Candide Jaune: A Whodunit By Mario Draghi

Adam Whitehead profile picture
Adam Whitehead


  • Despite alleged unanimity about ending QE, the ECB Governing Council members mistrust and diverge from each other.
  • The ECB “projects” that monetary policy will be on hold until it eases again circa 2021.
  • The Eurozone and the ECB Governing Council members are diverging along traditional geopolitical fault lines.
  • ECB financial stability policy is now by default everywhere a monetary policy phenomenon.
  • The New Capital Key is the catalyst and driver of deeper economic integration.

Instead of celebrating yet another Eurozone milestone, the ECB and European Project managers prepared for the next milestone. They did so by following the traditional strategy of creating a crisis for which they have the solution. Also as usual Useful Idiots, this time wearing Yellow Jackets, were on hand to politically enable the solution and to be conveniently blamed.

On the 20th anniversary, of the Eurozone’s single currency, there was no street party. There were in fact riots in the streets of Paris. The ECB had intended to celebrate with the ceremonial ending, of the unconventional monetary policy known as QE. In the end, the celebration was a low key affair in fear of provoking and triggering even more popular dissent across the Eurozone. The champagne may in fact have to stay on ice as economic conditions deteriorate further, as the end of QE turns out to be a swift pause that refreshed no one.

Ever the optimist, ECB President Mario Draghi chose the anniversary moment to pause for “candid” reflection. Upon reflection, he found that the single currency has been a “success” but not necessarily for all members of the Eurozone polity. On further reflection, he may also note that QE has not been a qualified success for the same members of the Eurozone polity either.

Going forward EU and ECB policymakers may have to come out of their ivory towers, voluntarily or by force, in order to pay closer attention to the democratic processes and national institutions that their own shaky transitive undemocratic structures are built upon. Before he became candidly reflective, Draghi had advised Eurozone policymakers and its peoples to “trust and converge”. This advice has been ignored, to the extent that it has become a process of mistrust and diverge.

The democratic deficit gap facing Eurozone politicians and the ECB is therefore widening once again. It should be understood that simply expanding fiscal and monetary policy may not address this democratic deficit, since there are some nations that desire economic reform rather than more fiscal and monetary stimulus. “Doing whatever it takes”, to save the Eurozone this time around, will have to be a more nuanced undertaking than previous semi-successful initiatives.

(Source: IHS Markit)

Less optimistically, yet more realistically, Draghi’s reflection upon the balance of risks facing the Eurozone is pessimistic. He equivocally characterizes the economic situation as one of "continuing confidence with increasing caution". From this, it can be inferred that whilst QE may be ending, ECB balance sheet shrinkage and interest rate increases will be a very leisurely affair. The start of alleged planned balance sheet shrinkage has thus already been extended from three months to one year.

Speaking after the latest ECB unchanged policy decision, Governing Council member Francoise Villeroy de Galhau confirmed that the end of QE bond purchases is not in fact the end of QE per se. Despite this contradiction, he opined that it is justified because “monetary policy is credible, but it remains flexible in the face of uncertainty.” The form of guidance known as the leak also informed that, despite the unanimous policy decision, some Governing Council members fearfully wanted to sound more Dovish than flexible.

These leaks also lead to the unavoidable conclusion that the Governing Council itself is also plagued by the mistrust and diverge affliction. The “trust and converge” frame of reference in the unanimous vote to end QE has therefore lost its halo effect. As soon as Villeroy had finished speaking, his Governing Council colleagues then swiftly interjected with their own frames of reference. These interjections reinforced the sense of mistrust and diverge.

This Governing Council divergence is one that follows geographical lines delineating the zones of Core, Baltic and Southern Europe. The speed with which the Governing Council members dissociated from each other simply reflects the degree of diverse political opinion that they face within their respective countries.

(Source: Seeking Alpha)

ECB Vice President Luis de Guindos is on the fence in the debate, but his center of gravity tips towards the Dovish side. He takes his baseline back to, before the latest Governing Council meeting, when Draghi pivoted and introduced what he termed “optionality” into the ECB’s toolbox. Thickening this baseline, de Guindos opined that “optionality” should be kept to the “maximum level”. Currently, he and the Eurozone are in what he alleges to be a “dark room” stumbling around and fumbling around for some clarity.

On the fence, but leaning in the opposite direction to de Guindos, is Ewald Nowotny. He currently sees risks as balanced, but if pushed sees inflation risk rising beyond the rest. At the very least, he expects to move NIRP back ZIRP in 2019.

Sitting on the fence, but capable and willing to go either way depending on data and events is Vitas Vasiliauskas. Whilst hyping up what he referred to as the Governing Councils “unanimous assessment” of economic conditions, he was clear to say that this could change and hence with it his own opinion.

Pablo Hernandez de Cos is already off the fence, on the Southern European Dovish side, tugging away at his fellow countrymen de Guindos. For de Cos, unconventional monetary policy “is here to stay”. This implies that the end of QE is in fact just a temporary pause in the big scheme of things.

Incoming Belgian Governing Council member Pierre Wunsch sat on the Fence and said that the ECB will be flexible in 2019. He also said that there is room to stall interest rate increases if the data demands this. Wunsch would be joined on the crowded fence by Governing Council member Jozef Makuch, who claims to be similarly data dependent about interest rate increases, had Makuch not been leaving this year.

Those on the fence or even leaning on the Dovish side will have noted with some measure of unease, that wage inflation for those in the Eurozone with jobs is rising steadily. At the latest measure Labor Costs are running at 2.5% Y-O-Y and Eurozone Wages just jumped to a 2.4% Y-O-Y reading. If there ever was a data set to affirm the decision of the ECB to end QE then surely this is it.

Mario Draghi should be cheering this data and taking credit for it. The Hawks should be talking this data up, but they are ominously silent. Instead, Draghi chooses to totally ignore it because it does not fit his current script for pausing the normalization. Those leaning on the Hawkish side of the fence have been silent about this data, which is even more telling. Evidently, there is a collective sense of pessimism pervading all those on the fence and also on both sides of it.

(Source: ECB)

The key to the pervasive pessimism is evident in the latest ECB staff projections for growth and inflation, which accompanied the latest Governing Council decision. Having accredited the lack of growth to new auto-sector emission regulations, the ECB staffers then erase this alleged cause totally from memory as the alleged bounce back from auto production never materializes.

In fact, nothing happens to growth and inflation between now and 2021. After 2021, there is no visibility at all. One could therefore easily conclude that the Governing Council is on the fence doing nothing with interest rates until the end of 2021 (or maybe sooner), at which point it starts easing monetary policy again. ECB staff projections of the past have been miserable reading, but they have also proved to be unerringly correct.

(Source: ECB)

A further note of pessimism should be read into the ECB’s communication on what it nebulously calls “the technical parameters for the reinvestment of its asset purchase programme”. This communication was quietly inserted into the raft of communications with the latest Governing Council decision.

(Source: Seeking Alpha)

Drilling down through the communication, it can be seen how the new Capital Key will be applied to the QE reinvestment process.

As detailed in the last report, this new formulation means that Spain, Italy and France will have net ECB balance sheet divestment as a result of being previously overbought during the QE sovereign bond purchase process. Monetary policy is therefore being tightened in these three countries via the Capital Key. It is common knowledge that Italy and France wish to boost their fiscal deficits. Less well known is the fact that Spain’s public debt grew to approximately 98% of GDP in Q3. All three nations are now in conflict with EU policy on fiscal budgets. Just as they need the ECB to cap their bond yields, the new Capital Key forces the ECB to actually boost them in these three countries.

What of the ECB’s corporate bond purchases and reinvestment under the new Capital Key? In relation to the ECB’s corporate bond purchases, equity market capitalization will guide the weightings of QE proceeds’ reinvestment. The larger capitalized companies will thus continue to have liquidity thrown at them, but smaller cap companies will have their funding choked off.

Since the ECB has tightened monetary policy in Spain, Italy and France companies in these countries will have the market capitalization of their listed companies adversely impacted. Said companies will then have liquidity tightened, in a second round impact from the corporate bond reinvestment program reduction based on their cap weightings.

What one can discern occurring is the systematic creation of a negatively reinforcing death cycle loop, from the sovereign bond purchase transmission mechanism into the corporate bond buying program. Weakened Eurozone companies will then reduce the GDP of their countries, which will then lead to a further reduction of the sovereign bond Capital Key support for their economies. This sovereign bond Capital Key support reduction will then ignite new round of equity market recapitalization. And so on and so on….

The drama does not end there. The ECB has also issued a Capital Key edict on covered bonds. Covered bonds that could not redeem at par, will in some circumstances have a “conditional pass through structure”(CPT). Bonds with a CPT are effectively able to kick the final principal payment down the road in the form of a new bond maturity. Going forward, the ECB won’t be buying any more covered bonds with the CPT feature. Continuing with the 'and so on and so on' train of thought from the previous paragraph, one can see that liquidity in the already distressed covered bond markets of Spain, Italy and France has also been tightened. This will knock-on to the health and market capitalizations of listed companies and their respected economies.

The new Capital Key is a slow acting Cyanide pill for the economies of Spain, Italy and France.

In summation, therefore, the change in the Capital Key has significantly tightened monetary policy in Spain, Italy and France already. In addition to ECB end of QE headwinds in these three countries, there are also growing political headwinds. The political headwinds have already impacted GDP in these countries. Walking the impact of this politically induced slowdown, through the ECB’s Capital Key will effectively amplify the headwind through the negative feedback loop explained above. No wonder the ECB staff projections are so pessimistic! The ECB may have to start easing well before the end of 2021 in this case.

The implied solution from the new Capital Key at the corporate level is for the small capitalized companies to scale up. They can do this through M&A. The other solution is for the large companies to simply buy the small ones. The reader should discern an implicit driver for deeper economic integration through this M&A process, which logically will transcend borders. The new Capital Key should therefore be understood strategically as the catalyst and driver of deeper economic integration. This should be noted as a private capital solution to the fundamental obstacles to deeper fiscally driven economic integration. In effect, fiscal bailouts are being replaced through cross-border business mergers. Only time will tell if this thesis is correct.

Governing Council member Ewald Nowotny signaled that he does not think that this proxy-tightening by Capital Key has gone far enough. Speaking after the latest monetary policy decision, he lamented the fact that the ECB will still be buying corporate bonds even with the tighter Capital Key guidelines. He would much rather reinvest in sovereign debt, which immediately precludes support for Spain, Italy and France at source.

France has become the most noteworthy Eurozone country to directly conflict with Mario Draghi’s trusting convergence advice. The Gilets Jaunes are now forcing France to break Eurozone deficit limits by gaining concessions from Macron. France is thus in the line of fire of this Capital Key negative feedback loop. In response to the protests, the Bank of France has forced the ECB to take a closer interest in French political issues. The French central bank recently slashed its GDP forecast and blamed this on the recent political unrest.

The ECB will have no choice other than to revise lower its own GDP forecasts for the whole Eurozone in response to the incoming French data. This will then have to be factored into Governing Council monetary policy behavior. By the OECD’s estimation, the French government has the highest tax take in the world. The discussion currently ongoing at street level should therefore be more constructively engaged in since it is clearly apposite.

(Source: Seeking Alpha)

The signs are that the Yellow Jackets are swiftly returning the French economy back to the low-productivity trajectory that it was on before Macron and his reforms were elected into office. The President’s capitulation and the raising of the minimum wage signal this return. Apparently, the Yellow Jackets will not compromise, so further humiliating concessions look set to be offered to them. Macron’s credentials to lead Eurozone integration, underpinned by a reform agenda are in tatters, as is momentum for this project. His partnership with Germany in reforming and integrating the Eurozone is over. He is now in political survival mode.

France may in fact soon find itself in conflict with the EU over its budget, if Macron’s concessions expand the deficit beyond already agreed to cuts. With classic Gallic arrogance, reflecting the entitled beliefs of the Yellow Jackets manifested as French global exceptionalism, Prime Minister Edouard Philippe casually informed his Eurozone colleagues that the deficit will be expanded beyond Stability Pact limits. The words fait accompli are after all a French invention.

Acting as spokesman for the European Commission, Valdis Dombrovskis warned that France’s finances will be scrutinized carefully going forward. The last report noted the German initiative of creating a Two-Tiered Eurozone fiscal system. France is currently headed for the Second Tier. The emotional political response of wounded French pride at being relegated may then swiftly lead to Frexit. At this point German discretion, being the better part of valor may then shelve the plans for the Two-Tiered Champions League system.

In any case, the ECB’s new Capital Key has created the ultimate economic solution to the French issue. All the Germans have to do is sit on their cash and wait to buy up French companies when there is real blood on the streets!

A similar fate ultimately awaits the current Italian flirtation with Populism. The latest Italian banking data reported that Italian banks continued to fire-sell bad debts and pass on the Italian yield premium to new borrowers. At the same time, they experience restricted funding opportunities and higher costs when funding is available. In the absence of some fiscal leeway from Brussels, the current Italian recession in its infancy will mature rapidly as the banks tighten monetary conditions in the real economy. Apply the new Capital Key to this situation and a similar outcome is inevitable.

It should be said, that Germany will not have things handed it to it on a plate. Economic weakness in its neighbors will weaken Germany. The difference is that German is starting off in fiscal surplus. It can therefore rely on the ECB’s balance sheet to fund its acquisition of its neighbors and their industries.

German policymakers continue to gradually ratchet down their economic forecasts. The German government has now officially lowered its GDP forecast to 1.6% from 1.8% for this year. This declining outlook may also be increasingly influenced by the deteriorating Brexit situation. Simultaneously, the German BDI industry association has told its members to prepare for a Hard Brexit outcome.

To its credit, the Bundesbank did not avoid the elephant in the room, of the missing auto-sector recovery, as its colleagues at the ECB did. With refreshing candor, the German central bank said that the auto-sector recovery is challenged by the deteriorating political and economic situation. The auto-sector recovery predicated on a recovery in orders for greener vehicles will thus now take longer.

It should be noted that the re-balanced Capital Key potentially eases monetary policy in Germany, just when the German economy is weakening. The reason that this monetary easing is potential is because the German fiscal balance is currently in surplus. Were Germany to fiscally stimulate its slowing economy through federal borrowing, then the ECB could translate this into a further monetary policy easing by buying more German bonds. Germany is thus in a position to receive both a counter-cyclical fiscal and monetary stimulus in 2019. Germans will no doubt use this, to illustrate the wisdom of German counter-cyclical fiscal adjustments in the good times, as a reason for other Eurozone economies to converge on its fiscal strategy.

(Source: Seeking Alpha)

The last report observed the attempts of the ECB to raise the role of financial stability policy, as a proxy form of monetary policy. ECB bank supervisor Ignazio Angeloni recently gave this process a little nudge further towards execution. He did this by acting like a fire-starter.

Speaking before Christmas in London, Angeloni opined that Eurozone macro-prudential regulators lacked the requisite legal authority to increase, the counter-cyclical capital buffers required for the next crisis, in the current economic expansion. Angeloni was presumably making the case for said authority to be mandated. Alternatively, he can be seen as creating the conditions for the new Capital Key endgame, to deliver deeper economic integration followed by a wave of further ECB liquidity.

Since the Eurozone is slowing and the political momentum to grant such macro-prudential powers is currently waning, Angeloni has highlighted a serious systemic risk in the Eurozone financial system. The only tool available to deal with this risk is therefore unconventional monetary policy at the present time. Should the ECB fail to raise interest rates in 2019, then unconventional monetary policy will be all that there is in the medium to long-term also.

But as we know from the last report, the ECB cannot buy the bonds of the nations most plagued with divergence risk by nature of the new Capital Key. A singularity has thus occurred where macro-prudential policy is unavailable, as is conventional monetary policy as is expanded current QE unconventional monetary policy. A real adjustment, such as the creation of a Two-Tiered Eurozone, is thus an elevated and rising probability. In the Second Tier will then be found all the nations and companies who have been ostracized by the ECB’s new Capital Key. At this point, deeper economic integration aka the Great Consolidation can occur.

Something has to give and Mr Market must taste blood. The highest probability is that the Euro will get hit, probably causing the Fed to stop normalizing and start easing again. In either case, the ECB will not raise interest rates; also Draghi and his successor will then “do whatever it takes” to solve a problem that they have created.

After Angeloni played his financial stability card, the Germans played theirs. The German Financial Stability Council, of regulators and central bankers, has noted the initiatives underway to ease monetary policy again in the name of stability. In an attempt to head this policy drift off, the Germans have warned that financial stability in Germany is at heightened levels as a result of interest rates being too low for too long. Any attempts to use monetary policy as the blunt solution to stability issues in 2019 is going to meet some resistance from Germany. Said resistance only makes the crisis look worse and the fire-sale prices of target acquisitions get cheaper.

German Finance Minister Olaf Scholz has foretold that the good old days of German fiscal surplus are over, thanks in great part to the global slowdown. Germany is thus moving to a point at which it will consider a fiscal stimulus. This consideration will be tempered by the news that it is likely to require deficit financing. No doubt, any fiscal stimulus will be matched with edicts on economic reform to go with it. Germany will no doubt also try and attach these conditions to any Eurozone fiscal stimulus being contemplated by its neighbors. As the Eurozone and German economy slow, however, the calls for deficit financing will grow and the ECB’s balance sheet will offer some cheap LBO terms.

(Source: Seeking Alpha)

The unfolding economic and political crisis and its impact, on the ability of the ECB complete its communicated normalization promise on schedule, is a matter of growing concern for the Procrastinator aka Governing Council member Olli Rehn. In fact, Rehn’s procrastination is a symptom of this growing problem. In an attempt to institutionalize a formal policy response, rather than continuing to shoot from the hip as Mario Draghi has done, Rehn is calling for change. This change would begin with a full-blown review of the ECB’s monetary policy framework.

(Source: Seeking Alpha)

Such a review as Rehn desires would take time. It would also directly call for monetary policy to be placed on hold until the review was concluded and a new formal policy framework ratified by the EU. Rehn is thus calling for his procrastination to become an official ECB policy guideline from the EU.

Such a political intervention would thus allow a pause, reversing previous communication to normalize, without a massive loss of credibility for the ECB. It would also give the ECB the justification and legitimacy to do something even more creative with monetary policy, should the pause morph into another ease.

Rehn has noted that global central banks are suffering from legitimacy and democratic twin deficits. As the Fed has clutched for and hidden behind its Congressional dual mandate, under assault from President Trump, so Rehn would like the ECB to get some political protection.

The December ECB Economic Bulletin sets a very gradual baseline for monetary policy changes in 2019. Downside economic risk from weakening global trade and declining economic momentum is seen as a significant threat to growth in 2019. The bar to raising interest rates has thus been raised significantly. The ECB also talked up the prospects for “gradual” Headline Stagflation, whereby global growth slows and inflation slowly accretes to its target.

Just to avoid the obvious heresy, Governing Council member Klaas Knot issued the disclaimer that core inflation remains subdued. When a central bank cherry picks managed Stagflation, as justification for its “gradual” approach to normalizing monetary policy, one can be sure that conditions are anything but normal. The ECB begins to sound more like the BOJ every time it guides.

Perhaps more notable was the end of year signal from ECB Executive Board member Sabine Lautenschlaeger. Normally an unconditional Hawk, on this occasion even she had to say that any interest rate increase from the ECB is heavily dependent on Eurozone inflation picking up. She spoke in the context of the latest Eurozone and German inflation data, which headed further below the ECB’s 2% target. The economic data baseline for a rate hike in 2019 is thus also a baseline for the ECB to consider easing further therefore.

Ignazio Angeloni then drew a further 2019 baseline, in relation to financial conditions in the Eurozone banking sector. In effect he blew on the flames he had ignited in London before Christmas. As 2019 begins with one failed Italian bank already in ECB custodianship, Angeloni connected the dots in the form of banking sector contagion magnified by weakening economic conditions and the end of QE. When it is considered that Spanish, Italian and French banks are effectively facing de facto monetary policy tightening, as a consequence of the ECB’s balance sheet adjustment, the risks of contagion spreading are higher. This baseline is therefore a much clearer basis for easing monetary policy.

(Source: Seeking Alpha)

Angeloni alleges that there is a macroprudential tool that will be deployed first. This would presumably involve a reduction in capital adequacy standards for the banks. It should be noted that these standards have never been counter-cyclically tightened however since the GFC. Banks are thus still in crisis mode on a macroprudential basis. It should also be noted that back before Christmas, when he started the fire, that Angeloni said that there was no such macroprudential tool currently available. Perhaps Santa Claus brought one! More likely that he didn’t, which means that only monetary policy is now available to deal with the contagion. The last report suggested that ECB monetary policy will “soon” be made in relation to financial stability policy requirements. Angeloni has just signaled that “soon” is now.

Benoit Coeure recently neatly summed up the context by which his Executive Board will frame the behavior of its colleagues on the Governing Council going forward. He does not expect interest rates to rise until “at least” the summer. He also expects them to remain as low as is necessary to achieve the ECB’s inflation target. Had he been speaking in Japanese in reference to the BOJ, his comments would have been equally as resonant.

Looking at the ECB’s miserable economic predictions for 2019/21, in combination with its de facto tightening of monetary policy in Spain, Italy and France, the observer could easily conclude a deliberate strategy of self-inflicted damage. The ECB is creating a financial crisis in these economies, in order to fulfill its own strategy to continue with loose monetary policy in the medium to long-term. This crisis may also trigger a market-based solution, in the form of cross-border M&A, which delivers the goal of deeper economic integration. Said integration will follow Draghi’s “trust and converge” thesis.

Fed Chairman Powell has been criticized for being behind the curve recently. The ECB is already onto the credit-cycle easing curve starting in 2021. Mistrust and diverge is thus being applied by fiat in 2019, in order to start “trust and converge” circa 2021. Such lead times show just how farsighted and entrenched plans for the European Project are, despite the violent diversions of Populism.

This article was written by

Adam Whitehead profile picture
Over thirty years of taking the volatility out of uncertainty, by taking the uncertainty out of volatility, for proprietary trading desks, commodity trading advisors, sovereign wealth funds and private offices.

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.

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