As the ECB celebrates 20 years of existence by signalling the all clear that emergency stimulus measures are no longer needed, existential challenges from within the Eurozone and externally from the global economy threaten to spoil the party.
The last time the ECB headed for the exit door a Taper Tantrum ensued, which was followed by an extension of QE during which Mario Draghi pledged to continue to “do whatever it takes”. This time around both Draghi and the ECB are headed for the door as the Eurozone economic data has softened and political headwinds from Italy and Spain are getting stronger. Is history rhyming or repeating?
The latest PMI data shows that with the exception of Germany, Q2 so far has yet to rebound from the softness of Q1. If things do not turn around dramatically in June, then Q2 will be viewed as the second quarterly declining dot. Three dots would make a trend, which would effectively be a reversal of the 2017 economic growth uptrend.
Retiring ECB Vice President Vitor Constancio is singing a familiar tune! His apocryphal warning resonated loudly with the data and political headlines in the last report and has framed perceptions of the evolving political and economic conditions in the Eurozone going forward.
The combination of weak economic growth, weak core inflation and stalled deeper economic union elicited the response from Constancio, in the form of reinserting the dropped guidance for the central bank to ease further if needs must. Not exactly Draghi’s “do whatever it takes” in the vernacular, but certainly in spirit. Constancio’s move went further than that of his colleagues, who were trying to talk up the weak growth data from Q1/2018 whilst avoiding the issue of the soft core inflation trends totally.
Most recently, Constancio’s warning has also been targeted at the Northern European members of the Eurozone. He accuses some of them of deliberately attempting to change their political and economic policies in order to frustrate further progress towards wider economic union so that their angry taxpayers are not infuriated further at the prospect of assuming the burden of their indebted neighbors.
Constancio’s words and the fact that his and Draghi’s jobs are up for grabs have clearly affected Bundesbank President Jens Weidmann. His draft application for Draghi’s job was framed by his own monetary policy mission statement, which was uncharacteristically guarded for him. He now only judges the end of QE in December to be plausible. This is a substantial U-turn from his commentary at the beginning of this year that wanted its termination signed, sealed and delivered by summer and then initiated in September.
Ollie Rehn, the Bank of Finland’s new Governor, was noted in the last report mirroring Constancio’s valedictory remarks, with his maiden speech in which he noted the downside risks growing in the Eurozone economy. Erkki Liikanen, the man who Rehn has replaced has adopted the same subdued rhetoric. Liikanen has also not left himself out of the running to replace Mario Draghi. What he says therefore, may be a guide to the thinking of the next ECB President.
Liikanen, recently focussed on the weakness in core inflation and noted that it will take some time to drive it higher. This view resonates strongly with that of the outgoing Constancio. Furthermore, Liikanen said that interest rates will remain low for a considerable period of time after QE ends. His commentary falls well short of Constancio’s insertion of the ECB Put clause in the last report and also Draghi’s promise “to do whatever it takes.” Liikanen is not Hawkish by any means, however, so that whilst monetary policy under his presidency would be tighter than under Draghi, there is scope for it to soften if the incoming data and headlines continue to blow stronger headwinds.
In response to Constancio’s remarks, Governing Council member Jozef Makuch widened his guidance spread, so that traders could quite literally drive a bus through it. He sees that the need to end QE is here, but on the classic two handed economist’s other hand he does not see inflation hitting its nominal target until 2020-21.
The growing confusion, surrounding the future of ECB monetary policy, has been exacerbated by a dissonant commentary from Governing Council member Vitas Vasiliauskas. He opined that he doesn’t disagree with the markets pricing in of a rate rise in six months’ time. The market is in fact pricing in a rate hike in mid to late 2019 and has actually reduced the probability of this substantially. It is therefore hard to understand what rate rise exactly Vasiliauskas is referring to. Perhaps Vasiliauskas has been blindsided by the recent negative global trade rhetoric, which made him lose his timeline since he admitted that the global macro environment will influence the timing decision to scale back QE.
Speaking for the ECB Executive Board, Benoit Coeure has made it clear that this part of the central bank rejects Constancio’s view and his re-insertion of the Put option. Coeure conveniently explains his own view, in contrast to Constancio’s, as one which believes that it now takes longer for the transition mechanism of easier monetary policy into growth and then inflation. He sees inflation continuing to rise and is not worried about the current economic slowdown. He will however concede that QE should not end abruptly, but that is the limit of his Dovish sentiment.
Coeure’s message was underlined by Executive Board member Sabine Lautenschlaeger. Completely discounting the current economic softness, she ventured that “June might be the month to decide once and for all to gradually end net asset purchases by the end of this year,” so that “a first hike around the middle of 2019 is not entirely out of the ballpark.” Germany’s ballpark, where Lautenschlaeger is a loyal season ticket holder it should be noted, is not playing the same game as the rest of the Eurozone. German inflation continues to rise above the ECB’s target in many states, whilst bottlenecks and tight labor markets combine to create overheating.
Evidently, the Executive Board wishes to press on with the normalization despite the risks.
The release of the minutes from the last Governing Council meeting simply confirmed that the rate-setters are not taking Constancio’s warning very seriously at all. The current economic softening is referred to as a “moderation”, rather than anything that will stop the ECB from ending bond purchases in December.
In line with this view, it was leaked that the central bank will lower its growth forecast but keep its core inflation forecast unchanged in June. It was also leaked that despite the economic deceleration, the ECB will still end QE but may postpone interest rate increases for some time after. Evidently, the ECB leakers want us all to believe that it will press on with the normalization come what may whilst keeping interest rates low. The ECB now risks being labelled as a Stagflation enabler and tolerator, just like the Fed is currently being viewed as.
The European Commission, through Valdis Dombrovskis as its spokesman , expects growth to continue in 2019. It has no other choice than to say this. Forecasting a slowdown would beget a slowdown, which would then unravel the progress made on deeper economic integration. In addition the debt crisis would rear its ugly head again, as indebted nations then face scrutiny over their ability to pay their creditors.
ECB Chief Economist Peter Praet has what must be the tongue-in-cheek way of dealing with Constancio’s warning. Praet spun the Q1/2018 slowdown, as being driven by the same supply side bottlenecks that funnily-enough are creating the desired inflation in the Eurozone. He however failed to note that there has been a distinct lack of inflation in the data to empirically support his assertion. To be fair to Praet, he did obliquely refer to the missing inflation by saying that globalization may be suppressing prices and wages in general. He also obliquely referred to the missing demand side of his thesis by noting that a crisis of confidence may be developing again in the Eurozone.
The last report observed the red light flashing the warning of an Italian debt crisis, as the Populist government tried to find ways of welching on its sovereign debt. Further evidence suggests that the populists are now testing the market response to a Banana Republic solution, fashionable in the country when it was able to print its own currency.
In the current absence of the ability to put a few more zeros on its notes, the Italian government is allegedly considering issuing short term IOU’s. The government hopes that somehow the ECB will print Euros to enable the settlement of the growing mountain of short term bills, as Italy switches its debt profile from long to short maturities and then attempts to roll them over at high velocity. The Italians are of the view that in the ZIRP/NIRP world, they will even get paid to run a short term deficit mountain of debt. Mr Market has other ideas and the spread on Italian short term debt blew out, with disastrous consequences for Eurozone stability as a consequence.
It should be noted that the Italian Banana Republic solution is the only option available to a nation wishing to exit the Eurozone. Should the Italians seriously go down this route, they will be signalling their intentions and capabilities to blackmail the Eurozone by threatening to leave it.
The Italian President refused to appoint the architect of the Banana Republic solution, as the new finance minister, thus plunging the country into deeper political chaos that may lead to new elections. The poisoned chalice of governing was awarded to technocrats. The Italian technocracy would be welcome in Brussels, but will find its legitimacy challenged immediately by the Italian populists. The entrenched Europhile Italian status quo would now rather bet on new elections than a potential populist catalyst to Eurozone exit and Eurozone destruction. At this point, in the Italian political chaos, it is a good bet.
The Europhile confidence is based on the Italian constitution, specifically article 75, which forbids the holding of a referendum on international issues without a two-thirds parliamentary majority. Given the weak coalition political dynamics, it is therefore impossible for the Italian government to vote to leave the Eurozone or even to vote in favor of giving the Italian people a referendum on the matter. On the contrary, the Eurozone nations are cursed by the fact that they are the dog being wagged by the tail of Italian populism which cannot be severed. This allows the Italians to threaten the EU with empty rhetoric in the hope of getting a concession to live beyond their fiscal means.
Previous ECB readiness, willingness and availability to enable this outcome has convinced the Italians to think that they can get away with it. Unfortunately, however, the Italians may have miscalculated based on the fact that the current Capital Key rules on ECB sovereign bond purchases preclude the central bank from buying more Italian bonds. Without deeper fiscal union and the merging of Italian debt with that of its neighbors, there is no way for the ECB to enable the Italian brinkmanship. In effect therefore, the Italian populists are trying to force through deeper economic integration (to save the Eurozone) on their own terms. This is a classical behavioral finance choice, of a gambler who has run out of softer options and therefore effectively has nothing to lose by adopting the nuclear option. The Italians calculate that (a) the Eurozone political leaders have more to lose and (b) the Eurozone political leaders actually have an aligned interest in enabling deeper fiscal union.
Conversely, until the Italians can engineer a vote to leave the Eurozone the EU can simply demure and maintain the stand-off. The situation doesn’t get serious until the Italian government can find a two thirds consensus, which seems highly unlikely at the moment. On the plus side, the Italians are doing the Eurozone a favor by weakening the Euro with their political posturing. A weaker Euro and the growth and inflation it begets can thus serve as basis for the charade of ECB normalization of monetary policy in the face of a political crisis. So there is also a further alignment of interest between the Italian populists and their alleged Eurozone adversaries. The fact that the Italian populists wish to keep the Euro belies this aligned interest in both sides in weakening the common currency. Faced with the breakup of the Eurozone, or the weakening of the Euro, even the Eurozone’s trade partners will accept the latter as a softer option.
The Italian political situation is threatening to put further progress towards deeper European economic integration on hold in the short term but closer in the long run. Conversely, the global geopolitical situation is bringing Eurozone nations together. As America pursues sanctions against companies and countries, trading with and investing in Iran, the EU is considering compensating those affected by such penalties. Such a move will doubtless trigger reciprocal actions from America which will then knock on into a full-blown trade war that has nothing to do with President Trump’s alleged original reasons for targeting Europe. Said original reasons were swiftly rolled out recently, as America levied tariffs on European metal imports and widened its investigation of other manufactured goods.
Germany’s recent Ostpolitik of rapprochement with Russia will also escalate the tension between Europe and America and elevate the probability of sanctions followed by trade war between the two.
Further Ostpolitik is evident in the EU’s move to avoid poking the Russian bear by diverting “cohesion” funding towards Spain, Italy, Portugal and Greece away from Poland and Hungary. Given the current hurdles to achieving deeper economic union of existing Eurozone members, the project to enlarge the Eurozone has effectively been stalled. In its recent assessment of membership potential of the would-be new members, the ECB lowered all their eligibilities.
This stalling of enlargement should however be put into the wider context of deteriorating relations between the EU and America. The EU no longer wishes to poke the Russian bear in the eye as things deteriorate with America. Putting Eurozone expansion on hold is therefore the acme of geopolitical skill at this point in time. It also illustrates that the Eurozone itself has very limited economic firepower to deploy to hold itself together. In the absence of Northern European taxpayer funding, political economies of force must be applied. In the further absence of Northern fiscal resources, the ECB’s monetary policy arsenal is becoming ever-more expedient and imminent.
Ewald Nowotny was the first ECB Governing Council member to attempt to frame the situation in Italy in relation to the bigger picture outlined by Vitor Constancio. He did this by opining his worry about the Italian political situation whilst affirming his view that there is no risk of growth and inflation rising uncontrollably. Nowotny would thus like to deal with the Italian problem from a position of low interest rates, which do not have any vectors aggressively pushing them higher.
The institutional response to the new Italian populist government from the ECB was done in relation to financial stability. The ECB’s latest Financial Stability Review dealt head on with the combination of weak economic growth and the potential for populists to seek a fiscal stimulus solution. The central bank warned that: “a deteriorating growth environment or a loosening of the fiscal stance in high-debt countries could impact the fiscal outlook and, by extension, market sentiment toward some euro-area sovereign issuers” and that “despite the overall favorable developments in recent quarters, some euro-area sovereigns remain vulnerable.”
The contagion from Italy soon spread to Spain. Taking inspiration from their compatriots in Italy, the Spanish populists have now resuscitated the idea of holding a no-confidence vote in Prime Minister Rajoy. Rajoy responded with alacrity by handing the poisoned chalice of government to his distinctly unpopular competitor Pedro Sanchez.
The last report noted the race against time for Eurozone policy makers to get the fiscal architecture for deeper integration into place before the next recession arrives and causes economic and political divergence. The current situation in Italy is the latest wake-up call. The European Commission recently showed its progress to date, with the release of a proposal for sovereign bond backed securities (SBBS) as the collateral pool and securitized issue. In an ominous echo of the pooled asset backed bubble that led to the last credit crisis, it was also announced that these SBBS' would have senior and junior tranches.
To follow the potential for a Taper Tantrum and the contagion which may or not influence the ECB’s monetary policy behavior, eyes are turning to the banking sector. It is widely understood that the non-performing loan (NPL) issue was swept under the carpet of and kicked down the road by further QE by the ECB in response to the last Taper Tantrum. Allegedly, the banks have now got wider provisions in place and stronger capital buffers in place to deal with another one. It now remains to be seen if this narrative is the reality. Tightening liquidity on bank balance sheets has an awkward tendency to lead to insolvency, especially when there is an economic slowdown occurring.
The key barometer, of how this all plays out, is evident in the behavior of the banks in relation to what they do with the last “do whatever it takes” infusion of liquidity during the previous Taper Tantrum. This ECB 400 Billion Euro cash injection was called the “targeted long-term refinancing operations” (TLTRO’s), ostensibly created by the ECB to encourage lending to the real economy.
The first series of TLTRO's was launched in 2014, and the second in 2016. They provided banks with interest-free funding and even the possibility of a rebate if they lent the cash on to businesses and households. The loans had a four-year maturity, with a quarterly option to repay early from two years after the loan was taken out. Early repayments for the first series of TLTRO's fell due in 2016 and most of those loans were rolled over into the second series. It will be time for the banks to repay or roll-over in June. Now it gets interesting.
If banks repay, does this mean that they are in a position to take up the heavy lifting of credit creation, or does it mean that they see no growth and lending opportunities?
If the banks roll-over, does it signify that they still have problems on their balance sheets and remain reliant upon crisis funding?
Tighter capital adequacy rules, since the TLTRO’s were initiated, create an incentive for the banks to repay in order to avoid higher regulatory capital costs, so as always in the Eurozone the picture is obfuscated by conflicted regulations.
It is undeniable that early repayment, in and of itself represents a tightening of liquidity in the banking system. The banks may thus tighten monetary conditions, at a time of economic softening, even before the ECB has even considered tightening monetary policy.
What is widely ignored is the fact that the TLTRO’s were conceived and rolled out as a crisis response to a tightening of liquidity triggered by the expiry of a previous emergency crisis-funding program from the earlier ECB response to the onset of the Credit Crunch. The fundamental story is clear therefore. The ECB could not safely take back its emergency funding in the first place. On the contrary, the ECB had to respond with even more emergency funding. The historical precedent and trend are clear. This time the ECB has signaled that it will leave substantial emergency funds rolling over in the financial system and keep interest rates low long after the emergency funding programs have been ended. Vitor Constancio’s recent re-insertion of the ECB Put clause shows that there is considerable uncertainty as to whether the end of QE is only the next step in the process of further QE.
The good news in the banking sector, to balance the TLTRO rollover risk question, comes from further progress towards the creation of a process to deal with any future crisis. EU nations recently made progress on the creation of stronger bank capital rules that may also lead to the strengthening of the mechanism to deal with future bank failures. Under a new accord, that must however be approved by EU national governments, the Single Resolution Board will be given a mandate to use its discretion on the setting of bank capital rules. There was pushback from the peripheral nations, who are trying to get the concession of debt sharing across Eurozone nations agreed. Optimism should however be tempered, since so far there is no agreement on a common Eurozone bank deposit insurance scheme. There is also the hurdle of the safe passage of the new risk sharing crisis rules through national parliaments. The current Italian brinkmanship has not done this process any favors, even if it has provided the catalyst to addressing the matter.
In the past, Eurozone policy makers have used a crisis to strengthen the European Project. This strengthening could not however have occurred without the ECB providing easy monetary conditions. This time around, the attempt to deepen economic integration in June is both stalled and negatively framed by events in Italy. Arguably, the ECB should be providing an easy monetary policy backdrop rather than heading for the door under the current circumstances.
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