The ECB's Twisting Time Is Here

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by: Adam Whitehead
Summary

Eurozone Core versus Periphery economic divergence is following underlying political divergence trends.

Italy is exploiting the divergence trend to push for a loosening of Eurozone fiscal governance standards.

Trade Wars, Turkey, Italy, the NPL issue and Brexit all mitigate for the ECB to do Operation Twist.

The ECB is already doing Operation Twist.

The weaker Euro will be the safety valve for the economic and political adjustments made by Eurozone policy makers.

The ECB has adopted a more circumspect attitude to its announced intention and capability to end QE later this year. It has also inserted an option to prolong the process should it need to do so. Current conditions precedent suggest that the ECB may now have to avail itself of this option.

The last report noted that the markets have given the ECB the flexibility to call the shots on its normalisation trajectory. The recent data combination of counter-balancing inflation and growth data reinforces the ECB’s hand.

(Source: Seeking Alpha)

Recently released growth and inflation data for June confirmed the logic of the ECB’s decision to leave things unchanged at the last Governing Council decision. Inflation is rising whilst economic growth is deteriorating. The inflation story was further confirmed by the recently released July data.

The ECB may have got too much of a good thing however, since the economic slowdown in the first half of this year is material. French Finance Minister Bruno Le Maire is already hinting that official 2018 growth predictions will be lowered. Such a change to economic inputs, by the French economy will knock on to the ECB’s own inputs and assumptions. For now, the end of QE is still on the table. A further deceleration in economic growth may remove it.

There is also a divergence in economic performance opening up between the Eurozone Periphery and the Core. The Core economies are recovering from the H2/2018 soft patch, whilst the peripheral nations continue to show weakness. This divergence is also manifest in the inflation trends with the Core nations showing stronger inflation than the Periphery.

ECB Executive Board member Sabine Lautenschlaeger signalled that her group will not be putting any pressure on her Governing Council colleagues to second guess the data. Whilst she believes that the normalisation should be the next step, she sets a pre-condition which gives the Governing Council greater flexibility on when to raise interest rates. Her pre-condition is that the inflation trend must be sustainable. Sustainable is in the eye of the Governing Council. It should be noted that Mario Draghi and many of the Governing Council members believe that inflation is only being sustained by QE itself. Lautenschlaeger has thus provided them with means to execute the normalisation or not at their own total discretion.

Governing Council member Ewald Nowotny mirrored the flexibility framed by Lautenschlaeger. Following Lautenschlaeger’s framing, he opined equivocally that whilst on the one hand he supports a faster normalisation, on the other hand he sees no harm to the Eurozone economy being caused by a continued period of low interest rates.

Taking no chances, the ECB covered the data base by releasing information that framed the balanced risk scenario perfectly. In its latest economic bulletin, the ECB reported that whilst pay rises are working through the economy this is largely being offset by productivity gains. The report also covered the Core versus Periphery divergence debate. Consumption patterns are also diverging, with Core Eurozone recovery far outpacing the Periphery. The report thus frames the risks as broadly balanced, thus giving the ECB further flexibility.

In the last report, Italy was noted as enacting a counter-cyclical fiscal stimulus that will bust its proscribed Stability Pact deficits even further. Simultaneously, the Italian leadership was making Populist noises about revisiting Eurozone membership, whilst immigrant trashing with President Trump and supporting Britain’s Brexit position. This Populist positioning is however only a negotiating tactic.

Having played bad cop, Italy then played good cop through its finance minister Giovanni Tria. Mr Tria embraced Emmanuel Macron’s vision for a more deeply integrated Eurozone economy. Subsequently, he confirmed that Italian growth will ease next year, widening the fiscal deficit.

Italian deputy prime minister Di Maiao then totally ran circles around his EU deficit overseers, by claiming that Italy’s fiscal stimulus will not break the Stability Pact cap. He then criticised the EU for seeking to hold back the Italian Stability Pact compliant plans by falsely claiming that they break limits.

There are apparently no limits on the mendacity of Italian negotiating tactics. The recent fatal bridge collapse in Genoa has been presented as an example of the danger of EU fiscal spending limits. Ironically, the Populists who blame the EU for the disaster were the ones who originally did not want to see funds spent on infrastructure before the bridge collapsed.

Having seen Mario Draghi capitulate by offering to “do whatever it takes” to save the Euro and the Eurozone, the Italian Populists think that they are onto a winner. The Northern League have thus returned to “do whatever it takes” redux tactics by opining that, unless the ECB caps rising Italian yields, a similar fate awaits the Eurozone and its currency.

The hope for Italy is that its expanded fiscal deficit will get shared across the Eurozone in Macron’s vision. If this cannot be achieved in the short-term, then at least the ECB will oblige by increasing its Italian bond purchases. The capital risk to the ECB will then militate strongly for the sharing of Italian risk out amongst the Eurozone nations. More money for Italy would then see the Populist government embrace more immigration and “swindle” Britain on the Brexit deal.

Goldman sees this economic and political singularity in Italy as an elevated and rising probability. It envisages that the Italian banks will end their practice, of being lender of first and last resort to the Italian government, at a time when the Populists wish to expand fiscal spending further. The blowout in Italian yield spreads will then be potentially an event of greater significance than seen when the Greeks defaulted.

Since this Italian endgame is being opined and discounted well in advance of the event itself, it will not come as surprise to Eurozone policy makers. In effect its impact can now be mitigated as the ECB and EU policymakers get their contingencies in place. As it also coincides, with the Brexit and worsening global Trade War environment, one may also assume that policy makers are going to be more pro-active in dealing with it.

The pro-active solutions will be based upon abundant ECB liquidity and a counter-cyclical fiscal expansion at national and EU level. Evidently, the Italian Populists have gamed this out in advance; and expect to come out the other end of this tunnel with their position strengthened. The Euro will come under pressure as the barometer of the easier fiscal and monetary policy outcomes of this political crisis. A weaker Euro will thus be the safety valve in which the global dislocation of this event is accommodated in the short term. History shows that, once the “do whatever it takes” medicine has been taken, there is a floor under the Euro from which it can strengthen again to discount the Eurozone’s salvation.

(Source: Seeking Alpha)

Spain, until now the Eurozone poster-child of structural economic reform in the face of Populist challenges, is starting to flash red light signals again. The Bank of Spain reports that consumer credit jumped 4.5% alone in the month of June. Credit rose 17% year-over-year in 2017 to give some idea of the growing problem. One hundred per cent mortgages are common once again. Previous reports have noted the Spanish banks’ reluctance to pay back emergency ECB funding TLTRO’s to the ECB. Evidently, this emergency funding has been used to fund the riskier kind of mortgages that then beget further emergency funding from the ECB, when the economy slows down. Moral hazard enabled by the ECB has thus found its way back into the Spanish banking system. This can now be added to the festering pile of NPL’s in the Italian banking system.

(Source: Seeking Alpha)

The last report observed that the ECB maybe preparing for Operation Twist to extend the duration of the assets on its balance sheet. The Italian Populists are clearly eyeing the potential future Twist as an opportunity to place some sovereign debt, now that Italy’s commercial banks can no longer warehouse it.

(Source: Reuters)

The delayed reporting of ECB QE purchase activity now reveals that in fact whilst the ECB was allegedly considering Twisting it was actually doing it in practice. The ECB has in fact been switching the makeup of its current QE purchases into longer duration securities for some time now. This is starting to look like the ECB is kicking the moral hazard problems from Spain and Italy down the road. Who would criticise the ECB for doing so however, given that the Brexit and its shockwaves could trigger a credit crisis in which all these problems unravel. Looked at more closely, the ECB Twist is also starting to resemble stealth Brexit preparation as the odds of no deal rise.

As economic growth diverges across the Eurozone, the ECB will be nudged to “do whatever it takes” again for Southern Europe. This directive will be given greater urgency by the negative consequences that this divergent performance will have on the banking sector in these countries, currently struggling with their own non-performing loan (NPL) issues. These problems are currently being exacerbated by President Trump’s stand-off with Turkey. Brexit will add another layer of risk and uncertainty to the situation. All these challenges can be framed within the larger challenge of trade protectionism. The ECB therefore has no shortage of reasons to Twist.

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.