The ECB Prepares A Reaction To The Unexpectedly Permanent, Expected Temporary Slowdown

by: Adam Whitehead

The ECB pivots from expecting the current temporary economic slowdown to being surprised by its permanence.

The Eurozone has environmental headwinds that are not fully understood.

The ECB is set up to pause, but not to ease yet.

The next Governing Council meeting will be massive.

The next permanent shoe to fall is a Eurozone trade war with America.

The Eurozone Doomsday Clock seems to be permanently stuck at five minutes to Midnight. Whilst the ECB procrastinate about the normalization, in preparation for the next monetary policy expansion, the IMF is swiftly nudging perceptions towards what comes next.

This brave new world must first wait for the policy makers and central banks to kill Bitcoin and all other cryptocurrencies. After this point, the IMF believes that central bank e-currencies will be issued alongside cash. Negative interest rates will be applied to both in the hope that holders will abandon them for consumer goods. If history serves, holders will abandon them for risk assets. In the meantime, central banks now need to frame perceptions away from the normalization towards said brave new world. The ECB is slowly coming round to this reframing exercise.

Having ended QE in 2018 and notionally tightened monetary policy already in Spain, Italy and France with the new Capital Key, the ECB stumbled towards its first Governing Council meeting like a Russian roulette player who has already shot himself in the foot in a previous game. The damaged foot on which it stumbled was displayed in the release of the quarterly survey, which showed that commercial banks have tightened lending standards whilst loan demand has fallen and is expected to fall further.

Lenders and borrowers have both seen the ECB signaling the end of QE and have both decided that they would like some more "thank you very much Mario" under the circumstances. Said circumstances are significant global headwinds, which they have rationally reacted to, whilst the ECB has irrationally decided to tighten monetary policy.

(Source: Seeking Alpha)

The last report suggested that in view of the current economic slowdown, the ECB would continue with maximum possible expiring QE reinvestment in the sovereign bonds of Spain, Italy and France. The consequence of this non-application of the new Capital Key rules would mean that these countries would in effect bust these limits even faster. In relation to Italy and France, this conclusion seems to be the case, as the latest data shows the ECB maximizing its QE proceeds reinvestment in these two countries' bonds. By trying to help them, the ECB is in fact making things worse for them. By ending QE, the ECB is also making things worse in general not just for Italy and France. That sounds like central banking for you.

Normally, under such tightening liquidity circumstances against a slowing economic backdrop, it would be expected that a central bank should ease or at least be guiding towards easing. Au contraire, ECB Governing Council members, who had been guiding that they actually planned for and expected this situation, have signaled no intentions or capabilities to ease. All that they may consider is pausing the first hike in interest rates.

The last Governing Council meeting was thus set up as an event to discuss and stall interest rate increases rather than to address the real elephant in the room of the experienced Eurozone Q4/2018 and Q3/2019 potential slowdowns. Two back-to-back quarters of slowdown would be a recession, but the ECB appears to be in denial of this.

(Source: Bloomberg)

The last report discussed the miscalculations that the ECB has made in its prescient assumption that the Eurozone economy is just as predicted by the central bank. Exogenous factors including Yellow Jackets, Trade Wars, new German car emissions standards and Brexit were high on the list of critical omissions. It now transpires that Climate Change may have trumped all the other unknown unknowns on the ECB's factor omissions list.

JPMorgan estimates that the dried up rivers in Germany have shaved 0.7% off GDP in 2018. If one looks at the revisions to German forecast data, one may note that it is of similar magnitude to this JPMorgan climate change guesstimate. The surprise evinced by forecasters at the current slowdown that they all missed suggests that they do not have this environmental factor in their models. After all JPMorgan is looking ex post facto.

Presumably there has also been an inflationary shock from this environmental risk. Assuming that there has been an inflation shock, the mediocre reported inflation from Germany shows just how weak the overall inflationary picture is. Taking out the dry-river inflation boost, German inflation would have been even lower than the 1.7% headline print. German disinflation is thus a much bigger problem than the Bundesbank and ECB are letting on.

Simply saying that the German economy will rebound when the rivers refill doesn't really cut it. What if they don't fill up? What if their drying up has reconfigured supply chains? What if the economy was in fact so weak that their drying up was of no consequence in any case? Etc., etc., etc. Going forward the ECB is going to have to incorporate some environmental factors into its monetary policy framework. Just calling it E and then adjusting for it ex post facto, like JPMorgan has done, is a good starting point.

(Source: De Nederlandsche Bank)

The Dutch central bank is ahead of the Buba and ECB in factoring in these new environmental risks amongst a host of others. The Dutch central bank has even gone beyond national and Eurozone borders to look at the risks to the Dutch financial sector from its loans and portfolio investments in regions of conflict and environmental distress. This move shows how global factors are now influencing Eurozone monetary policy by default. This significance of this global influence highlights the inadequacy of the ECB's narrow inflation mandate as a robust fit for purpose monetary policy framework.

(Source: Seeking Alpha)

It is no surprise therefore to hear ECB Executive Board members asking to be given a financial stability mandate, as we shall hear later. Monetary policy may ultimately be made according to principles and calculations more familiar to insurance actuaries and underwriters as a consequence of this drift.

This series of reports has seen the drift of the ECB away from a pure monetary policy mandate per se towards a financial stability framework. This drift allows the ECB to elude its strict inflation mandate and the Bundesbank! At the end of the day, financial stability is everywhere a monetary policy phenomenon.

The ECB has therefore found a neat way of retaining its independence whilst broadening its scope of macroeconomic policy making under the general subtitle of Financial Stability. This gradual drift will allow the ECB to play with its normalization timetable and even to consider monetary policy easing again in unexpected circumstances. It will also allow the ECB to dabble in the banking sector and enable the Great Consolidation game underway there, thereby influencing liquidity conditions and consolidation outcomes.

The Italian banking sector was observed as the first on the list for consolidation in the last report. Italian policymakers championed the cause of domestic consolidation rather than cross-border M&A to create scale entities to compete with European peers.

Bank of Italy Governor Ignazio Visco recently made the direct connection to privately financed consolidation as the alternative to bailouts financed by Eurozone tax payers. Visco lamented the fact that this route to deeper Eurozone banking and economic union is now closed due to lack of political interest. He failed to note the alternative solution of deeper union, involving a private capital financed consolidation, as the alternative being forced out of necessity by this lack of political will.

(Source: ECB)

ECB news from the rest of the Eurozone banking sector was not as dire as in Italy, nor was it optimistic however. Demand for credit is gradually rolling over and is expected to get worse moving forward. Credit pricing is tightening. In addition, the non-performing loan (NPL) situation is growing and is already acting as a brake on new credit creation. The Eurozone banking sector is thus blowing a headwind in addition to that now blowing from the ECB as it ends QE. The conditions precedent for the Great Consolidation have not arrived just yet.

(Source: ECB)

ECB news on the state of liquidity in Eurozone capital markets showed a gradual deterioration that undermines the integrity of the Eurozone financial system as a whole at the beginning of the year. The end of QE will worsen this situation.

(Source: ECB)

Faced with the clear economic and political deterioration at the Eurozone and global level, ECB President Mario Draghi had no choice other than to incorporate this into his commentary after the latest Governing Council meeting. Whilst policy was left unchanged, the outlook for the Eurozone economy and hence further normalization of monetary policy was lowered. Incrementally shifting to become more pessimistic than at the December meeting, he now accepts that the balance of risks has shifted to the downside. If said balance deteriorates further, he promises to react with a monetary policy stimulus of some kind.

(Source: ECB)

Draghi's pessimism was underlined in thick red ink by the ECB survey of professional forecasters the next day, with 2019 and 2020 growth and inflation projections significantly and marginally lowered respectively from the December 2018 numbers. Things get much worse this year and then get a little worse 2020. The bottom line is that there is no recovery in growth and inflation for two years. The question mark over normalization thus becomes a question mark about easing again during this period.

Mario Centeno, the chair of the meetings of Eurozone finance ministers, signaled that this group of policymakers has lost its enthusiasm. Trying hard to avoid the word recession, he warned that the current slowdown will last a "bit longer". Interestingly, he was happy to embrace the unknown unknowns relating to global uncertainties in apportioning blame. The last report noted that the ECB was trying to say that things are going to plan, and that all unknowns are known and thereby factored into policy making. Centeno on the other hand was very clear in admitting that policy makers have failed to anticipate and understand the growing list of risks.

(Source: ECB)

There was no signal from the ECB that it will be applying the new Capital Key rules in the near future, thereby tightening monetary policy in Spain, Italy and France by reduced QE proceeds reinvestment. On the contrary, the ECB is accelerating towards this point by maintaining its QE proceeds reinvestment in Italy and France.

Evidently the economic situation is so dire that fundamental forces will weaken the economies in these countries without any nudge from the ECB applying the new Capital Key. In fact, the ECB is at great pains to show that it is doing everything possible to sustain them by fully reinvesting maturing QE proceeds. The Great Consolidation will thus begin as a quest for the survival of the fittest. The fittest will then consolidate the weakest.

Draghi thus faces a situation in which further normalization has to be postponed, even before he leaves his post in October. By then, Mr Market will be discounting that his successor will have to ease monetary policy.

A very animated Governing Council member Francois Villeroy de Galhau swiftly framed Draghi's message for the benefit of Davos Man, Davos Woman, Mr et Mme Gilets Jaune and the global economy in general. Allegedly Draghi means that the ECB will be pragmatic in relation to further normalization going forward. The next step will be for the central bank to lower its official growth forecasts in March. In other words, higher interest rates are off the agenda until the global economy improves. It also means that the TLTRO emergency tool is being primed for action.

De Galhau was followed by a very transparent mouthful of dovish guidance from Governing Council member Vitas Vasiliauskas. This tastes like a clear indication that policy will be unchanged until March, during which time the economic situation deteriorates at which time very clear guidance will be given that the TLTRO emergency funding program will be renewed and injected into the system. No doubt in March, the ECB will then claim that everything is going as anticipated again! Executive Board member Benoit Coeure then inserted his CV for the upcoming ECB presidency position along with his personal view that it is still too early decide whether interest rates will go up or not this year.

When Mario Draghi spoke to the European Parliament after the latest Governing Council meeting, he dropped all the pretenses of his colleagues that everything is going as they expected. On the contrary, he went out of his way to emphasize how things are deteriorating. He then framed the ECB's new stance as "The Governing Council stands ready to adjust all of its instruments, as appropriate".

Draghi's opining should be viewed as creating the precedent and preparing the way for a formal policy change as soon as March. This may involve pushing back interest increases. It may also involve the provision of further emergency TLTRO funds to the banks. The problem however is that such support for the banking system does not get passed on to the real economy. Banks may not foreclose on zombie companies, which could be viewed as a kind of stimulus, but this is regressive and does no good in the long term.

(Source: Forexlive)

Governing Council member Pablo Hernandez de Cos ostensibly then took the Dovish baton from Draghi. De Cos would like the ECB to study the duration and causes of the current slowdown to see if in fact they may be permanent. This sounds like interest rate increases being pushed even further back. If indeed the slowdown is then deemed as permanent, then the pause will be viewed as a prelude to further easing. Such easing may well come in the form of expanded crisis TLTRO funding rather than the full nine yards of more QE. The ECB does not need to appear to be alarmist. It also needs to keep its QE powder dry to extract maximum justification for it and maximum impact if and when it is applied.

(Source: Bloomberg)

Germany will receive the baton on the one-year anniversary of its "temporary" slowdown. News out of the German economy ministry should make the passing of the baton resemble the permanent rather than temporary tossing of a live grenade. The economy ministry officially slashed its economic growth forecast for 2019 from 1.8% to 1%. It is interesting that this was done immediately after Britain and the EU hardened their Brexit negotiating positions. The ministry alluded to Brexit as one of the vitiating factors in its new forecast. This German known unknown certainly lends itself to the permanent slowdown label.

The prize for German pessimism must go to the German Chamber of Industry and Commerce (DIHK). The DIHK recently slashed its 2019 GDP forecast from 1.9% to 0.9%. The German Finance Ministry has also had to admit that the slowdown will blow a massive hole in its "black zero" strategy much sooner than anticipated. Germany will thus not enter the slowdown from a fiscal surplus position after all. It will enter from neutral/deficit hybrid position that in effect is a deficit. The ability of Germany to enact a counter-cyclical fiscal stimulus is thus challenged. It will now have to finance any stimulus with a fiscal deficit. That's the bad news.

The good news for Germany is that the ECB has massive Capital Key limits for German bonds. Financing the fiscal deficit at a low rate of interest should be easier for Germany than any other Eurozone country. The cost of this is that Germany must accept that the ECB cannot shrink its balance sheet and raise interest rates. Bundesbank President Jens Weidmann has already made words to this effect. Indeed, his embrace of an expanded ECB balance sheet just might get him the job as the next ECB President.

Weidmann has carefully avoided the environmental issue, with his own equivocal summation of conditions in Germany and the Eurozone. To his credit, he dispensed with the pretense of some of his Governing Council colleagues that everything is going as expected.

Admitting his failure to see the current economic slowdown coming, Weidmann has predicted that it will have a longer duration than currently envisaged by the optimists. This is not however a reason to pull the plug on normalizing monetary policy in his opinion. Since things are going to get worse, he thinks that it makes sense to normalize now in order to deal with the worse conditions later.

Weidmann seems to be ignorant of the fact that, by normalizing, the ECB is making the situation worse. Presumably, his confidence comes from the fact that he sees the normalization process taking several years so that the real Eurozone economy won't feel it happening. The data clearly shows that it is already feeling the rumor of it even before the fact sets in.

News out of Italy is definitely of the permanent nature. In an attempt to get out ahead of the ECB and the EU over Italian deficits and the chance of more QE, Italian Prime Minister Giuseppe Conte called a spade a spade or rather a slowdown a recession. Bank of Italy Governor Ignazio Visco pivoted from a temporary to permanent slowdown guidance, with the view that the country's economic prospects are "less favorable" than a year ago. The bank's own coincident indicator (Itacoin) has been negative since last October, suggesting that Italy entered recession in Q4/2018. Forced to fess-up by the Itacoin data, the Italian statistics authority Istat finally admitted that it now foresees a pronounced slowdown in the economy.

(Source: Bloomberg)

The European Commission is a little slower out of the blocks than events of the ground. This is to be expected from an institution that must balance all the national self-interest of all the European nations, some inside and some outside of the Eurozone. Nonetheless, the Commission is catching up with the early movers. A recent Commission survey notes the increasing pessimism across the Eurozone about job prospects.

ECB Governing Council member Ewald Nowotny hasn't even put his running gear on yet. Conveniently switching to the only inflation indicator that is not falling, he bigged-up the incremental rise in Core CPI and talked down the chances of recession this year. His view looks increasingly fallacious, as even his native Austria is experiencing steeply falling inflation and economic growth at present.

Finland's approach to the lengthening "temporary" softening also demonstrates that there are strongly diverging views within the Eurozone about economic policy. The Finns stoically accept that a recession is a certainty. They also believe that it is something to be endured as a nation rather than something to be fought collectively as fiscally integrated Eurozone allies. The Finnish Finance Ministry advocates austerity measures to cut off non-essential fiscal spending in order to build a counter-cyclical buffer to deal with the ensuing recession. Like the Germans, the Finns thus prefer to make the recession worse in order to survive it in the long run.

The ECB finds now itself hoist by its own twin petards of firstly adhering to its QE-ending promise, and secondly by then pretending that the current slowdown is as it expected as the consequence of ending QE. Both petards are anachronisms.

Faced with the fact that it has fallen behind the curve, ECB staffers are now in the process of crafting data to justify the ECB's subtle pivot away from normalizing. They are doing this by highlighting the known unknowns of Trade Wars and Brexit and then pretending that they have suddenly appeared rather than exploded in slow motion as all other observers can attest to. It is not so much that the ECB has been unaware it has simply refused to deal with these factors as it anchored all its research and efforts to ending the normalization on schedule and claiming victory over deflation.

This new ECB mea exculpa in lieu of mea culpa was kicked off by the latest ECB bulletin. This mea exculpa concludes that "increasing uncertainties at the global level constitute a downside risk to the outlook, particularly for business investment." The ECB also finds that latent wage inflation has not been passed through to consumer price inflation. European companies have taken a hit to their earnings by swallowing higher wages, thus weakening their outlook. If the Eurozone consumer does not show up with its alleged higher wages to spend, then things are looking grim.

(Source: Bloomberg)

The ECB's mea exculpa conflates with a similar mea exculpa from the EU. Last November, the EU's rosy forecasts failed to envision the current carnage. It will therefore now have to play catch-up with a new set of lower forecasts.

It should be noted that both ECB and EU mea exculpas continually fail to forecast the future economic weakness. Things are therefore much worse in practice by the time that they get to them.

It is hard to see further progress towards deeper Eurozone fiscal integration, when one sees the Finns embarking on austerity and the Italians boosting counter-cyclical fiscal spending. The only solution therefore to enable deeper economic integration in the Eurozone is the private capital solution of the Great Consolidation. Standing in the way of this solution is national protectionism. It should make for an exciting existential struggle, which may unite Europeans economically but will also bitterly divide them politically.

Anti-capitalist populism has some fertile ground to sow its seeds of malcontent in. The only solution is for Brussels to embrace the populists and then buy them off with meaningless positions in the Eurozone political superstructure. Once they get accustomed to the rich rewards of Eurozone high office, they will then become its strongest advocates.

(Source: Bloomberg)

Deutsche Bank's (NYSE:DB) CFO recently confirmed that the Great Consolidation is on in the banking sector. A previous report noted that Germany may not be best placed to play the role of consolidator in the Great Consolidation of European companies forecast to start in 2019. Further evidence of this is showing up in the relative values of German companies and their Eurozone peers.

(Source: The Daily Shot)

German EPS estimates are lagging their Eurozone peers. The IfW institute estimates German Q4/2018 GDP at just a 0.1% growth rate. This all suggests that Germany Inc. may not have the currency in the form of its own shares to exchange for that of its targets. The obvious solution for this would be for German companies to merge together before targeting foreign rivals. They will need also to do this in order to avoid being targeted by said foreign rivals before they go on the counter-offensive.

The abortive attempt at a cross-border merger of Alstom (OTCPK:ALSMY) and Siemens (OTCPK:SIEGY) has highlighted a significant regulatory hurdle in the way of the Great Consolidation. The response from French policymakers is telling. Rather than accept the rights of the Eurozone consumer, France is simply lobbying to get the rules changed.

(Source: German Economy Ministry)

Fearful of the weakened position of Germany Inc. in the Great Consolidation, the German Economy Minister Peter Altmaier issued the new order of battle from his bunker in the Economy Ministry. The order of battle is an operation code-named "National Industrial Strategy 2030".

Under the diversionary tactics of erecting barriers to prevent acquisition by China Inc., Germany is protecting its own industrial base from acquisition by any foreigner from inside or outside of the Eurozone. It is also setting out the clear order of battle for the Eurozone game of Great Consolidation. The main strategic points clearly evince this strategy as follows:

  • The state must support innovation and help bring key technologies to Germany and Europe while reducing business costs from new environmental and social policies.
  • Competition law must be overhauled to facilitate company mergers in specific situations when a larger company could better compete at a global level.
  • German or European companies should be encouraged to take over key technology companies up for purchase.
  • In "exceptional situations" the state must be allowed to partially nationalize such a business in order to avoid takeover by a foreign investor.
  • An investment fund would be created in order to support these partial state takeovers, which would be of limited duration.
  • Industry should make up 25 percent of Germany's economic value by 2030, up from 23.4 percent today, and 20 percent of the EU's by this same date.

(Source: Bloomberg)

As Italy falls into recession, it is now becoming commonly accepted that a banking crisis there is the next shoe to fall. In fact, speculation has now moved further along to address the consequences of contagion from the ensuing Italian economic crisis.

In terms of banking sector contagion, France appears to be the most vulnerable. The last thing President Macron needs now is for a Eurozone banking crisis to trigger a French financial crisis. French banks will therefore be under pressure from Macron to get in there and start buying their Italian peers and also each other. Conversely, wily Italian politicians will be blackmailing the French to lobby in Brussels and at the ECB on their behalf. Italy has become systemically too big to fail for France.

The latest data showing that the ECB is doing maximum QE proceeds reinvestment in Italian and French bonds is also anecdotal of a linked crisis involving them.

(Source: Seeking Alpha)

Anecdotally, the market is full of rumors about French bank OTC derivatives losses and their potential contagion impact on the global financial sector. Socgen (OTCPK:SCGLF) and BNP (OTCQX:BNPQF) have been culling the culprits and Natixis (OTCPK:NTXFF) is also alleged to be in similar trouble. The appearance of these problems as things go south in Italy is possibly more than just coincidence. A big French bank merger is an elevated probability, assuming the EU competition regulators allow. If no mergers are allowed, then the French banks will become targets for foreign competitors.

(Source: Investment Europe)

Spain is not immune to the wave of consolidation speculation spreading through the Eurozone banking sector. The next consolidation wave is expected to hit the mid-sized banks, as they scale up to repel foreign rivals and also to look for foreign targets.

ECB Executive Board member Yves Mersch signaled the central bank's intentions and capabilities during this economic slowdown. He directly called for control of financial stability policy in the Eurozone to be handed to the ECB, with national regulators reporting to it on a straight-line basis. He also called for new "corrections with instruments" to be made at the national level. This latter demand is somewhat nebulous, but seems to imply that the ECB has carte blanche to create new asset classes in line with its own views on risk.

This suggests that the ECB intends to do away with the current risk-weighting criteria that give all sovereigns zero risk-capital weightings. The topic of Risk Free Bonds from merged and repackaged national sovereign components looks set for a revisiting. Evidently, Mersch sees some significant financial instability heading the Eurozone's way. As always, he wishes to use this crisis to further the ECB's power and to engineer deeper economic integration. A Doomsday Clock permanently serves this purpose until the mission objectives have been achieved.

(Source: Reuters)

EU Commissioner Pierre Moscovici played the harbinger of said financial instability. He takes the dubious accolade of being the first EU speaker to fully embrace the permanence of the temporary slowdown. The Commission slashed its growth forecasts for the Eurozone across the board, egregiously in the case of Germany, Italy and Holland.

The Dutch story is an unknown unknown that speaks to something rotten in Core Europe. Perhaps it is the Dutch environmental headwind that the Nederlandsche Bank is opining on that is the cause. It certainly leaves Dutch central banker Klaas Knott looking incongruent with his call to push on with the normalization.

Without actually saying permanent or recession, Commissioner Moscovici opined that the slowdown is both sharper than expected and will continue for longer than expected. That's near enough for government work, as the bond trader said to the central banker.

What is required now is for ECB Governing Council members to tell us how the embrace of the permanence backs out into monetary policy. They should not take too long to do this, even though they are preoccupied with finding new people to tell us right now, as key personnel change over, otherwise Mr Market will tell them what to do.

(Source: ECB Bulletin)

The signs of a swift response from the EU or the ECB are not good. Commissioner Moscovici added that he expects growth to rebound in 2019. The ECB has played its part by releasing its own "surprised" pessimistic growth outlook in its bulletin. From previously saying that the slowdown was to be expected, the ECB was hinting that in fact it has come as a great surprise. Was this a Eureka moment? The stage was thus set for a lay-up easing response from the ECB. This swift response was however lacking.

Executive Board member Benoit Coeure then told Barron's that "we (ECB) don't think that we have enough elements to conclude that we're facing a lasting and serious slowdown of the euro zone economy."

All this means that although the normalization is on hold, there is no hint of a required monetary policy easing to come. In fact, Mr Market is expected to price in tighter monetary policy pushed back into in 2020. Either Moscovici was asleep, when Chairman Powell fumbled similarly back in December, or he was awake and intends to do a spectacular U-turn in about a month's time. The next ECB Governing Council meeting is going to be massive. Mr Market needs to spell out what happens at it in the meantime.

(Source: Seeking Alpha)

American ambassador to the EU, Gordon Sondland, just gave Mr Market some spelling lessons. The ambassador recently opined that European "good faith and understanding" haven't persisted. This is code for saying that America will turn its trade negotiating guns on Europe once it has negotiated "something big" with China. The Europeans have already upset President Trump by setting up a parallel sanctions evading trade deal with Iran. He will therefore not be in a forgiving mood when he is done with President Xi Jinping.

This American-Eurozone trade event could possibly be the permanent that the EU and ECB have been looking for. The stakes are especially high for Germany since it thrives on its exports. The latest data reveals that 2018 was a record year for German trade. As with Brexit, Germany has good trade reasons to break ranks with the Eurozone protectionists. Let's see just how European and just how Global the Germans actually are.

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.