will be viewed as accepting the freedom of movement of labor that is the cornerstone of the EU's reason to exist. It is hard to see the EU accepting any outcome that subordinates the freedom of movement principle. Pragmatic Brexit is therefore semantics and meaningless in practice.

The UK Conservative party seems to be blissfully ignorant or unwilling to accept that the EU that it triggered exit from no longer exists. The Conservatives have reframed their perceptions and strategy to attempt to replace Hard Brexit with something called Pragmatic Brexit. Allegedly, this pragmatic approach will accept the safeguarding of EU immigrants' rights to work in Britain in exchange for EU single market access. There is however no guarantee that safeguarding immigrant employment rights will be viewed as accepting the freedom of movement of labor that is the cornerstone of the EU's reason to exist. It is hard to see the EU accepting any outcome that subordinates the freedom of movement principle. Pragmatic Brexit is therefore semantics and meaningless in practice.

The EU immediately seized the initiative from May's strategic gamble failure, by moving the negotiations onto its own terms rather than Britain's. Post-election May was tersely informed that should she try and include access to the single market, in the initial negotiations over the terms of the exit bill, that the EU will delay responding for a further year. If May accepts this ultimatum, she will be attacked from within her party. If she rejects, the EU will walk away and a vote of no-confidence could then be forced upon May which could then lead to her removal and the prospect of new elections.

The EU also has its own agenda and timetable for deeper integration, that it does not want Brexit to interrupt or disrupt any further than it already has. One such disruption is on timing. As British politicians become more focused on capitalizing on domestic opportunities to govern, by nature of the hung parliament result, their focus on the details required to negotiate a Brexit will diminish. There is however a finite time-limit between now and November 2018 by which negotiations with the EU should have yielded an agreement on the Brexit process. The clock is ticking therefore; and failure of Britain to address the details through negotiation raises the probability of no agreement at which point Britain is ceremoniously ejected. As Prime Minister May scrambled to form a government with the Irish Unionists, her attempt to delay negotiations further with the EU was met with a strong warning from Michel Barnier that Britain now risks leaving without any agreement in place. Once the German election process is completed, in September of this year, the EU will effectively have covered all its own political risks so that it will be in a position to negotiate aggressively. The threat of Britain leaving without an agreement will then become a powerful weapon in the EU's arsenal.

The initial deterioration in EU-American relations observed in the last report during President Trump's bruising G7 visit is now becoming officially institutionalized. European policy makers leaked their version of the casus belli, as being President Trump's backtracking and procrastinating over the negotiation of a new free trade agreement. The implication is that, with no aligned economic interest, there is no requirement for political alignment between the two former NATO allies. The aligned interest in mutual defense against terrorism does not apply, since American escalation and intervention in the Middle East is antipathetic towards European foreign policy in this region.

Following the finger pointing, by leaky EU sources, the European Commission then followed up by publishing its intentions and capabilities for deeper EU defense cooperation outside of the NATO chain of command. To highlight the growing divergence over the War on Terror, Germany signaled that it will withdraw its troops and planes from the Incirlik airbase in fellow NATO member Turkey. Turkey has been angered by German support for the Kurdish ethnic minorities in the region. Somewhat coincidentally, the Kurdish government in Northern Iraq also announced that it will hold an independence referendum in September. Clearly an independent oil producing Kurdistan is not something that Turkey will accept in principle. A clear overspill and escalation of the Syrian conflict into Iraq is to be expected. This will create a rift within NATO, also between NATO and evolving European Union foreign policy and between America and all of the aforementioned parties. Thus far, both Germany and America have warned the Kurds in Iraq not to pursue their separatist agenda. Deteriorating relations between Germany and Turkey, in comparison with President Trump's recent strengthening of ties with both Russia and Turkey, suggests that American warnings to the Kurds are more sincere than those from Germany.

With no common trading agreements in place, to create some kind of pecuniary aligned interest, there is nothing in the economic arena to counter-balance the political forces of opposition that are driving the EU and America apart. Chancellor Merkel heralded this deepening estrangement leading to divorce, with her framing of the upcoming G20 summit. Using America's exit from the Paris Agreement as the cover story, for the geopolitical maneuvers that Germany has made, she signaled that the summit will achieve little. The question now is whether it becomes an event that is a holding pattern for the current low-point in relations with America, or whether it becomes the catalyst for further division and acrimony. The remarks made by Jean-Claude Juncker on behalf of the European Commission, show exactly where things stand and where Europe is headed. In his own words America is "no longer interested in guaranteeing Europe's security in our place". From this statement it can be inferred that deeper European integration will proceed driven by the necessity of collective self-defense outside of NATO. America is no longer viewed as an automatic ally, even if it is not yet viewed as an enemy by default.

The pressure on Mario Draghi from within the Governing Council, the Executive Board and the incoming data mitigating for some concession in his view of the need for continued loose monetary policy, has now become overwhelming. He can however console himself and take credit for the fact that this economic improvement has gone some way to defeating Populism at the election polls this year. The latest Governing Council decision was therefore a compromise, that left policy unchanged but omitted reference to "or lower levels" in its guidance on interest rates. The continued guidance of "interest rates to remain at their present levels for an extended period of time" should not however inspire a belief in a sudden and swift reversal of QE. Draghi has signaled that he favors Peter Praet's exit strategy of end QE first and then raise rates. Framing the guidance of "an extended period of time" on interest rates, through Praet's exit prism, the beginning of balance sheet reduction this year should not be expected; even if the Governing Council debates it vociferously at meetings and with public commentary. Any successful attempt to change Praet's exit strategy, to one that allows interest rates to rise before balance sheet reduction begins, would be a game changer.

"The debate over when to end QE may ultimately morph into a debate currently being held by the FOMC. The FOMC is agonizing over the issue of why inflation, especially wage inflation, has not yet materialized with an economy allegedly at full employment. It is certainly in Mario Draghi's interest to stimulate this debate. Perhaps he will do so at the next Governing Council meeting and then his following press conference. Now that such a point has been reached in the USA, all bets about the further increase in interest rates are coming off. The Eurozone may find itself in such a position, even before the first rise in interest rates!"

(Source: Seeking Alpha)

The last report suggested that the general debate within the ECB may follow the one currently ongoing within the Fed, as to why wages are so low even though employment is strong. At his press conference post rate decision, Mario Draghi gave a strong signal that this is the way he intends the debate over the end of QE and its removal to go.

(Source: Bloomberg)

In Draghi's view: "What needs to be explained is the flat and low profile of underlying inflation. That has to do mostly with subdued nominal wage growth." He did not venture his own conclusion on the matter at this point in time; but doubtless it will lead to a protracted QE exit strategy that may follow the Fed's guidelines. Said Fed guidelines see at least $2 billion of Fed balance sheet assets left in the system; and a commitment to reduce the balance sheet over a five year timeline. Presumably Draghi's new priority is to engineer a similar gradual exit strategy. The Fed has been able to achieve this so far, based on its willingness to raise interest rates before shrinking the balance sheet and flatten the yield curve. The ECB may thus find itself debating the sequence of balance sheet adjustment and interest rate increases, in addition to the timing of the end of QE.

ECB Governing Council member Ewald Nowotny has taken a strong position against anything thing other than a continuation of Draghi's status quo. He is particularly concerned about the headwind that a strengthening Euro, as a result of the discounting of the end of ECB QE, will push inflation and inflation expectations lower.

The concept of inflation targeting was introduced into the debate by Nowotny. Adapting this subject to the specific requirements of the deflation prone Eurozone, he suggested that a range rather than an outright target should be chosen. This implies that the ECB should be allowed to overshoot the current notional two percent inflation target; which further implies that the exit from QE will be a delayed and laboriously slow process.

Governing Council member Ardo Hansson simply drew his opening baseline, on the discussion, as one which assumes that no additional further easing of monetary policy on top of the current one is necessary.

Governing Council member Jan Smets joined the widening debate, with a skeptical view of inflation trends and the Phillips Curve. In his opinion whilst it is logical to expect falling unemployment to trigger inflation, its current absence is a fact that needs a detailed explanation. Some of this explanation could involve increased labor supply, increased migration, more flexible labor contracts and the impact of structural reforms of the labor market. Clearly, he is open to the suggestion that economic conditions may have fundamentally changed in a way that shifts and even negates the Phillips Curve.

Governing Council member Klaas Knot contributed his equivocal opinion, that whilst QE has been successful in lowering borrowing costs it has failed to raise inflation expectations. In the absence of further context, it is therefore not clear whether he thinks that this partial success should lead to a swift end or continuation of the QE program.

(Source: The Daily Shot)

Peter Praet has currently robbed Draghi of the flexibility enjoyed by the Fed. Praet's QE exit process involves balance sheet reduction before interest rate increases. If it transpires that Draghi values the flexibility of an extended exit period more highly, then he may have to abandon Praet's sequential exit methodology. The market expectation for higher interest rates from the forward curve is also sympathetic to the narrative that higher European interest rates are just around the corner. There is therefore fertile ground to accept a change of exit strategy to rising interest rates even before balance sheet reduction is attempted.

(Source: Bloomberg)

The debate over the curious case of the missing inflation has recently received further global support from the OECD, which warns that "Real wage growth might remain subdued even with continued improvements in national labor markets." The problem has been traced back to the Credit Crunch, that created a paradigm shift to weaker worker productivity. Ominously, the OECD warns that there has also been a structural shift in the global economy; that will negate any improvement in worker productivity even if it occurred. The following global environment characteristics have been identified as vitiating strongly against labor productivity gains:

· weaker bargaining power as a result of fast technological change,

· automation of certain tasks,

· rising global production integration and

· offshoring of low-skill, labor-intensive tasks.

The OECD's description of the global environment infers a secular change, that cannot be overcome by traditional cyclical upticks in the global economy.

The rise in Populism and Protectionism certainly seem to endorse the OECD's analysis. As policy makers wrestle with their own economies and conflict with the economies of their trade partners, it is therefore unlikely that developed central banks will have the courage of their convictions to fully unwind the post crisis QE in its entirety. The moot question is whether they will respond with further QE in the face of this secular paradigm shift.

Italian politics is throwing off some interesting signals about the state of the Eurozone economy and Populism. The Italian attempt to synchronize its electoral cycle with that of Germany, noted in the last report, has now officially been abandoned. This move to reform the voting system to adopt the proportional representation model was judged to be flawed, since none of its advocates could command a meaningful majority to govern. Evidently this concern was felt to be a significant obstacle, so the initiative has been dropped. Italy has thus retained its traditional model that creates weak governments in perpetuity, in a tactical rejection of a system that would have immediately created such a condition in the short-term based upon the current political sentiment in the country.

Any fear that a move to proportional representation may lead to a Populist government in Italy should subside after the results of the recent local elections are analyzed. The Populist Five Star party did extremely poorly, even in the hometown of its leader Beppe Grillo. This suggests that the economic recovery in Italy is entrenched and voters have lost their appetite to overturn the political system in consequence. What showed a real return to the Italian status quo of ephemeral weak governments was the rebirth of momentum for Silvio Berlusconi and his party. As the Italian economy recovers, so the interest in political change from voters is waning.

(Source: Bloomberg)

As things appeared to calm down in Italy, the opposite was occurring in Spain, where the Catalans finally announced that their independence referendum will be held in October this year. It was noted in previous reports how Spain has been held up by Mario Draghi as a country that has utilized his QE largesse to good effect, by using the breathing space of low liquidity to restructure its economy. This restructuring was questioned because it has led to the proliferation of a "gig economy" resembling Spain's pre-Eurozone past "black economy" which yielded little in terms of tax revenues and stable jobs with decent wages. There is now a growing consensus view which confirms this negative thesis of the great Spanish economic miracle during the QE period. Whilst gross domestic product is on track to finally reach the 2007 level employment is almost 12 percent lower, wages remain low and social inequality has increased. The Spanish coalition government is on shaky foundations, just as the Socialists are rediscovering their Socialist tendencies in order to mount a challenge to break this coalition.

(Source: Bloomberg)

The deteriorating picture in Spain should be an ominous warning to Emmanuel Macron. The last report suggested that French election would be a proxy referendum on structural economic reform. Instead it was a referendum on charismatic leadership for the voters, which the new charismatic leader will take away as vote for economic reform. Structural economic reform has been victorious by default. Having won a governing majority in the first and second round of the parliamentary elections, Macron's party is now set up to legislate the structural economic reforms to the economy that he initially threatened to enforce by decree. Macron is a political animal who is keenly aware of the gaps between perceptions of him as a leader in distinction from future perceptions of his reforms. He is thus attempting to leverage his charisma and charm into structural reform, in order to sell it.

President Macron's first industrial policy signal however informed that, beneath the charismatic veneer, he is in fact a chip off the old dirigiste block; that has traditionally intervened in and protected key industries in France at the expense of trade partners and fellow EU members. Verbally intervening in the Italian takeover of the St Nazaire shipyard, he voiced his disapproval of the loss of this "strategic" industrial asset and his intention to review the case. Evidently, if Macron is going to reform industry which may lead to redundancies and lower wages, he is going to be in control of the process rather than the forces of private capital.

When it comes to banking regulation and the application of Basel III rules, France is also off on a protective tangent all of its own. Since it has the most too-big-to-fail banks in the Eurozone, France is pushing back against the objective Basel III rules on the definition and valuation of risk capital; in order to continue to implement its own subjective rules which favor its banks. Bank of France Governor Francois Villeroy de Galhau disingenuously framed the French protectionist move in terms of the trade dispute between the EU and America. In his opinion, the French subjective move to set its own capital adequacy rules and models is consistent with the rationale adopted by Germany, the Netherlands and the European Union's executive European Commission. He then muddied the situation even further by implying that in fact Basel III is an American conspiracy to punish the European banking system and put it at a competitive disadvantage.

The end result of this enhanced French state corporatist behavior may therefore not deliver the lean competitive edge that reduces the role and fiscal burden on the state. French economic policy going forward looks to be as enigmatic and inefficient as it has always been, with the risk that it becomes wrapped up in the ego and personality cult that is growing around President Macron. Trade partners and EU member nations should beware of this behavior, especially when it is framed by the French as compliant with the EU's position.

"Evidently something has happened in Germany, France and/or Europe since all this mutual affirmation to cause Schaeuble to swiftly qualify his initial comments on deeper integration."

(Source: Seeking Alpha)

Germany may already have the measure of Macron. The last report also noted German policy makers distancing themselves from the Macron bandwagon after using his halo to promote their own election campaigns. The distancing was triggered by Macron's calls for deeper European integration. Recently, German Finance Minister Wolfgang Schaeuble has provided further context to Germany's aloof posturing. According to Schaeuble, there cannot be deeper fiscal integration and the mutualization of Eurozone sovereign debt, until there are clear proscribed budgetary rules in place that are enforceable. Evidently, Germany has noted the bending of the Stability Pact rules by indebted nations and also the way the ECB has bent the rules on sovereign bond buying in its recent QE phase. Germany has no appetite for this fiscal and monetary free for all that is principles based, with the vague notion of European integration as the driver, rather than rules based.

Clearly, Germany wishes the next phase of European integration to be rules based rather than emotionally driven by the kind of charismatic posturing of the likes of Macron. The Eurozone Project will thus be held up by the debate over which rules to follow. Some nations may not even favor any change in the rules. In the absence of an economic crisis, which drives deeper integration out of fear of rising Populism, the European Project has now stalled again. The defeat of Populism by economic growth and the degeneration of Eurozone nations, back to their own subjective interpretation of what European integration means, are further examples of the stalled integration process. Central banks have signaled that rising interest rates and the removal of QE are going to be so incremental, that there is not going to be some kind of capital markets fallout to drive the integration process either. Perhaps turbulence caused by the Brexit will be the new catalyst that drives it. Alternatively, the deeper estrangement between Europe and America will do the job.

Bundesbank President Jens Weidmann supported the German position with comments that link the gap, between monetary and fiscal policy in the Eurozone, which Schaeuble wishes to see filled with binding rules that cannot be broken. Arguing for an end to QE, Weidmann focused attention to the implicit moral hazard involved in the process which rewards sovereign nations and even encourages them to borrow beyond their means. In his opinion, a continuation of QE at this point is now entering the moral hazard risk zone. The Bundesbank clearly has no enthusiasm for the Eurozone to slip back into its pre-crisis status quo as economic growth nullifies the enthusiasm for economic reforms.

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.

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