The ECB had a chance to frame itself, as nearly done with its unconventional monetary policy mission. Having bravely seized the initiative, the ECB must now accept that its immediate fate is in the hands of President Trump and Chairman Powell.
The fallout from the tractor beam of rising real US interest rates is exerting its perverse influence on the Eurozone. This comes against a backdrop of deteriorating trade relations between America and the EU. The ECB had hoped to convince market observers that it is part of the trend of rising global real yields. In practice, the ECB may be forced to do the exact opposite.
France has framed the current global and internal Eurozone challenges as existential threats. According to Finance Minister Bruno Le Maire, these threats are the opportunity to either strengthen the Eurozone or abandon the project altogether. Angela Merkel responding for Germany, agreed but explicitly stated that this does not involve debt sharing at this point in time. The German thrust is to pivot, a "more German" Eurozone, away from America towards the under threat globalist world order. Needless to say, German Finance Minister Olaf Scholz soundly endorsed the plan. Le Maire then acknowledged the German conditions and signaled French acceptance in principle.
European Commission Vice-President Valdis Dombrovskis eulogised over Merkel’s proposals. This eulogy involved saying that the German proposals are identical to those of the Commission. What the Commission Eurocrats like is the fact that Merkel has not asked for painful sovereign debt restructuring, as the principle driving force behind the new move to further economic integration. There will therefore be no painful losses at this point for private investors.
The debt can appears to have been kicked down the road, into a European institutional framework to deal with it. Said framework by inference will be less austere and painful, since the political priority is to keep the European Project alive at all costs. There will be pain however, but this will appear further down the road and also within the Eurozone rather than in the global domain.
The Germans envisage deeper economic integration coming at the expense of American influence. This will involve replacing the International Monetary Fund (IMF) with a European Monetary Fund (EMF). The Germans believe that the European Stability Mechanism (ESM) is the best vehicle to become the new EMF. Indebted nations like Italy will then have their finances restructured by the EMF in the same way that the IMF would normally do.
Over time, Europeans will grow to loathe the new EMF, as its emergency funding terms get more onerous in the pursuit of economic reform. In the meantime, the immediate threat of Eurozone dissolution due to populism can be averted. This aversion can be achieved by avoiding debt sharing, whilst allowing traditional crisis funding to be provided by a Eurozone fiscal agency. This agency can then refinance these debts at the ECB.
(Source: Zero Hedge)
A model of how this fiscal internalization process will work going forward was shown recently in the case of Italy. Whilst the EU politicians were saying no mas to debt sharing, the ECB switched its current QE phase of buying from Italian bonds to German Bunds.
Allegedly, a mass of German bond maturities meant that the ECB was below its target German holdings and therefore needed to overcompensate. The fact that these German bond redemptions also shrink the availability, of an already dwindling supply, seems to have been conveniently forgotten. The reason that this German buying came at the expense of Italian bond buying was also not clearly explained.
The net effect of these forces was to cause a blowout of Italian bond yield spreads. The sublime message was clear. Nations that run tight budgets are favored by the ECB and have lower debt costs. Nations that threaten to leave the Eurozone, in order to blackmail the ECB into monetizing rising fiscal deficits, get punished by the market.
The Italians are indignant and feel victimized. Since they do not have the political consensus, to seriously ask to leave the Eurozone and thus apply some real leverage in the negotiations, they have no alternative other than to comply.
The precedent and protocols are clear. Nations that reform their economies will be patronized by the ECB and the EMF. Nations that do not will be ostracized, unless they have enough popular support to leave the Eurozone. Eurozone policy makers have capitalized upon and to some degree engineered a crisis in order to further the European Project. They can do this until the populist cows come home and demand a real exit from the Eurozone. A weaker Euro is just an added bonus!
If this new EMF follows the traditional German model, it will get the weak indebted nations to pledge their hard assets and Gold reserves as collateral for emergency funding. Having pledged their only assets, that could support a national currency on leaving the Eurozone, the indebted nations will thus be effectively held prisoner. Populism may then degenerate into terrorism.
The ugly endgame is however some way off and will be ameliorated by lashings of ECB liquidity to kick it further down the road. At that stage also, having effectively sequestered the sovereign assets of the indebted nations, the Germans may then feel that fiscal union on their terms has been achieved. They might then decide to transfer the seized financial resources back to their original owners as sign of goodwill and solidarity!
If this new fiendish plan is correct, then Germany will trade fiscal slippage in the short term for long term political and economic gains. Perhaps sensing that this strategic game may see him missing out on the prize of ECB President, Bundesbank President Jens Weidmann has voiced his misgivings. He warned that the current horse trading, of reform for deeper integration, should not be literally interpreted as “more money for Europe”.
Weidmann may also be worried that giving the indebted nations an inch will turn into a mile and much more, thereby setting a precedent by which these nations can always avoid biting the fiscal bullet. In his opinion, the rolling back of fiscal reforms to date in order to achieve future solidarity would be “tragic”. To support his view, he noted that the current crisis shows that the Eurozone and its currency are still not crisis proof even with the reforms made to date. By inference therefore, rolling back said reforms would make the Eurozone systemically crisis prone by default in perpetuity.
Despite all the political shenanigans and market manipulation going on, the ECB is keen to spin the situation as under control and proceeding as planned towards the scheduled end of QE. The story is that the current Italian situation is not significant enough to delay or even terminate the end of QE.
Barred from speaking directly about monetary policy, in the quiet period before the latest Governing Council meeting, members used the Italy spin to indirectly address the matter. In Ewald Nowotny’s estimation, the Italian political situation will not “come to an actual crisis”. Governing Council member Vitas Vasiliauskas opined words to the same effect. Both therefore opened the door for the ECB to guide for the end of QE at its upcoming meeting.
There is allegedly no crisis, therefore the ECB no longer needs to maintain its crisis level monetary stimulus. This rosy outlook should be compared and contrasted with a Fed that is admittedly “agonizing” over when to stop the current interest rate hiking schedule.
ECB Chief Economist Peter Praet projected this benign construct, like a skilled actor, in his final commentary before the Governing Council went into monetary policy conclave. He stated that the upcoming meeting would be one in which significant debate and decision would be taken about the scheduled ending of QE. His representation inferred that the decision to end QE would be officially tabled at this meeting.
ECB Chief Economist Peter Praet extemporized that: “signals showing the convergence of inflation towards our aim have been improving, and both the underlying strength in the euro area economy and the fact that such strength is increasingly affecting wage formation supports our confidence that inflation will reach a level of below, but close to, 2 percent over the medium term” and also that “waning market expectations of sizable further expansions of our program have been accompanied by inflation expectations that are increasingly consistent with our aim.”
Governing Council member Ardo Hansson joined in on the buy the rumour sell the fact tactics of Praet with commentary of his own. According to his view, interest rates can start to rise circa mid-2019. Just for good Hawkish measure, should inflation and growth dynamics accelerate between now and then, the scope for a faster rate rise than currently envisioned becomes a rising probability.
Governing Council member Klaas Knot then nudged sentiment even further towards the Hawkish end of the spectrum, when he opined that QE should be wound down asap.
Perhaps with the view, that he no longer has anything to lose in his quest to become the next ECB President, Jens Weidmann spoke more objectively in relation to the prospect for ending QE this year. His estimative probability is only at the “plausible” level, rather than at the higher probabilities of his colleagues. His objectivity speaks to a nagging problem in relation to economic conditions (especially in Germany!) and the capacity of monetary policy to deal with them.
Weidmann’s subdued view, belies a creeping sense of economic fear within Germany. This growing sentiment was highlighted by the latest DIW Institute revisions to its forecasts for GDP. 2018 has been revised down to 1.9% from 2.4% and 2019 has been revised lower to 1.7% from 1.9%. The reasons for pessimism cited are the scale of the slowdown in early 2018, combined with internal Eurozone and global trade fears. The German Ifo institute was even more pessimistic, cutting 2018 growth from 2.6% to 1.8% and 2019 from 2.1% to 1.8%.
The canary in the German coalmine outfit was donned by Mercedes-Benz. The automaker became the first global company to predict a profit warning on trade war issues. It is getting hit from either side by America and also reciprocal blow-back from China. Germany will clearly be the biggest loser in the Eurozone if a global trade war breaks out. Ironically, this will make Germany embrace the Eurozone project significantly more than its current weak populist hug.
This German embrace could then extend to giving the Eurozone nations, who buy its exports, access to further credit underwritten by German taxpayers. There is no doubt that Germany will embrace a weaker Euro, just as it embraced the single currency on inception when the strong Deutschmark was choking its industrial base. This emerging German position on the Eurozone and the Euro, in light of trade war tensions, is a game-changer for the European Project.
What is amusing to watch is Germany trying enforce deeper Eurozone integration on its own terms, even though it is the most strategically weakened in the current global economic environment. If Italy was bluffing about leaving the Eurozone, then Germany is also bluffing about its current economic strength.
Even the Bundesbank was forced to lower its growth projections. It also stubbornly avoided lowering its inflation forecast, so as not to provide any obstruction to its desire to terminate QE. The German central bank also made it clear that it strongly rejects the move to raise the 2% inflation target.
The Bundesbank’s growth pessimism resonates with the ECB’s own June forecasts. Growth is predicted to slow down between 2018 and 2020, whilst inflation remains subdued throughout the period. Even the Bank of Spain has been forced to admit that the blistering pace of the Spanish recovery cannot be maintained further. There is thus no clarity or optimism on growth from either the Core or the Periphery in the Eurozone. In fact, it is not clear where growth in the Eurozone is to come from.
The ECB Executive Board has a wider context than its colleagues on the Governing Council’s narrower monetary policy focus. This context, involves the detailed preparations for the alleged deeper economic integration which, frames monetary policy in general. Whilst supporting the attempt to frame the end of QE, the Executive Board was careful to ensure that this was done in the wider context of deeper economic integration.
Reflecting this wider context, Executive Board member Yves Mersch opined that there will need to be some rule changes, in relation to collateral markets. These changes will allow the withdrawal of monetary stimulus to be transmitted through the capital markets. These rule changes will necessarily involve the tightening of liquidity, by tightening the eligibility of specific classes of collateral for money market financing operations.
Mersch is specifically interested in preventing the rules of eligible collateral from allowing sovereign governments to avoid the overall tightening of liquidity at the end of QE. Tightening collateral rules will levy a penalty on such actions which may be prohibitive. Mersch is also concerned that rule breaking, using the asset class of bank loan collateral, is choked off. This will prevent the continued transmission of sovereign indebtedness into a wider bank non-performing loan (NPL) issue.
The result, of the spin doctoring of ECB guidance, was a market consensus expecting the announcement of the end of QE at the June Governing Council meeting.
(Source: Seeking Alpha)
The April report in this series suggested that the weak economic fundamentals in the Eurozone, will preclude the ECB from building of a conventional monetary policy interest rate cushion. Consequently, the ECB will continue to rely on unconventional monetary policy. It may even have to expand monetary policy, if the current economic slowdown becomes protracted.
(Source: Seeking Alpha)
Since this April report was written, exiting ECB Vice President Vitor Constancio has re-inserted the ECB’s "do whatever it takes" Put clause back into the guidance lexicon. This is effectively an acknowledgement that (a) conventional monetary policy is dead and (b) that the current slowdown has got long legs.
Currently, the Governing Council is playing charades and would have observers believe that a conventional monetary policy cushion will be under construction in 2019.
Fundamentally speaking, the ECB-Put remains on the table. The underlying economic data shows no sign of strengthening as yet. In the absence of firmer economic and inflation data, speculation over easier unconventional monetary policy will re-emerge. In fact it is already doing so.
As advertised, the ECB Governing Council confirmed the ending of QE in December of this year at its June meeting. Negative interest rates will however be extended into 2019. All is clearly not well enough for a genuine normalization of monetary policy as is underway in North America. Mario Draghi’s press conference conceding that the economic soft patch was durable but not a game changer, lacked a certain degree of credibility to fully endorse the ECB’s actions.
Unfortunately, the Fed had already stolen the ECB’s and Draghi’s thunder by the time of his press conference. The FOMC’s signal, that the gradual interest rate increasing process remains very much in place, provides the attraction of rising real US interest rates. This US attraction is boosted further by the ECB’s guarantee to keep negative interest rates in place into 2019 after QE ends.
Indicative of the fact that the Fed rather than the ECB stole the show, ECB speakers swiftly stepped up to speak after Mario Draghi’s fumbled press conference.
Speaking for the Executive Board, Benoit Coeure opined of QE that “it has worked”. In his opinion, inflation will “durably” converge on the 2% target, an opinion also broadcast by Governing Council member Ewald Nowotny. Nowotny was at great pains to tell his audience that the Governing Council decision was unanimous. He tested the limits of his credibility, by also announcing that “technically” inflation has hit target so that the normalization can begin.
Governing Council member Vitas Vasiliauskas then plaintively leapt in, to support the remedial action, with his view that risks are balanced. Allegedly there are “no clouds” as medium term growth threats on the horizon. By his estimation, the sun will be shining on interest rate increases from the ECB by Q3/2019. This sounds like a lifetime away.
Governing Council and Executive Board are thus aligned. The collective ownership of the normalization decision is admirable, even if it shows a certain lack of confidence in the future at the ECB.
In these times of global trade uncertainty and a fracture in the accepted western alliance, rising real US interest rates are a magnet for capital flows. The Fed has therefore tightened global monetary policy. The ECB has allegedly compounded this misery by signalling the end of QE and the extension of NIRP/ZIRP.
Suddenly a falling Euro is not a monetary stimulus at all, since the cheaper Euros are being dumped to chase yield and safety in North America. A falling Euro is thus a symptom of declining global liquidity this time, rather than a signal of expanding ECB liquidity.
It may even come to pass that a weakening Euro is dubbed as a signal that the Eurozone is still breaking up. Absurdly, yet typically, the ECB may have to "do whatever it takes" again to ease monetary policy in order to save the Eurozone. In so doing, monetary policy easing would then actually boost the value of the single currency.
Perhaps with this in mind, Governing Council member Jan Smets moved a little closer to retiring Vice President Vitor Constancio’s penciling in of the ECB-Put back into guidance. Whilst opining his colleagues’ view, that it is time to normalize, Smets was surprisingly quick to discount this view by saying that if things soften the ECB will quantitatively ease again.
Having failed to fool anybody, with his press conference at the last Governing Council meeting, Mario Draghi capitulated and fessed up at the following ECB forum at Sintra in Portugal.
This capitulation involved a formal embrace of Mr Market, after Draghi had failed to move him with the normalization rhetoric at the preceding Governing Council meeting. According to Draghi’s Sintra view: “We (ECB) will remain patient in determining the timing of the first rate rise and will take a gradual approach to adjusting policy thereafter” and “the path of very short-term interest rates that is implicit in the term structure of today’s money-market interest rates broadly reflects these principles.”
Draghi also re-inserted the ECB-Put guidance of Constancio, to be struck if economic conditions deteriorate further. The incoming data and President Trump will however be the main arbiters of future ECB monetary policy. There is surprisingly little that Draghi can do other than hope for the best. Planning for the worst in plain sight would simply expose and then raise the probability of this worst case scenario outcome.
Further context for Draghi’s Sintra comments was provided by Governing Council member Philip Lane. Whilst noting that the ECB has signaled a shift in “gears” on the end of QE, Lane emphasized that the reverse gear has not been engaged and that its selection will depend on how global events unfold. In his opinion, there will be no official discussion of raising interest rates until next summer.
Governing Council member Erkki Liikanen then blinked very publicly and confessed that interest rates could be on hold for much longer in 2019. Governing Council member Jan Smets supported Liikanen’s act of contrition by admitting that uncertainty over trade issues make it impossible to pick a date in 2019 to raise interest rates. Given the rising global risks and economic headwinds, Francois Villeroy de Galhau tentatively sees summer 2019 as the window of opportunity to start thinking about the first interest rate rise. Admittedly, he is still uncertain where the Eurozone economy is in its current cycle.
Governing Council member Ewald Nowotny used the platform of Sintra, to do some unorthodox and potentially unacceptable currency intervention, that may add to the growing sense of attrition between America and its trade partners. He openly forecast that the Euro will fall against the US Dollar. Whilst this could easily be construed as stating the obvious, it is dangerous for a central banker to do this when talking about his own currency in times of trade tensions.
Nowotny attributed the Euro depreciation to widening interest rate differentials, driven principally by the Fed rather than the ECB. He also stated that financial stability risk, driving this currency move, is politically driven with the Euro under pressure from trade wars and Brexit. He was very clear to avoid the elephant in the room, of slowing Eurozone growth, which is a factor that clearly unnerves the ECB and derails its normalization schedule. Nowotny also refused to be drawn into speculating about the impact of the latest Franco-German moves towards deeper economic integration and the positive influence that this could have on the Euro.
One interesting development, in thought leadership on display at Sintra, was in relation to wage rigidity and its converse-twin labour market structural reform. A recent article in the US series of reports noted how Chairman Powell is ignoring wage rigidity and its disinflationary effects at his peril. This labor market rigidity problem was noted as not being exclusive to America. New research at Sintra throws it into a curious perspective, in relation to the current fashion for supply side labor market reforms.
University College London researchers presented that they have found that it is the quality of the labor market reform that is most important. Simply reforming low-paying jobs, to make them even more competitive on price, does not boost aggregate demand. The utility and benefits of the “Gig Economy” and related labor market reforms is a myth therefore. Collective bargaining with organized workers, allegedly leads to the optimal market allocation of labor resources. The inequality, created by the current process of labor market reform, is therefore exacerbating the structural disinflationary and demand suppressing forces in developed economies. This observation clearly resonates in the political dimension represented by the growth of populism.
The architects of the German solution, for deeper economic integration combined with structural reform, should take note of this obstacle to their grand designs. One suspects that we have not heard the last of this subject and also that central bankers may find themselves pulled into the political world of opining the benefits of wealth redistribution.
Central banks have redistributed wealth and increased inequality to the asset rich with the QE process. This socialist reflex should come as no surprise therefore especially as central bankers’ independence and livelihoods are being challenged by the populists.
Bank of France Governor Francois Villeroy de Galhau seems to be playing with fire in relation to this subject. He recently penned a strong letter to Eurozone political leaders, demanding that they speed up the economic reform process, whilst there is still some economic momentum to be had. Those wishing to ignore his call will be swiftly reaching for the University College research with one hand, as they reach for their weapons with the other.
The Sintra forum was also an opportunity for the ECB to update its peers on what or rather what it won’t do, about the festering non-performing loan (NPL) issue plaguing the Eurozone banking sector.
Evidently, as trade wars and rising US interest rates threaten the liquidity and solvency of the Eurozone banking system, the ECB has decided that discretion is the better part of valor. This discretion involves the dropping of a comprehensive rules based solution for Eurozone bank capital adequacy. The ECB now favors adopting a wait and see, followed by “case by case” solution according to top regulator Daniele Nouy. The ECB will therefore wait to see which banks take a hit as conditions deteriorate and then deal with them as they fall.
Italy is clearly on a crash-course to be dealt with on a “case by case” basis. With the populist government’s bit rammed between its teeth, the Bank of Italy is pressing ahead with a consultation process. This process will lead to a relaxation of capital adequacy requirements for its banks to issue more covered bonds. The threshold base capital level to issue said bonds will be lowered to 250 million Euros.
As a consequence, smaller Italian banks with poor capital bases and even worse asset books will be trying to securitize said poor assets and get them off their books asap. Credulous Italian retail investors should beware this latest attempt to jam their accounts with allegedly attractive yielding assets. Italy’s renegade financial moves have certainly caught the attention of the IMF. Managing director Christine Lagarde is demanding clarity on the Italian government’s fiscal intentions and capabilities going forwards.
Unattributed central banker sources from Sintra say that Draghi didn’t pull off the impossible mission, of convincing the markets that the ECB can exit QE. It was a nice try though. Matters are now out of the ECB’s hands and in the hands of President Trump and Chairman Powell.
By way of insurance policy and also a tacit admission of failure, the ECB then leaked its plans for the scaling back (or not!) of QE as the summit ended. There will allegedly be substantial rollover reinvestment of maturing bonds on the ECB’s balance sheet. This will provide a benign liquidity legacy.
With a hint to the ensuing chaos to come in sovereign debt and NPLs, the ECB also signaled that it is considering changing the rules on sovereign bond limits to its own QE buying.
The ECB is not only preparing a substantial liquidity cushion after QE supposedly ends. It is also preparing for more QE. The Capital Key rule is going to be changed. This will be aimed at the indebted nations who will suffer the combined effects of QE ending, trade wars and Fed rate hikes going forward.
Why bother ending QE at all, if you are going to reinvest and expand sovereign bond purchases of the weaker nations?
The irate Italians will have noted that, after blowing out Italian bond spreads, the ECB is now making room to load up on cheaper Italian bonds. The thesis of the carefully laid German plan, for economic integration on its terms, has also received support from these latest ECB signals.
Since Mario Draghi is headed into the sunset, as Germany is becoming the surprising sick man of Europe, the post-summit commentary from Jens Weidmann may prove to be more apposite. Weidmann's words may also be more enlightening on the subject matter of the deeper integration conspiracy.
The Bundesbank President walked a fine line between over-confidence and deep concern. In his own words, the it will take “some time” for yields to rise to 0%. Allegedly, the recent Governing Council move towards normalization was just “to get the ball rolling”. Compared to his quotidian Hawkish guidance of the past, this new circumspection is Dovish …. and he doesn’t need to explain why. The ball is in fact rolling, towards deeper economic integration, by way of a crisis that can be blamed on President Trump and the Fed.
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.