'Catastrophe' Bonds That Bind: A Post-Brexit 'Consolidated' Eurozone Asset Class

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Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EUFL, EUFN, EURL, EZU, FEP, FEU, FEUZ, FEZ, FIEE, GSEU, HEDJ, HEZU, HFXE, IEUR, IEV, PTEU, RFEU, UPV, VGK
by: Adam Whitehead
Summary

The ECB signals that the Great Banking Consolidation has started and will run on loose monetary policy until at least 2026.

Like the Fed, the ECB also disingenuously fails to distinguish between growth and inflation forecasts, targets and indicators.

The ECB will blame Brexit when it needs to pause/reverse the normalization.

Weak economic fundamentals mean that the central banks of Spain, Italy and France will run into the new Capital Key limits faster than their neighbors.

Re-initiated ECB emergency term-funding programs will plug the liquidity holes until the ECB is ready to consider easing monetary policy again.

As "patience" is the buzzword in America, "catastrophe" is the buzzword in the Eurozone. Both words may be self-inflicted by the respective central banks. The Fed's self-harming was done at the December 19th FOMC. The ECB's latest wounds were inflicted recently.

The last report presented the thesis of the ECB engineering a Eurozone financial stability crisis this year in order to halt the monetary policy normalization process and to herald an era of consolidation in Eurozone equities that will deliver deeper economic integration across the region.

(Source: ECB)

The ECB needs to be very careful about how it orchestrates this Great Consolidation. European Central Bankers from the Baltic to the Balkans to the Mediterranean have been embroiled in scandals. The invisible hand of the European Central Banker is no longer a trusted one, and has been used for self-enrichment in the name of supporting the European Project. Perhaps, with this in mind, the ECB has decreed a new Papal Bull on the conduct of behavior for its shepherds.

The ECB is apparently also very keen to make sure that this decree is enforceable, so that the central bank is not just a sheepdog that doesn't bite. Spanish bank BBVA is currently being investigated because of its espionage techniques in relation to the tactical execution of the Great Consolidation. An enforcement action may follow, which will send the signal that the ECB is serious in making the consolidators play by its rules.

(Source: Reuters)

The Great Consolidation thesis now seems to be getting broadcast and embellished in the wider public domain. The French dimension and the conflicts between the need for fiscal stimulus versus Stability Pact guidelines is garnering significant column width.

(Source: Seeking Alpha)

The connection between the Capital Key constraints on ECB further purchases of French bonds has yet to be discovered in the public domain. It was also speculated in the last report that Germany could emerge on the right side of European history this time as the Great Consolidator in this Great Consolidation.

Right on schedule, German Chancellor Angela Merkel has emerged onto the scene at the source of the Alpha and Omega of Europe. Speaking in Greece, she identified the Useful Idiots who are ostensibly undermining the European Project, and in so doing neatly attached blame to them and justification for the project itself. Said Useful Idiots are in her opinion the agents of a "Catastrophe" that only deeper European integration can prevent from degenerating into the conflagrations of the past.

UK Prime Minister Theresa May picked up on these sentiments and the word "catastrophe" but in a different sense. For May, it would be "catastrophe" for Britain's Useful Idiots not to exercise their democratic right to be so. Said exercise of democratic rights voted for Brexit and rejected her Brexit bill. The EU responded with horror converging on a Shock and Awe decision not to negotiate any further. Thus the Useful Idiots on either side of the Brexit debate are driving the narrative towards a Hard Brexit outcome.

Simultaneously, President Macron launched his "National Debate" as part of the broader Eurozone initiative. Showing that he is still out of touch and conscious that he does not come across well on TV, the President launched his initiative with a 2,300 word essay to the Yellow Jackets. The launch was made with an indelicate verbal tirade, accusing the Yellow Jackets of being feckless and indigent malcontents who are just "messing around" instead of working for a living.

As a symbol of good faith Macron decided not to go to Davos in order to have his debate on quasi equal terms with the Yellow Jackets. This could easily be viewed as a tactical positioning of himself as far away from the hated Globalists as possible. Davos and those who go there is anathema to a significant majority of the French polity. Debating the Yellow Jackets from the rarefied atmosphere of Davos is an obvious no-no even for a thick-skinned yet thinly-disguised Globalist French President.

(Source: Bloomberg)

Totally ignoring the fact that he is facing a fate similar to that of the hapless Theresa May, Macron then informed those "messing around" in the UK that the EU won't solve their "internal political problem". Not only does he miss his own internal political vulnerability, but also ignores the fact that the Brexit vote was all about preventing the EU from solving Britain's "internal political problems". Frenchmen who live in glass houses should not throw stones. Macron has signaled that he is working for the EU and not the French people. Theresa May has at least tried to serve the British public as ungovernable as it is.

Literate Frenchmen and women, with time on their hands to read, will now have three months to plow through Macron's thesis and engage in more civilized debate about where their taxes should go.

Just to add greater distance and incomprehension between himself and his audience, Macron placed custodianship of this important undertaking in the hands of Karate fighter. This fighter was to be compensated with a purse significantly higher than the average Yellow Jacket combatant. Needless to say, the Karate Kid stepped down when this came to public attention, providing the Yellow Jackets with yet another victory.

Whilst the French public is reading his thesis, President Macron intends to forge ahead with the reforms that they hate rather than put things on hold as a sincere act of goodwill. By the time that they have finished reading, assuming that they even bother to, they may therefore find that the train has already left the station irreversibly. They will then conclude that the length of the letter and cooling-off debate period was nothing more than a play for time to make the President's initiatives irreversible. They will then reply to his 2,300 words with two words, the latter of which is "off"! Paris Spring is a headline to look forward to, or not if you happen to be the President.

Finance Minister Bruno Le Maire demonstrated this lack of sincerity for equal dialogue by refusing to pause the privatization of state assets process. The selling of state assets is a prerequisite to keep the budget deficit in line and to enable some kind of deficit-neutral fiscal stimulus. The Yellow Jackets will just see the government privatizing jobs and the generous benefits that go with them. They will also say that the President has tried to play them by wasting time on his fake debate whilst he forges ahead with irreversible reforms.

Going into the National Debate period, the polls show a 70% dissatisfaction rate with President Macron, although it must be said that Yellow Jacket support has fallen to 60% since before Christmas. It will be impossible for Macron to turn this political deficit round by simply feigning listening and debating rather than by genuinely pausing and persuading. The lack of a pause shows a lack of good faith on his part that he will be punished for. Seemingly, in the knowledge of this ultimate failure, he has decided to push the economy to a point of no return on the reform front as his parting pyrrhic victory. The Bank of France did its patriotic bit to shore up perceptions of the health of the Republic's economy. The French central bank continues to downplay the impact of the Yellow Jackets on the economy in Q4/2019.

In sync with French political and economic fundamentals, ECB Governing Council member Francois Villeroy de Galhau has established the spring as the next milestone at which point the central bank should consider any changes to monetary policy. He was also swift to signal that the ECB should be flexible, which means that monetary policy could either be eased or continue to be normalized at this point in the future.

ECB Vice President Luis de Guindos began the New Year by nudging this Great Consolidation thesis closer to reality. He demanded that Eurozone regulators should force banks to raise macrostability buffers. His demands show how the ECB is impotent in doing anything other than creating a crisis for the national regulators to execute this strategy on its behalf. When the process is completed, there will be no national regulators and the ECB will be able to create and execute strategy in the consolidated economic Eurozone as a whole.

Recently released minutes of the last Governing Council meeting portray a similar situation developing as that found in relation to the Fed and its little pre-Christmas fumble and market tumble. Although Mario Draghi affirmed the commitment to normalize back in December, the meeting of the minutes show palpable fear at the consequences in the current slowing economic environment. So heightened was this fear, which was perceived as a "fragile and fluid" situation, that an extension of the ECB's expiring term emergency funding programs was put back on the table.

(Source: Seeking Alpha)

In what the last report termed the Great Consolidation, Germany was viewed as potentially being the Great Consolidator. Germany is blessed in that it enters the current economic slowdown with a fiscal surplus, albeit one that is swiftly eroding. In addition, the ECB's Capital Key limit for German bonds is large as a result of its fiscal surplus position combined with its largest in the Eurozone GDP.

Germany can therefore finance any counter-cyclical domestic fiscal expansion and foreign acquisitions of Eurozone assets very cheaply, especially if the ECB pauses! A pause by the ECB still represents a tightening of monetary policy in Spain, Italy and France since their Capital Key limits have been cut, thereby precluding them from resorting to the ECB for more emergency funding.

German Economy Minister Peter Altmaier wasted little time in signalling that the counter-cyclical fiscal stimulus is coming soon even as he denied that the country is heading into recession. Germany's fiscal gap is currently estimated to be around 100 billion euros through 2023. This is however a moving target. It now remains to be seen how this figures as a percentage of Germany's flagging GDP. The country will need to get maximum bang for its fiscal spending to keep its debt-to-GDP ratio within limits that will allow it to avail itself of the cheap funding that the ECB's balance sheet can guarantee.

The risk for Germany is that its economy implodes into recession that then puts its debt-GDP ratio in the same league as the basket cases of Spain, Italy and France. Should Germany join them, then it will face rising yield pressures which will act as economic headwinds also. It is therefore essential that German policy makers get a good handle on just how weak the economy is and what their real fiscal options are. Right now, they appear clueless as to how bad things are.

It was also noted that the real costs of German fiscal and acquisitive expansion will increase with the hit to its own economy from global and Eurozone economic weakness. Germany can pick up cheap assets, but its own currency in the form of its asset prices will also be weakened. The German strategy game is therefore to make sure that the relative cost of target assets falls by more than the German ones do.

The latest German factory orders and industrial production data speak to this real economic cost. The exposure of this industrial weakness and hence the threat to the Great Consolidator position prompted the Bundesbank to swiftly verbally intervene. In an attempt to frame perceptions, the Bundesbank opined that it will be "looking through" the recent weak industrial data. The observer will note that Germany Inc. and the Bundesbank are pulling out all the stops to get the value of the former up and thus the acquisition cost of the rest of the Eurozone down in relative terms.

Further evidence of the German strategy was revealed in a Forsa poll conducted for consultancy firm EY, the DIW economic institute and the DGAP foreign policy think-tank. Two thirds of Germany Inc. want higher interest rates to go with a German fiscal stimulus despite the threat this would present to Germany's trade partners. A staggering 83% of Germany Inc. is satisfied with the current Eurozone mixture of bail-in and bail-out catch-nets for the unfortunate.

Germany Inc. will burden German taxpayers with a fiscal stimulus, but this will only be spent domestically and not on foreign bailouts. Germany Inc. is happy to pay for the stimulus with higher interest rates. The added bonus is that the German economy strengthens on this fiscal tailwind and pushes its neighbors into recession with higher interest rates. Said neighborhood recession provides the acquisition targets for Germany Inc. at discounted prices.

Eurozone Governing Council member Ewald Nowotny is also looking through the same lens as the Bundesbank to a virtual world known as Nowotnyland. In this "imaginary" world, Germany avoids a recession and the ECB raises interest rates this year. There is also no need for the ECB to renew its term emergency liquidity funding for the banks. In this strange world, however, there is a parallel reality in which the ECB must proceed with caution when it does begin to raise interest rates. Nowotnyland is an uncertain place, which is not getting any brighter and clearer anytime soon. It is a backward-looking, nostalgic kind of place. As its founding father says, looking backwards, 2018 was a year in which the inflation stability target was met, thereby justifying the decision to end QE.

(Source: Plantu)

In an interesting aside to the thesis, Nissan (OTCPK:NSANY) has also noted the Eurozone's Great Consolidation. Japan Inc. has therefore initiated its attempt to ring-fence its shareholding in its European venture with Renault (OTCPK:RNLSY) before it gets acquired and/or diluted by another Eurozone consolidator. Carlos Ghosn is thus a prisoner of the Great Consolidation as much as he is a corporate malfeasor as charged. He could have been arrested any time before now. The decision to arrest him now must therefore be part of a wider issue. The current Trade Wars therefore have a deeper context than the headlines portray.

It would be ironic if American Private Equity beat Germany Inc to the punch for Eurozone assets. Private Equity would be a great place to warehouse said acquisitions until it is then flipped to real industrial buyers. The observer may also have noticed that the ratcheting up of Trade War rhetoric and barriers to Eurozone entry for Chinese state financed acquisition can also be applied swiftly to would-be American acquirers.

The Spanish government has signaled that it will attempt to try its luck at balancing the conflicting demands of Stability Pact limits against the political requirement for a fiscal stimulus to avoid further national elections. Prime Minister Pedro Sanchez announced a mythical new budget that will be fiscally neutral and stimulative. Spain's rich will allegedly be mined with higher taxes to balance the books.

Sanchez has therefore decided that it is politically more expedient to eat the Spanish rich rather than to anger the bond markets and the EU. The Spanish rich are neither wealthy enough nor numerous enough to balance the nation's books. In addition, they can be expected to fight back by making people unemployed in the businesses that they own and deploying their captive politicians to fight the budget in parliament. Sanchez's initiative will be hampered by the fact that the ECB is tightening monetary policy in Spain through cutting its Spanish debt QE reinvestment process, in line with the new Capital Key rules. Spain is an orange light moving towards red on the risk spectrum.

Whilst Spain runs into the Stability Pact buffers, Italy is frantically trying to get them removed. European Commission Vice President Valdis Dombrovskis has already warned the Italians that they will run into a confrontation with Brussels unless they mediate a proposed budget fiscal stimulus with tax increases to avoid the deficit widening further. The Italian response has been equivocally evasive.

Italy carries on regardless of EU warnings. The Italian parliament recently passed legislation, sponsored by Five Star, to reduce the pension age limit whilst also boosting pension benefits in addition to increasing social welfare payments to those on low incomes. The incoming economic data signals that these increased fiscal benefits will immediately be deficit negative.

The Bank of Italy has confirmed that growth slowed dramatically in Q4/2019. The only question is now whether this will continue into Q1/2019, thus confirming a recession. Finance Minister Giovanni Tria calls Italy's current recession a "stagnation". The Bank of Italy's Senior Deputy Governor Salvatore Rossi sees the Italian slowdown as an "acute" manifestation of a larger global one.

In a recession, there would be no growth and hence no tax revenues, so Italy couldn't even pretend to be paying down its debts. "Stagnation" implies that Italians are doing their best, and just need to be allowed to borrow a little more in order to get them out of debt when this new borrowing creates economic growth. It's a familiar story. With no support from the ECB, Italian yields will rise further creating a headwind and raising financing costs. It is unlikely that the country will ever grow out of its debts should it sincerely wish to.

Italy and its banks have been noted as one of the key drivers of the Great Consolidation in the banking sector. The ECB and its eminence grise Ignazio Angeloni have also been identified as the invisible hands manipulating this part of the Great Consolidation.

Before Christmas Angeloni gave the project a nudge by opining the egregious lack of capital buffers in the banking system to deal with an economic shock. Just after Christmas, Angeloni then put the heat on Eurozone national banking supervisors by urging them to raise capital buffers or face a financial crisis unprepared.

The ECB just recently raised the odds for the banks in dramatic fashion by asking that they provision for current impaired loans rather than juts for ones that have been historically non-performing. The ECB gave the banks until 2026 to get their act together.

Traditionally, Eurozone banks would look at the end date for compliance, and then say that since it is so far away, they can postpone doing anything about it until the Eurozone recovery is stronger. This time around there is a message of menace and urgency in the ECB's current edict however since it applies to existing loans which are getting impaired. The provision for existing loans means that this process can't be put off until the alleged Eurozone recovery occurs. In fact, the inference is that the Eurozone economy is going to get much worse.

Banks that can't provision will thus become targets for consolidation and/or acquisition. They will also get picked up cheaply, because the Eurozone economy will soften and reflect in their share-price valuations. The only good news from the ECB is that it will provide loose monetary policy until 2026 in order to enable the Great Consolidation for the Great Consolidators!

(Source: Reuters)

In a portent of the Italian Job to come, liquidity tightened for Italian banks on the ECB's request for all Eurozone banks to make provisions for current impairments. Italian bank share-prices collapsed. Sensing that the Italian banking sector is being set up for the Great Consolidation, Italian Deputy Prime Minister Salvini called out the ECB for deliberately trying to take down the Italian banks. Roberto Gualtieri, a senior EU policymaker who is also a member of the oversight committee of the ECB, joined the Italian resistance movement, fighting behind enemy lines to prevent its banking system from being overrun.

(Source: Reuters)

Stefano Buffagni, Five-Star's cabinet undersecretary, confirmed Italy's desired solution to the Great Consolidation. Five-Star would prefer it if Italian banks can merge together rather than get taken out by their stronger rivals. This would allow the Italian government to have some semblance of control over the country's economic policy.

Speculation has already begun that the ECB will have to keep the Italian banks on the life support of new emergency TLTRO funding. This is wishful thinking by the Italian bankers. The ECB may only administer enough support to keep the Italian banks alive pending acquisition rather than enough to enable them to live on as independent zombies.

(Source: Bloomberg)

The Great Consolidation is thus fact in Italy at least. Contagion will take it to other Eurozone countries in due course. European regulators are making no secret of the fact that they favor cross-border mergers. It may be the only way to dodge anti-monopoly rules within national boundaries.

(Source: ECB)

The recently released minutes of the last ECB Governing Council meeting provided an insight on how the central bank will play the Great Consolidation game this year. There was unanimous doom and gloom about the "fragile and fluid" environment. The minutes were ingenious in that the doom and gloom was discounted into balanced risk, based on the observation that ECB staffers had already forecast this situation in advance of the meeting. This clever play on words allowed the Governing Council to its promise to adhere to the ending of QE, even though it should actually be thinking about easing again. The minutes saved face and bought the ECB time.

Further evidence of this face-saving methodology was then provided by Executive Board member Yves Mersch. He neatly drew a line under the chaos with the Inspector Clouseau guidance that "what is happening now is what we were expecting to happen," so "now that the slowdown has come, we don't have to consider it again in our response." Mersch's colleague, Sabine Lautenschlaeger, also opined the same inductive reasoning about everything going to script. The current Eurozone slowdown is thus allegedly all part of the ECB's plan.

(Source: Seeking Alpha)

The ECB's forecasts therefore by default must be targets if Mersch and Lautenschlaeger's verbal gymnastics are taken at face value. What we find here is the ECB taking a leaf out of the Fed's book. In a sister article, the Fed was observed to be playing hard and fast with economic data by switching between indicators, forecasts and targets whenever expediency determined. The ECB also plays the same game.

One thing that the ECB cannot (and does not) claim omniscience about is Brexit, even though its impacts are clear in the Eurozone data that the central bank alleges that it is in control of. In fact, it now seems that Brexit will be used as the excuse when it is time for the ECB speakers to say that everything is in fact not going as they had planned. Nowotny and Mersch have already indicated in advance that Brexit will be their excuse of choice if and when they decide to pause and/or reverse the normalization decision. It should come as no surprise that Brexit is also the excuse being framed by the Bank of England for the same equal and opposite reaction.

(Source: Bank of Finland)

It is instructive to compare the recent ECB minutes with the refreshing candor of the commentary by Finnish central bank. Although refreshing, the Finnish forecast is freezing cold. Growth implodes from 2.7% in 2018 to a cool 1.9% in 2019 and a glacial 1.5% in 2020. This outlook is also conditional upon continued strength in the Eurozone, continued QE from the ECB, and strength in the global economy. Should any of these drivers decelerate, then things will get even colder. All three would seem to be decelerating tight now, so this chilly forecast is actually red hot! The reader may be inclined to disagree with the Finnish central bank's view less than that of the ECB, but both seem very optimistic.

Eurozone economic fragility should therefore be met with fluidity in the form of term emergency funding, when the lack of ECB net asset purchases starts to be felt. The minutes were clear that net asset purchases, i.e. QE, will end. Tweaks to emergency term funding are the best that the central bank can be expected to do before it Q-eases again.

In relation to reinvestment of QE proceeds, the ECB tried to disguise the tightening of monetary policy by nature of the new Capital Key that will occur in Spain, Italy and France. Reinvestment of QE proceeds will still be allowed to be directed by national central banks and their maturity schedules. There was however a general indication that over time this reinvestment will be expected to reflect the new Capital Key limits. Monetary policy tightening in Spain, Italy and France will thus be a gradual process.

The ECB is setting no fixed targets and dates on reinvestment; instead it is going to play it by ear. Evidently, the tightening of monetary policy in Spain, Italy and France along with the Great Consolidation is going to be coordinated with the politicians.

The politicians need to manipulate the Useful Idiots, who are challenging deeper Eurozone integration, with great skill and care going forward. This will occur within a context of changing personnel in the Eurozone political executive. The politicians also need to provide the ECB with some new key players, including the President, during this period.

With Eurozone executive policy makers personnel appointments in a state of flux, the pace of the Great Consolidation cannot be too aggressive. Neither can the ECB normalization aka the monetary policy tightening in Spain, Italy and France. There is simply nobody there in the EU and ECB right now to execute in the future.

The first job is therefore to get a team of willing and capable executives in place. Given these personnel challenges, it is unlikely that monetary policy changes will be rapid either. It is now also clear why the ECB and the BIS have given the banks such clear lead-times to prepare for the Great Consolidation in the banking sector. The Great Consolidation and the continuation of the Eurozone Project will thus proceed at the historical snail's pace seen to date on a tide of liquidity falling gradually for the Consolidated and rising gradually for the Consolidators.

In his first state of the Eurozone address to EU politicians, Mario Draghi addressed the sum of all their fears. Rhetorically he answered their question of whether the Eurozone is facing recession, with an answer which frames monetary policy for the year ahead.

According to Draghi, this is not a recession, but the slowdown is of such magnitude and duration that it will prevent the ECB from raising interest rates quickly. It now falls on the national central banks in cahoots with the ECB and their politicians to play the QE proceeds reinvestment game in line with developments in the Eurozone hinterland.

Clearly, the current softness will cause the national central banks to reinvest as much as possible in their own sovereign debt. The unintended (or perhaps it is intended) consequence of this maximum sovereign reinvestment is that the Bank of Spain, Bank of Italy and Bank of France will run up against their new Capital Key limits very quickly. They will then be forced to taper towards the new Capital Key. Tighter monetary conditions will then in fact hit these countries way in advance of their Eurozone peers. The ECB will have by then started to drip-feed them some emergency TLTRO funding. This however will be insufficient to sustain their banks in the long-term. It will just keep them from going under before they can be consolidated.

At this point the politicians and the central bankers will also need to get into a huddle to decide what to do next. This of course assumes that all the new positions in the ECB and EU executive have been filled by then. If not, then it is going to be messy.

The view of Governing Council member Francois Villeroy de Galhau in contrast to Draghi's has introduced an outcome with a probability quite close to that of the ECB President's. De Galhau focused on the American trade dog wagging the global tail, of which the Eurozone is part. He noted an asymmetrical outcome in which the global headwind is in fact a US tailwind, as was the case in 2018.

America attracts global capital, which stimulates its domestic economy at the expense of the weakening global economy. Faced with the lack of capital, the ECB could therefore be quickly forced to consider Q-easing again. If the current envisaged Fed pause is followed by such a second wind, then De Galhau's vision will become the most likely outcome.

It is good to see the ECB thinking out of the box, and evaluating different possible trajectories for the Eurozone economy. If they have policies ready to go for said possible outcomes, then so much the better. For now, whilst the situation is uncertain, De Galhau signals that any possible ECB interest rate increases will be some way off and very gradual if and when they occur. He is not yet ready to consider Q-easing, but it logically follows his train of thought and guidance.

The big takeaway is that the ECB is assuming that the current Eurozone slowdown is a consequence of its announced ending of QE. As Inspector Mersch said, it was all to be expected. If the ECB's monetary policy were the only factor, Mr Market would be inclined to agree. Unfortunately, the ECB had not planned for Trade Wars, low-Carbon legislated auto headwinds and Brexit, although it may have factored in the Fed ending QE and raising rates. Should it transpire, which seems very likely, that the ECB has missed these important vitiating factors out, then its calculations and assurances are flawed.

Embarking upon the Great Consolidation would appear to be reckless in such a time of uncertainty. It is however this uncertainty that presents the opportunities for consolidation in the form of weakened share prices and ECB liquidity for the leveraged buyers.

If you have miscalculated the vitiating factors, then things can only get worse, so that targets can only get cheaper!

This situation also presents numerous blame contenders. If you can ultimately blame the Brits, so much the better!

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.