The ECB Trusts The Process And Ignores Some Potential Outcomes, By Being 'Very Gradual'

by: Adam Whitehead


The ECB Governing Council has got its QE-end blinkers on.

The Twist may mitigate the negative consequences of monetary policy normalization.

Core versus Periphery divergence is getting greater traction and attention.

The “Frexit” from Core story has become “a tale of two reforms” and German expansion.

The ECB is hiding behind the Phillips curve to advance its own “very gradual” agenda for deeper economic integration through a market solution to banking union.

The ECB is officially in QE-end mode, to the exclusion of all else by the look of things. The process will follow the afore-mentioned outline of ECB Chief Economist Peter Praet, whereby balance sheet expansion is stopped first, then followed by interest rate increases. Such faith in the process, over debate and analysis of its potential future outcomes, evinces a strong centrality of commitment to the process. Will this commitment stand the test of time, in the face of a worrying softening in the Eurozone and global economies, however? As the Russian proverb advises, one should “trust but verify.” The ECB appears to be blinkered, however. If it won’t test its convictions then the markets will.

The last report observed that the ECB is Twisting, by extending the duration of the assets it holds on its balance sheet. This policy stance does not officially conflict with the signal to end QE this year, even though it does effectively kick the can down the road to mitigate the growing headwinds on the ECB’s radar screen. On balance, the Twist is an offsetting risk mitigation tactic; to deal with the potentially negative consequences of normalizing monetary policy through 2019.

The Twist tactics are also consistent with the message from the recently released minutes of the last ECB Governing Council meeting. The minutes showed that there is a consensus that the economic recovery has momentum which faces the growing challenges from trade wars and protectionism. The consensus also extends to the belief that a substantial monetary stimulus must remain in the system even after QE ends. The commitment to Twist therefore allows QE to end this year, whilst creating a buffer of liquidity in the system to kick the various growing risk cans down the road.

The Bundesbank signaled compliance with the ECB’s Twist in its latest assessment of the state of the German economy. The German central bank acknowledges the H2/2018 economic softening, yet remains reluctant to go all-in on putting the normalization on pause. The German economy is referred to as “sound,” although exactly whether this is the sound of a half-full or half-empty vessel remains unreported.

With one eye on the soon to be ECB President vacancy, Jens Weidmann was even more transparent and compliant than his Bundesbank colleagues. Unfortunately for his candidacy, Chancellor Merkel is ready to trade the ECB presidency for the more politically influential European Commission presidency position. Merkel’s only caveats are that the new ECB President should be capable of communicating and delivering on a credible commitment to end QE this year. Weidmann is, however, clearly on board with the view that despite all the hype about QE ending this year, ECB monetary policy is still going to remain highly accommodative.

(Source: Seeking Alpha)

The last report noted the divergence in economic performance between the Eurozone Core and Periphery.

(Source: IHS Markit)

This divergence is now showing up in the numbers and also the specific commentary on Eurozone PMIs.

The latest growth and inflation data out of the Eurozone, provide some granular nuance to this observation. The divergence is more a case of the Periphery leading the Core lower in terms of growth and inflation. Resilience in the Core is preventing it from converging lower on the Periphery. Both Core and Periphery are however softening, with the latter leading the way and outpacing the former.

Jens Weidmann’s latest commentary directly addressed the outcome from this continuing nuanced divergence and the monetary policy accommodation that it necessitates. He identified national imbalances and the macrostability risks that these represent as taking precedence over the ECB’s traditional mandate to deal with inflation. In his view, the ECB must be ready to act on this risk; even though it is a matter for national governments and regulatory agencies.

In Weidmann’s opinion, even though now is the time to end QE, this process will be expedited gradually. His analysis is, therefore, consistent with mitigating the growing political and economic headwinds by Twisting.

The last report also noted the game being played by Italy, to leverage the market threat from its expanding fiscal deficit, into a Populist threat to quit the Eurozone thereby dissolving it. The objective is for the EU to share Italy’s widening deficit, or failing that for the ECB to Twist into longer dated Italian government bonds. Cabinet Undersecretary Giancarlo Giorgetti recently confirmed that this is indeed Italy’s strategy, with his demands that the ECB extends QE purchases of Italian bonds to kill off the speculators.

(Source: Daily Shot)

In relation to the divergence, in economic performance between the Core and Periphery, France signaled that it may become a laggard within the Core. French consumption is now shrinking at a rate even worse than at the height of the Credit Crunch. Prime Minister Edouard Philippe recently set out the nation’s 2019 budget. This will be predicated upon a subdued forecast of just 1.7% GDP growth. The warning signal was boosted by Finance Minister Bruno Le Maire. This signal was then triangulated by Bank of France Deputy Governor Sylvie Goulard, who opined that she expects future growth to be slower. Emmanuel Macron’s economic reforms are the main driver of this subdued economic performance, by nature of their negative impact on fiscal stimulus. Macron and his confederates would argue that French under-performance is in fact because his reforms have not gone far enough. French political and economic debate will thus get polarized as these two competing views fight for acceptance by the polity.

The deteriorating French fiscal position, despite economic reforms, is a growing cause for concern. The French economic model is evidently predicated upon and driven by fiscal spending and support. This should be contrasted with the recent commentary from German Finance Minister Olaf Scholz. Scholz is expecting a fiscal surplus and debt to fall to about 60% of GDP; as the German economy goes from strength to strength. The German Finance Ministry reported that it expects the economy to strengthen in H2, despite all the headwinds. This seems likes wishful thinking, as there are clear signs in the data that Germany is feeling some contagion. Compared to France, however, the German economy is much more resilient. It is also self-financing, which is something much more critically important.

In France, on the other hand, President Macron’s popularity and hence support for his reforms are falling precipitously. He now polls worse than former President Hollande at the same stage in their presidential terms. The under-performance of the French economy, relative to Germany, may ultimately undermine President Macron’s bid to dominate the policy-making agenda for the Eurozone. France is gradually exiting the Core. This exit is gaining momentum as President Macron’s halo slips. As President Macron’s halo and popularity slip further, his Labour Minister Muriel Penicaud called for patience. She now estimates that it will take two years for Macron’s reforms to work.

It is unlikely that Macron will be given this much time. This time-frame could be looked at as the duration of the “Frexit” from Core and/or Macron’s exit from the Elysees. “Frexit” from Core is far more destabilizing, than anything the Italians can threaten or even the “Brexit” can deliver. Combining all three events, however, is a noble cause for whoever replaces Mario Draghi to “do whatever it takes” again.

The Bank of France recently signaled that it is even more pessimistic than the Finance Ministry with lowered growth and inflation projections. Hoping not to break with its support for the Government, Bank of France President Francois Villeroy de Galhau attributed the weakened forecasts to the fact that France “is still lagging on reforms.” His further act of solidarity was his conciliatory glass half-full award that the French economy is doing better than its historical trend. This says nothing good about France’s abysmal past more than it says about the future. France’s political and economic future look set to degenerate into conflict and stagnation respectively. Germany will expand into the vacuum created by this French implosion at the Eurozone level. Or at least it thinks that it will.

Italy, seeking to leverage its indebtedness, will have noted this Franco-German divergence; and will support Macron in the hope that fiscal limits are waived by the French in pursuit of growth.

Germany will use this period of French under-performance as an opportunity to expand its influence throughout the Eurozone. Chancellor Merkel has already signaled these intentions and capabilities, by offering to sacrifice influence at the ECB for greater influence in the European Commission. The Germans have also adopted the tactic of supporting candidates from the smaller (and hence politically weaker) nations such as Ireland for the top EU policy-making jobs that they are not directly interested in. German influence is strengthened whilst French influence is diluted through these tactics. Said weaker nation officials are effectively sock-puppets for German puppeteers. Germany thus governs and/or rules by proxy, whilst retaining the image of being non-interventionist as per the rules and regulations post-Nuremberg. Looks can be deceiving and things will feel very different in practice, perhaps even reminiscent of things pre-Nuremberg, however. President Trump wouldn’t have it any other way and neither would President Putin. There is thus an inevitability about it all.

Germany’s Eurozone ambitions are conditioned by its own internal Populist threats. Bundesbank President Jens Weidmann set the limits on which German’s may be interested in financing a common European budget. Needless to say this limit sets the conditions which are the antithesis of Italian Populists yet the thesis of German Populists. Said conditions demand structural economic reforms in the deficit countries which will effectively receive fiscal transfers from the stronger nations.

German taxpayers are unlikely to support wealth transfers to Italy and the rest of Southern Europe, without reform conditions attached. They will, however, be easily bought off with a German domestic fiscal expansion. The surplus conditions in German finances can enable this. This will then propel the German economy to drive the surrounding Eurozone. German economic influence can then be leveraged into political influence.

Starting off cautiously, Chancellor Merkel set out Germany’s budget targets for 2019. She deliberately avoided the creation of a deficit, so as not to allow Germany’s Eurozone trade partners any fiscal wiggle room themselves. Having set the fiscally neutral agenda, she then committed to investment projects that will create jobs and productivity driven economic growth. If this fails to inspire German voters, she can then default to the traditional method of buying solidarity with tax cuts, since she will have a balanced budget to start from. The growing specter of a full blown trade war with America will also help to loosen the German fiscal purse strings. This may extend to fiscal stimulating of Eurozone export markets for German goods also. Tax transfers from Germany to Periphery, thus return back to Germany as an even larger trade surplus.

Rather than running deficits to retain its global control and hegemony, as America has done since World War II, Germany intends to achieve this through surpluses. President Trump has wised up to this strategy and intends to have a crack at it through tariffs, rather than balancing his own fiscal books. The contest should make interesting viewing.

ECB Governing Council member Klaas Knot articulated the Dutch view of deeper Eurozone economic union, specifically in relation to banking union. His view resonates with that of Weidmann and thus supports the thesis that the Core is trying to set the Eurozone economic agenda.

Knot does not foresee full banking union until the current risks in the banking system have been significantly reduced. What this means in practice, is that sovereign nations must deal with their own banking sector non-performing loan (NPL) issues first. Evidently, Dutch taxpayers aren’t willing to share the burden of bailout risk with their neighbors either.

There are signs that the ECB may wish to promote a practical solution, which acts as a stepping stone on the way to banking union. Olli Rehn recently opined this solution, in the form of a common deposit insurance scheme. This would have the merit, of creating a single Eurozone baseline standard, as the first step in subsuming national banking rules. This solution would also have the benefit of setting a gross financial value to the level of risk associated with Eurozone consumer banking sector risk. From this baseline, banks could then be ranked, by their ability to cover their deposit bases. From there, share prices and credit ratings could then be adjusted to reflect this risk. Having established this methodology, it would then be a simple step to next make weak banks either raise equity capital to cover their risks or consolidate through mergers and acquisitions.

ECB Governing Council member Ewald Nowotny does not believe that the Southern European economies are leading the Eurozone lower. On the contrary, he believes that the Northern European economies are growing and leaving the Southern economies behind. On the subject of Italy he acknowledges what he calls “more or less stagnation,” but sees this as an isolated incident created by Populism. Since Italy is an isolated and political case to him, he will not condone any monetary policy easing to support the Italian economy. He may have worked out and may therefore be signalling that a German fiscal stimulus is just around the corner.

ECB Vice President Luis de Guindos, a Southern European native by birth and Core European by practice, will have none of either these slowing growth or divergent trend signals. Speaking for the first time as ECB Vice President, in his native Spain, he opined that in fact the ECB is becoming more confident in its positive growth and rising inflation forecasts.

ECB Executive Board member Yves Mersch reminded his colleagues and all Eurozone policymakers exactly where the central bank legally stands, in relation to the grey zone of monetary policy and fiscal policy overlap in the name of macrostability. He reminded all concerned that, from a strict legal mandate and hence governance perspective, the inflation - ECB’s target - is the only legitimate directive for the ECB. Financial stability comes second. By inference therefore, he and the Executive Board will not tolerate the Governing Council enabling the breaking of fiscal guidelines through the purchase of indebted sovereign bonds in the name of financial stability.

As always Mario Draghi had the last word on guidance, at his press conference after the ECB left policy unchanged. Evidently Draghi is committed to the prior-signaled end of QE. This conviction is stronger than his own acknowledgement that things are slowing down in the Eurozone. In order to maintain this conviction, he noted that whilst growth has now been forecast slightly lower, the Phillips curve will assert itself as the Eurozone economy mops up further pockets of excess capacity going forward.

The Q’s in the Q and A session revealed further that the Governing Council in fact debated and/or discussed very little about what it will do in 2019. Mr. Market will therefore feel obliged to fill in the blanks that remain unanswered with price action; through which the Governing Council will then discover if it has correctly been economical with its decision making and related communication.

What was notable in Draghi’s commentary was his signal to his fellow countrymen that he will not come to their assistance by monetizing their expanding fiscal deficit any more than he is currently doing under the current QE umbrella sovereign bond purchases. Mr. Market may therefore infer that he can initially continue to be a Bond Vigilante with Italian bonds. Should the ECB press on with its normalization, Mr. Market may then use the widening Italian yield spread to probe the ECB’s centrality of commitment to “do whatever it takes” again if the cracks in the Eurozone widen further.

Also notable in Draghi’s commentary was his fear for the impact of ECB normalization on the shadow financing market in the Eurozone. By choosing to alert regulators to tighten up their scrutiny and governance of these shadow markets, he was in effect signalling that he is about to test them with a withdrawal of liquidity. He was also confirming Nowotny’s warning that macrostability is not the ECB’s priority. In fact, he may have been signalling that the ECB intends this macro-instability as the basis of a market solution to the problems in the banking system. The normalization and the tantrum it creates in the financial sector can thus serve as a catalyst for the banking consolidation that is a prerequisite for deeper economic union. Just like the Germans, the ECB also likes to play big games with the Eurozone.

Just like the Fed, the ECB has signaled that it will hide behind the mantra of “when in doubt apply the Phillips curve.” If the economic softness, however, creates greater pockets of excess capacity, then the ECB will have to apply said Phillips curve dogma to justify easier monetary policy. Draghi is gambling that the Twist and the legacy of abundant liquidity it creates at the long end of the bond markets will keep the excess capacity from growing in the long run.

Convictions get tested, as does the centrality of commitment of central banks to their guidance going forward. Perhaps in anticipation of the test to come, Governing Council member Jan Smets framed Draghi’s commentary as implying that “we (the Governing Council) do foresee a very gradual process of policy normalization.”

Smets also sees the risks to financial stability from the ECB continuing with its already prolonged period of easy monetary policy. If he is correct in his assumptions that growth and inflation will make steady progress, then the stability risk will become greater if monetary policy is not normalized. There is therefore very little more to be gained and substantially more to be lost by maintaining easy monetary policy going forward. Smets also confirms the thesis that the ECB intends to trigger deeper economic union through banking consolidation.

So now it’s just a matter of how gradual is “very gradual.” Chairman Powell has utilized the slow growth and inflation dynamics in America, to create flexibility and time to be both right and/or wrong with the normalization. The ECB is finessing this technique. The problem for the ECB is that growth and inflation may be slowing. Even “very gradual” can then appear to be ahead of the curve, from time to time, as the ECB’s centrality of commitment comes into question. The reader should also remember that every cloud has a silver lining. By testing the ECB’s centrality of commitment, through the conditions of a Taper Tantrum, the exact conditions for banking consolidation and deeper economic union are being created.

This kind of happy accident unfortunately cannot also be said of a “Frexit” from Core though. “Frexit” from Core, however, gives the ECB the chance to “do whatever it takes” again.

Discounting these risks and opportunities is what makes trading the Eurozone such fun! This should be done “very gradually” to minimize risk and maximize reward in sync with the policy-making fundamentals.

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.