'Twisting' Draghi's Advice To Prepare For The Next Eurozone Slowdown

by: Adam Whitehead

Economic weakness and trade war threats are nudging German politics and economics closer into line with the wider Eurozone agenda.

Counter-cyclical fiscal stimulus is coming to the Eurozone just as the ECB is ending QE.

The ECB may kick the problems from counter-cyclical fiscal expansion down the road by Twisting.

EU policy makers are making the post-Brexit situation worse unwittingly or by design.

The markets have afforded the ECB the privilege of being able to play the normalisation by ear from now until December 2019.

At his latest press conference, ECB President Mario Draghi advised his audience to prepare for the end of QE and also for the next economic slowdown. Audience attention was more focused on the former, assuming that his successor will "do whatever it takes" in the event of the latter.

Just as President Trump had thrown a spanner in the ECB's works for ending QE on schedule this year, he swiftly removed it from Jean-Claude Juncker's hand just in the nick of time for the latest Governing Council meeting. Global conditions were thus finely balanced on the eve of the meeting, closely reflecting the finely balanced conditions within the Eurozone itself.

The European Commission had already begun to lower its economic growth projections in response to the growing global trade tensions. As trade war tensions build and the rhetoric on both sides becomes more partisan, the Bank of France tactically begins to address America's strategic weakness. Deputy Bank of France, Governor Sylvie Goulard, noted that the Trump fiscal stimulus may be the catalyst that unravels the current dynamic of higher US interest rates, stronger US dollar, and weaker global liquidity. Having worked themselves into a stalemate, the only solution was a compromise. Fortunately, President Trump extended a shaky hand of compromise and Jean-Claude Juncker gladly seized it. We will now have peace in our time until the next presidential tweet on trade.

(Source: Seeking Alpha)

The last report highlighted the current horse trading going on at the higher level of Eurozone policy making. The horses being traded are the redistribution of tax receipts from the north to the south in return for enforceable rules to reciprocate with structural economic reforms. The trade is framed under the general heading of deeper economic integration.

(Source: Bloomberg)

The last report also suggested that German vulnerability to global trade war threats would make it pivot towards a deeper embrace of Eurozone economic expansion. Ultimately this embrace would then lead to German taxpayers picking up the tab for this pivot. Angela Merkel recently began to mobilise support for this pivot in a speech in which she clearly aligned German economic and political interest with the wider European Project.

Merkel's coalition partner, Finance Minister Olaf Scholz, then took the pressure off the ECB to tighten monetary policy in a deteriorating economic environment. His expectation is that the ECB will normalise monetary policy gradually. The German Finance Minister then clearly identified President Trump as the villain of the piece, with a direct admission that German wealth redistribution will soon occur at the national level. This will be done in order to avoid the creation of German "Trumps". He fell short of calling for Eurozone wealth redistribution to that same end, but clearly he could see its merits in theory if it boosted German exports.

A domestic German counter-cyclical fiscal stimulus is thus underway, which will represent a clear reversal of the country's Black Zero strategy to get through this period in the European economic history.

The ECB recently provided a further nudge to enable this high-level horse trading in its latest edict on the subject of structural economic reform. The nudge was more of a warning and implied threat. Laggard fiscal reformers were reminded to get with the reform programme, whilst the Eurozone economy still has residual momentum, before the ECB ends the QE process.

(Source: Seeking Alpha)

A previous report noted that June was a key period in the calendar to assess the health of the Eurozone banking sector. By default, it was also said to be an opportunity to practically assess the feasibility for the ECB to make a credible exit from QE. The barometer used is the level of repayments under the early repayments option of the ECB's emergency TLTRO-II funding operations of 2016. The ECB recently announced that of the almost 400 billion euros of emergency funding provided for four years back in 2016, only 11 billion euros will be repaid early.

Rationally speaking since the ECB has already announced the end of QE and the prospect of higher interest rates in 2019, there is a pecuniary incentive for the banks to hold on to the cheap funding. Granular analysis shows that the Italian and Spanish banks availed themselves of more than half of the emergency facility when it was offered. Clearly, they are still hanging on to it, so the sustainability of the alleged strong economic recoveries in these countries should be questioned.

The recent blowout of Italian yields suggests an even stronger incentive for Italian banks to cling on to the cheap funding. This behaviour is also reflected in the latest Target 2 data of inter-nation central bank clearing balances at the ECB. The Bank of Italy's Target 2 liabilities are now at all-time highs and rising. Italy owes the ECB 500 billion euros, and this figure continues to compound.

The Italian Target 2 and TLTRO data should be put into the context of the country's widening fiscal deficit to GDP ratio under the hands of the new Populist executive. Italian debt grew to 3.5% of GDP in Q1 this year, clearly breaking all Stability Pact limits. Bank of Italy Governor Ignazio Visco has also recently warned that the GDP denominator is going to get even larger because the Italian economy is slowing. The EU and the ECB have thus been put on notice that Italy will be breaking its fiscal guidelines for some time to come.

Italy remains unpunished by the EU and even uncensored for its fiscal indiscretion however. Italy is clearly getting away with it as usual. Italy may now also smell blood in Germany's weak global trade position that will give the Italian Populists greater leverage. The Italian government has wasted little time in exploiting this leverage with an expansionary budget and challenging the EU budget restrictions tabled on the legislative agenda. Punishment of Italy has come from private investors, who dumped Italian debt by record amounts in May and pushed yields higher.

The Italian banks are funding their sovereign bond holdings with cheap ECB emergency funding. The classic perverse Eurozone response to the growing Italian banking crisis risks allowing the Italian poachers to become gamekeepers. The three favourite candidates to replace outgoing top banking regulator head Daniele Nouy are all Italian as luck would have it. This insidious situation has become invidious, with the Germans hardly able to contain their anger that this conflicted situation will allow the Italian banks to wriggle free and their sovereign debtor to follow suit. Since Germany has bigger economic issues from trade to worry about, the Italian situation may be viewed as a lesser necessary evil to be endured.

After watching Italy bending the fiscal rules with great success, Spain has decided to try its hand too. Finance Minister Montero announced that economic growth should take precedence over fiscal rigour. The Spanish government will now raise the fiscal deficit and stare down the EU and the Bundesbank.

Surveying the finance ministries of Germany, Italy and Spain, one can discern a growing counter-cyclical fiscal stimulus developing, just as the ECB has signalled that QE will end.

(Source: ECB)

With the health of the banking system clearly in view, it is interesting to follow the progress of the Eurozone non-performing loan (NPL) issue more closely. In the last report, the ECB was noted to have adopted a "case by case" approach to dealing with the issue. This "case by case" methodology has now been officially adopted as doctrinaire. More recently, the Bundesbank announced that it is fully supportive of these ad hoc measures.

The NPL issue will thus be addressed through principles-based rather than rules-based banking supervision. Whilst it appears to be a uniform process, it will degenerate into a myriad of quick and dirty fixes that will detract from, rather than support, the integrity and solvency of the Eurozone banking system in general.

Far from being aggressive in proscribing a swift solution to the NPL problem, necessitating shareholder bail-ins, the Germans are now much happier to go with the relaxed flow. This relaxed attitude towards bank solvency mirrors an equally relaxed attitude towards the ending of QE.

The last report noted that Germany is at the greatest risk in the Eurozone from global trade wars. Recently, the Ifo Institute's chief economist, Klaus Wohlrabe, opined that the German boom is over and that lacklustre normality will ensue. The dramatic weakening in the German economy and Ifo forecasts for 2019 and beyond also spoke to this swift change in the fundamentals. Evidently, the agencies and institutional policy makers in Germany are collectively adjusting to the new threat.

The collective complacency about the banking system seems misplaced unless one assumes that policy makers and the ECB will intervene well before the NPL crisis feeds through to the real Eurozone economy. Indeed, the ECB recently appeared to completely write off the banking sector's collective ability to deal with the next crisis. ECB bank regulators dubbed the banks' recovery plans so bloviate as to be impractical. Evidently the banks will not be left to their own devices. Consequently, the EU and the ECB can be relied upon to assume the responsibility for dealing with the situation through the provision of abundant liquidity and light-touch regulation.

The Eurozone banking sector will already be in crisis if the Bank of England's Financial Policy Committee's comments about the Eurozone's preparedness for Brexit are anywhere near the truth. The EU is showing a tendency not to plan for worst cases, therefore deliberately making them inevitable. Thus far according to ECB statistics only 20 out of the 50 banks operating in London have applied for a licence to operate in the EU post Brexit.

Advancement of the Eurozone Project and deeper economic union only seems to gain traction during a crisis. There is therefore method in the apparent madness of the EU policy makers in making the situation worse by not planning Brexit contingencies. It would seem that they intend to blame everything on Brexit and then hide behind this excuse as they accelerate towards deeper economic union as a crisis response. The EU's cup of excuses runneth over, as the growing trade war threat provides yet another tale to weave into the crisis enabled Eurozone integration story.

After the underwhelming announcement that QE will end this year at the last ECB Governing Council meeting, Governing Council member Vitas Vasiliauskas attempted to underwhelm further. The latest underwhelming initiative comes in relation to the prospect for higher interest rates against a deteriorating growth and trade backdrop. In his latest guidance, Vasiliauskas suggested that the first interest rate raise by the ECB may now be pushed back to circa October 2019.

Governing Council member Benoit Coeure chose the subject of maturing ECB balance sheet re-investment to underwhelm further expectations for rising interest rates. By his calibration, the ECB will re-invest approximately 15 Billion euros per month of maturing bonds on its balance sheet next year.

The best bit of underwhelming was done by ECB Chief Economist Peter Praet however. According to Praet, the ECB did not actually announce the end of QE at the last Governing Council meeting. In fact, it only communicated a vague "anticipation" of this event. After thinking about the implications of this statement, he then felt obliged to re-frame it so as not to question the Governing Council's verbal commitment to end QE this year. His re-framing opined that disinflation expectations have definitely been shifted, whilst patience is still required on seeing QE through to the bitter end. His re-framing only served to draw an even bigger question over the ECB's sincere commitment to normalise.

In contrast to the underwhelming rhetoric of his colleagues, newly appointed ECB Vice President Luis de Guindos sounded distinctly positive. This was probably more to do with his intention to strike a positive incoming note about himself rather than any fundamental belief in what he had to say. According to him, everything is still on course for continued growth and rising inflation despite the obvious global headwinds.

The ECB's own economic bulletin for June acknowledged the continued progress on the inflation and growth front whilst acknowledging the increasing global trade headwinds. The report sets the balance of risks to the downside in the short- to medium-term however.

Given this downside balance of risks, the ECB was highly motivated to signal that long-term interest rates will not rise rapidly in 2019. So strong is this motivation that, to all intents and purposes, the ECB has signalled that it may in fact expand the QE programme. This expansion may come in the form of a tweak to the QE proceeds reinvestment process. Sources close to the ECB revealed that an Operation Twist is under strong consideration. This Twist will involve the purchase of long-dated government bonds. It is alleged that the intention and capability behind the Twist is to simply extend the maturity of the assets on the ECB's balance sheet. Shorter-dated securities maturing will then be replaced with longer-duration ones. The resulting flows will suppress the yield on long-dated bonds across the Eurozone. By default therefore, there is a growing question mark over the current plans to end QE later this year and then to raise interest rates in 2019.

Such a Twist move is a de facto easing of monetary policy targeted at the sectors of the Eurozone economy which have liabilities linked to the long-dated bond benchmarks. The ECB is thus quantitatively easing again just as it has announced that it is officially ending QE. Clearly the interest cost to sovereign governments will be reduced, thus alleviating the sovereign debt crisis risk somewhat. Conversely, the indebted nations will have no incentive to reduce their deficits. Sovereign nations will in fact go with the Twist and extend their own liability maturity profiles. The ECB has thus signalled that the sovereign debt can is going to be kicked down the road ... again! The collective problems from the current counter-cyclical fiscal stimulus in some nations combined with the worsening NPL situation could thus be conveniently kicked down the road by the Twist.

ECB President Mario Draghi has injected some positive balance into the guidance to prevent the underwhelming sentiment from getting carried away to a point where the pressure would be back on the ECB to ease again.

Draghi was motivated to be more threatening about the trade war risk but positive about the Eurozone economy's ability to sustain its momentum. He chose to focus singularly on the threat posed by the deteriorating global trade situation as the main threat to the Eurozone. Despite this threat however, he still sees sufficient economic momentum to sustain growth and inflation. The ECB can still therefore end QE this year in theory.

With some irony and perhaps disingenuously, as it was giving the green light to kick the sovereign debt can down the road, the ECB was simultaneously warning indebted Eurozone nations to apply fiscal restraint. Dogs that bark do not bite, as the Southern Europeans know. The ECB was simply ticking the box to show that it has gone through the process of warning on sovereign indebtedness before enabling it to increase further.

(Source: ECB)

The underwhelming guidance from the ECB Governing Council members is not as strongly reflected in the corresponding guidance of their colleagues on the Executive Board. Yves Mersch had the dubious privilege of kicking off the Q3 Executive Board guidance process. His view of both the Eurozone and global economy is sanguine about trade war threats, but still maintains that there will be sustained growth and positive inflation performance nonetheless. The normalisation process is therefore still on, commencing with the end of QE in December of this year, as far as he is concerned. There is however a slight underwhelming tone creeping into his guidance and thinking. This is reflected in his unwillingness to commit to anything other than ending QE. As he said: "We do not make any unconditional commitments regarding the long-term future due to the many unknowns and uncertain developments."

Executive Board member Benoit Coeure is much more positive than his colleague Mersch. According to Coeure, the ECB had already factored in the global trade environment into its decision to communicate that QE will end in December.

(Source: Seeking Alpha)

Bundesbank President Jens Weidmann wasn't so much underwhelming as conciliatory with his early Q3 guidance. The last report observed that Germany will have a tendency towards embracing the European Project even in its flawed unreformed state, because its global export markets are under threat from the deteriorating trade climate.

(Source: Bloomberg)

This German theme, along with the fact that he would like to succeed Mario Draghi, was very evident in Weidmann's discourse. He believes that the next ECB president should have the intestinal fortitude to tighten monetary policy, although he sees no urgency to do this until late 2019 at the earliest. He also praised Italy, something previously deemed heresy in the Bundesbank. His praise of Italy did not however extend to endorsing the country's attempts to bend the Stability Pact rules further in order to increase the fiscal deficit. In his view, deeper economic integration should not be done with the aim of allowing such fiscal transgressions by the over-indebted Eurozone nations.

Governing Council member Ewald Nowotny shares some of Weidmann's rate hiking bias since he also talked up Eurozone economic growth for the rest of the year running into the end of QE. He is however much more circumspect about both the threat of a trade war and also a disorderly Brexit. The trade war is of particular concern to him as he also sees the potential for it to degenerate into a currency devaluation war.

The release of the previous Governing Council monetary policy decision minutes neatly illustrated the game being played with the ambiguity in the underwhelming yet broadly positive guidance. The minutes clearly showed a unanimous support for this behaviour. They also showed Jens Weidmann as instrumental in leading the support for low interest rates after the QE process ends later this year. The desire to remain flexible about the exact timing of the end of QE, contingent upon "uncertainty" about global trade, was a clear theme. Finally, this flexibility also led to the maintenance of the ECB-Put to maintain and/or extend the current phase of QE.

To telegraph the flexible posturing and its causes, ECB sources then leaked the story that there is a split within the Governing Council about the timing of the rise in interest rates. There are allegedly three camps; one for this year, one for next year, and one for no rate rise at all. Governing Council member Olli Rehn provided greater context to this rumour when he suggested that the ECB should adopt a more flexible position to incoming data and news rather than predictably follow its guidance on ending QE. Governing Council member Francois Villeroy de Galhau then opined that this flexible posturing is still biased towards ending monetary policy expansion. In his view, inflation is on a sustained upward trend that is unlikely to be influenced by economic headwinds as strongly as the internal growth tailwind.

The positive feedback loop from the capital markets broadly affirmed the ECB's flexible posturing and guidance. Sentiment now allows the ECB to do nothing on interest rates for all of 2019 without triggering an averse spike in volatility. The ECB is thus in the enviable position to play it by ear on the normalisation from now until December 2019.

The ECB is in a hurry to claim that QE has been a success. This is to be expected as a general post-mortem is held on QE because it is scheduled to end this year. If it can be framed as a success, then the ECB will be vindicated. The central bank will also have a precedent to deploy QE again swiftly in the event of an economic slowdown. This latter feature is critical since the ECB has thus far been unable to build a conventional monetary policy cushion in the form of higher interest rates to deal with the next slowdown.

The challenges from populism and global trade war headwinds only add to the ECB's urgency in getting QE accepted as a monetary policy tool. Objective researchers at the ECB thus partnered with the allegedly objective economists at Princeton to study the impact of QE. Unsurprisingly the analysis found that QE was not only a success but also did not lead to greater wealth inequality. The critics and the populists have thus been silenced to some degree.

Having prepared Mr. Market and Mr. Eurozone audience for a fait accompli in advance of an uneventful phasing out of QE, the Governing Council officially delivered this message. At the latest Governing Council meeting, monetary policy was left unchanged as a precursor to the earlier announced timetable for the end of QE later in the year. Mario Draghi provided further clarity as to exactly what is to be expected between now and the end of the year. He also clarified what will be happening to interest rates out into 2019.

Draghi assessed positive progress on the growth and inflation front. This progress is however still conditional on continued easy monetary policy. The easy policy is to be sustained after QE officially ends through the reinvestment of the proceeds of bond purchases. There was no mention of the Twist at this point in time. Although the risks are balanced, the ECB is taking no chances. It will be providing a substantial liquidity cushion in place when QE ends to prevent any economic relapse.

Draghi also advised that this liquidity cushion period should be used by the region's financial institutions to build their own capital buffers. Eurozone nations should likewise implement fiscal reform whilst the liquidity cushion lasts. Draghi is advising the Eurozone to prepare for the next slowdown. No doubt this advice will fall on deaf ears, as his audience continues to use the ECB's liquidity largesse to live beyond its means.

The counter-cyclical fiscal stimulus from Germany, Italy and Spain may in time be followed by other Eurozone nations. Such actions strongly vitiate against Draghi's warning to structurally reform and build liquidity buffers. Such actions seem to take a leaf out of the President Trump book of demand management. The Eurozone is therefore preparing a fiscal stimulus to counter for the next economic slowdown, and Draghi's successor will no doubt also have to replay the "do whatever it takes" meme to warehouse this with the ECB's balance sheet.

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.