Eurozone And Brexit Convergence Basis December 2018

by: Adam Whitehead


Economic performance across Eurozone nations converges.

Northern Europe wishes to address the bubble risk from the pro-cyclical impact of Quantitative Easing.

Market feedback signals a growing acceptance of a non-volatile normalization in 2018.

ECB plans to expand Qualitative Easing by default when Quantitative Easing ends just met their first challenge.

The Franco-German-Anglo-Saxon front continues to politically gestate as European structural reform degenerates.

(Source: Bloomberg)

The last report focused upon the ECB’s strangle of expectations and volatility for a disruptive normalization process in 2018. The OECD recently applied its own hands to the strangling initiative by advising the ECB not to consider raising interest rates until 2020. Drilling down into the ECB’s own guidance, some observers have found that the ECB has woven in further flexibility to its actions beyond the end of the current phase of QE in September 2018. The ECB has stipulated that reinvestment of the proceeds of its current bond-holdings will follow the strict Capital Key rules set on said purchases. Beyond the September 2018 end date, this stipulation to reinvest in line with the Capital Key rules may no longer apply. This would allow the ECB to divert liquidity and economic support to weaker economies with larger budget deficits from 2018 going forward. Taking this offer together with the ECB’s written commitment to expand monetary policy again if required to do so and there are some potent monetary stimulus factors lingering out beyond the official end of QE. To strangle volatility a little further, Bank of France Governor Francois Villeroy de Galhau opined that he sees little evidence of any pan-Eurozone bubbles in asset prices, although there may be some isolated localized instances that do not merit serious consideration from an ECB perspective.

(Source: Bloomberg)

The logic behind the ECB’s volatility strangle is sound. A decade since the crisis began and its survival was threatened, the Eurozone is now starting to see national convergence in economic performance and also most importantly in productivity. With hindsight, commentators may look back and say that although unwanted and unintended, the Credit Crunch and the policies that ensued were responsible for European convergence and hence deeper integration. This convergence in economic performance is also something that Mario Draghi will insist upon seeing through to a successful conclusion by maintaining an expansive monetary policy for years to come. In fact, the absence of inflation will only embolden him to bequeath this legacy when his time comes to step down.

(Source: Bundesbank)

ECB Governing Council member Ardo Hansson recently tried to re-balance the Dovish expectations for the end of QE by suggesting that the winding down of the ECB’s balance sheet after September 2018 should be factored in as a probability if inflation strengthens towards target. Hansson’s nudge may be based in a Northern European initiative to address the growing bubble risk, denied by Mr. Villeroy de Galhau, in the Eurozone from the ECB’s continued adherence to a pro-cyclical monetary policy expansion in an environment of strengthening underlying economic growth. In line with this view, the Bundesbank’s recently released financial stability report identified this risk in detail under the headline “Persistently low interest rates and strong growth: risks might be underestimated.”

Bundesbank President Jens Weidmann then fertilized the seed of caution that the Bundesbank has planted with his call for the ECB to raise its economic forecasts at its next meeting. To specifically address the flaw in his argument, based on the continued undershooting of inflation, he attempted to discount this by saying that: “Even after the end of net purchases, monetary policy in the euro area will continue to be very expansionary.” Further Northern European support came from the Netherlands, where its ECB Governing Council member Klaas Knot weighed in with his view that victory over deflation should be declared in September 2018 and QE should be promptly wound down.

The position of the ECB Executive Board has been clear for some time that it would like to see the end of QE. Board member Yves Mersch recently reiterated this view, based on his observation that both wages and inflation have reversed their declining trend.

(Source: ECB)

This Bundesbank view should be compared and contrasted with the view of the ECB, released on the same day, for greater context. The ECB sees the same market volatility risk as the Bundesbank, but wishes to address it through more of the pro-cyclical loose monetary policy that the Bundesbank says is causing it!

ECB Chief Economist Peter Praet did his best to square the circle, of divergent Northern Europe and ECB pan-Eurozone thinking, in a way that compromises both viewpoints whilst adhering to the ECB directive to strangle volatility. His initiative also supports his view that the ECB should normalize first and then raise interest rates second. Under his broad church all-embracing view, he believes that: "While monetary policy still plays an important role in sustaining the recovery, it is not 'the only game in town' ….. Years of balance sheet repair, institution-building – at both national and supranational level – and structural reforms are all supporting the recovery.” In this view, however, there is still room for further balance sheet repair and structural reform, enabled by the ECB’s generous hand, until the Eurozone can stand on its own two feet.

The market discounting mechanism according to Reuters is sending useful messages to the ECB on its ability to successfully strangle volatility as it normalizes through 2018. A recent sentiment poll indicated that, whilst it is generally expected to end its QE buying in September 2018, some still believe that this bond buying could extend into 2019. Draghi’s unconditional offer to continue with and/or expand QE if required to do so is clearly visible in the polled results.

The feedback on the discounting mechanism, provided by a recent Bloomberg poll, also complies with the Reuters signals. The sample pool for Bloomberg (see chart at the beginning) showed a gentle climb down the wall of worry surrounding QE exit, with the same short tail of QE spill-over into 2019.

Mario Draghi will settle for this feedback, as he heads for the exit from QE and the ECB simultaneously. He can still satisfy the general global central bank normalizing imperative, which will take the steam out of the risk asset bubble that is worrying central bankers. He also has his put option to continue buying in place beyond 2018, should the normalization become a Taper Tantrum, being factored in as a tailwind insurance policy. He now needs to manage the basis between now and the expiry of both his ECB contract and QE as time erodes towards delivery date of both.

The market discounting feedback has also been supported by the political feedback from the EU. Eurogroup head Jeroen Dijsselbloem recently announced that Eurocrats widely understand that the normalization is underway and also that it is necessary for the ECB to proceed with caution. The Eurocrats can therefore be expected to do their rhetorical bit to strangle volatility going forward also.

The most valuable information for the ECB, however, has recently come from research bloggers at the Bank of England of all places. They have found that it is the physical act of buying bonds, rather than just holding them, that is the most potent force behind QE. They figure that this signal of intentions and capabilities frames expectations and provides the positive halo effect that translates into optimism. Mario Draghi evidently understands this, because he forced the inclusion of the offer to buy more bonds into the guidance signal about the normalization in the last ECB communication. When the buying stops the party ends. The party may end even sooner as the discounting mechanism begins to move in anticipation of the end of buying. Draghi has therefore added an insurance policy in his signal that he will buy more bonds if needed in the future. Thus far the discounters are looking at December 2018 as the point at which the fat lady sings for the end of QE buying. ECB attempts to strangle volatility should address December 2018 and beyond going forward.

(Source: Seeking Alpha)

A warning signal on the ECB’s console was just flashed in an incident in the credit markets. Financial impropriety at Steinhoff has just caused the central bank to incur a loss on its bond holding of this company. This has ramifications for the ECB. Firstly, its original decision to take credit risk will be called into question. Second its ability to understand credit risk will be called into question. The ECB’s admonishment of commercial banks over their NPL’s will look amusingly absurd based on its own little hiccup with Steinhoff due diligence. Thirdly, its strategy for increasing the portion of corporate bonds on its balance sheet going forward as it winds down QE will be challenged. Fourthly, as the Fed and other central banks normalize in 2018 the potential pressure on credit spreads will have negative feedback into the ECB’s ability to normalize by defaulting to Qualitative Easing. Mario Draghi therefore has plenty to think about and opine; as his ability to strangle volatility next year just ran into its first hurdle. He may have to rely upon his global central banking colleagues to slow down their own normalization processes somewhat next year to help him out. His one bit of good news, however, is that Germany is shifting towards a pro-Eurozone position, out of political necessity. This good fortune is, however, contained by the precarious nature of the minority German coalition that upholds it. The ECB’s recent strategic defeat at the hands of European politicians, in its attempt to address the Eurozone bank capital adequacy and related restructuring issue, should inform him to tread with caution.

European Banking Authority (EBA) Chairman Andrea Enria succinctly explained the real problem for the Eurozone in relation to the non-performing loan (NPL) issue. Identifying the individual retail investors in bank debt products - many of them missold in the first place - who represent a significant stakeholder risk in the event of any bail-in, he clearly identified the real problem. A systemic risk, inside a political crisis, wrapped inside a fraud is a useful categorization of this Eurozone-wide can of worms that Enria has identified. Since said private investors in dodgy retail bank products also vote in national elections, it is unlikely that Eurozone political incumbents will want anything to do with a resolution of this crisis that may involve bail-ins until Populism has been well and truly defeated. Bail-ins would dilute and destroy the value of said retail banking products, which would have clear negative political consequences for said political incumbents. In its un-elected ivory tower, the ECB has the luxury of creating solutions to the NPL issue that do not have to factor in realpolitik! The ECB’s grand plan to reform and recapitalize the banking system therefore still remains largely hypothetical until the politicians have tamed the beast of Populism.

Having failed massively in its attempt to set the standard and process for resolution of the NPL issue, the ECB has regrouped and then come back tenaciously. This time it is hiding behind the cover of creating a market-based solution to the problem through which it can intervene when the price discovery mechanism identifies the systemic problem. The ECB’s latest proposal involves the creation of a secondary market to trade NPLs and to involve private capital. Such a market will provide transparency and lead to an immediate mark-down in prices, which will force banks which currently mark to their own model to take write-downs; which will then ultimately force them to make capital provisions. It’s a great idea, but once national regulators understand where it is leading they will doubtless start taking potshots at it. The interbank market price discovery mechanism will ultimately lead to price discovery by retail investors in bank debt products. At this point in the price discovery process, realpolitik will intervene before the ECB gets its chance.

Combined with the nudge towards a market solution to the NPL problem, ECB Vice President Vitor Constancio opined some inflammatory rhetoric whilst remaining compliant with the central bank’s mandated guidelines. Constancio warned that the weak health of Eurozone banks in general, based on their failure to come to grips with their NPLs combined with inflated cost structures, is a structural economic headwind and a source of economic risk for the bloc.

The discernible ECB strategy is now to let the invisible hand of Mr. Market resolve the banking sector’s structural problems through cost-cutting and cross-border consolidation. This is, however, a process that will lead to politically unacceptable bail-ins which threaten the Eurozone.

For every ECB action on the NPL issue, there is an equal and even more powerful reaction from Eurozone politicians who wish to protect their own voters and bankers’ national franchises at all costs. The latest reaction to the ECB’s market price discovery comes courtesy of European Parliament member Peter Simon, the German Socialist Vice Chairman of European Economic and Monetary Affairs.

Simon believes that the banks should be allowed to sell their loans at deeply discounted prices, without having to raise capital to provision for the losses or to cover the rest of their portfolios. He thus adopts the ECB’s market price discovery, but then tries to politically mitigate it by avoiding its ultimate consequences. Banks can sell at a loss, but avoid the balance sheet consequences of doing so. In theory, nobody loses in a classic political framing of events.

Applying Simon’s model there is no penalty for reckless lending and moral hazard is rewarded and incentivized with legislation to promote them. It would be business as usual and the Eurozone banking system would just continue with its current risky behavior. Given that Angela Merkel is currently involved in forming a weak coalition that is pro-European, with the Socialists one should not rule out these alarming developments in the health of the Eurozone banking system.

The recent adoption of Basel III capital adequacy standards has also given the European banks a lucky break. The new rule on the capital floor required has been set at 72.5%, which is nearer to the European demand of 70% than the American one of 80%. In this current environment, where credit spreads are under pressure from the threat of rising yields as global central banks exit QE, the European banks will take any break they can get.

(Source: Seeking Alpha)

An emerging Franco-German-Anglo-Saxon front was discerned in the last report. This construct has come out of the practical necessity and political expediency created by the confluence of events in relation to Brexit, Emmanuel Macron’s victory and Angela Merkel’s pyrrhic victory. Brexit was presented as a catalyst for Eurozone reform in general that would lead to a greater alignment of English and EU interest, presaging Britain’s negotiations to re-join a reformed EU. The latest signs of a Brexit compromise, in which Britain pays up in the hope of a beneficial free trade deal, provides further context and support for this Franco-German-Anglo-Saxon front thesis. This signal was underwritten further by the Bundesbank’s Executive Board member Andreas Dombret, who opined that he is in favor of London retaining its derivatives (including euro-denominated) clearing franchise post Brexit.

In order to disguise this new political driver and also to give Southern Europe a feeling that it is a key player, the position of Eurogroup chief being vacated by Jeroen Dijsselbloem was awarded to Portuguese Finance Minister Mario Centeno. The recent award of the German Charlemagne Prize to President Macron as the “courageous pioneer for the revitalization of the European dream,” however, should serve to show who is really in the European driving seat. The Franco-German-Anglo-Saxon front is looking like more of a certainty. Given the horse-trading and compromise with the rest of the Eurozone and its banking system, as the quid pro quo for this grand alliance, the structural cost in achieving it in the form of a zombie financial system is a substantial one. Brexit is therefore not a catalyst for reform as originally thought by this author after all. It is in fact just a stepping stone on the way to a new political status quo that comes at great structural economic cost and risk to the taxpayers involved. The French, German and British taxpayers will effectively finance the Franco-German-Anglo-Saxon front that is currently being negotiated through fiat behind closed doors rather than at their national polls.

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.