(Source: ECB, caption and editing by the Author)
For those who believe that the ECB will be forced into monetary policy easing again soon, the latest mid-year Financial Stability Review has come just at the right time. It may also have come just in time for the new Chief Economist Philip Lane to nudge his solution for stability through fiscal integration into life.
The report also comes at a time when the ECB and the EU are playing at musical chairs for the top policy-making positions in the Eurozone. The report will therefore be used to frame the job descriptions for those who are in the running. Those whose CVs do not match said job descriptions, can forget it.
(Source and caption by the Author)
One can always tell, just how perilous the situation in the Eurozone is, from the behavior of the ECB. The two negatively correlate. The release of the minutes from the last Governing Council meeting unequivocally showed, that there is no confidence that the Eurozone’s recent economic bounce is anything other than Dead Cat. The ECB traditionally uses the threat of impending doom to nudge the Eurozone closer to closer economic and fiscal integration. It is now pushing on a string, but Mario Draghi hasn’t given up yet, until the fat lady sings for some more QE.
Last June, before he was elected, ECB Chief Economist in waiting Philip Lane was noted as a key individual in the next nudge towards closer economic and fiscal integration. Since then, he has been elected to his new position. Most recently, as the “rotten” Eurozone shows further signs of collapse again, his nudge has been energized.
On the “rotten” subject of Brexit, Lane insists that the ECB has had three years to prepare for Hard Brexit and is ready to act. On the “rotten” issue of the Eurozone’s internal economic malaise, he has similarly crafted a solution some time ago before he was promoted to Chief Economist. After promotion, he now needs to execute his solution.
Lane’s solution comes in the form of an asset class known as “Safe Bonds.” These are pooled from the Dogs and the Stars, of the Eurozone sovereign credit spectrum, to create something that today’s independent central banker would have no problem in putting on his/her/their balance sheet.
(Source and caption by the Author)
“Safe Bonds” also allow the ECB to break its own Capital Key rules, which limit its purchases of the Dogs in the Eurozone credit spectrum that it is already maxed out on. In fact “Safe Bonds” may force a whole re-calibration of the Capital Key formula; so that the ECB can buy Stars and Dogs simultaneously with gay abandon. Just for good measure, since they are pooled, “Safe Bonds” may even have a positive yield. The ECB can thus get paid for its nudge!
(Source: Bloomberg, caption by the Author)
Once pooled, securitized and QE’d the ECB then has a call on the merged tax base of the Eurozone. Economic and fiscal integration is therefore de facto, and de jure when one of the pool defaults. Cross default clauses and hence implicit taxpayer-funded bailouts are the factual and legal consequence of this process. Nobody gets bailed in with “Safe Bonds,” as the ECB ultimately prints the currency to meet the obligations. The Federal United States of Europe has been nudged into life, just in time for a global trade war.
Unsurprisingly therefore, as the Eurozone Doomsday Clock has moved further towards midnight the issue of “Safe Bonds” has resurfaced. Moral hazard is just around the corner. Germany is going to fight this one down to the line, since it is an issue that is deeply unpopular with the average German.
(Source: ECB, caption by the Author)
The ECB’s latest financial stability report nudged the clock’s minute hand to four minutes to midnight. By doing so, it nudged the appearance of “Safe Bonds” a little bit closer. The timing and content of the report suggest that this was the whole point. The report was a litany of bad news for the Eurozone economy and its banking system. The doom-loop, running from weak economic growth, amplified by unsustainable sovereign and corporate debt through to bank exposure was clearly drawn.
In this environment, there can be no way out of ZIRP/NIRP, hence the pressure on banks will be even more intense. They will have to merge to survive with scale. In addition, the ECB will have to expand the safety net, for the sovereign debt that the banks hold on their balance sheets. Bail-ins will break the banks. Taxpayer-funded bailouts are politically dead on arrival under the current system. The only solution, that the ECB foresees, is a pooling of sovereign debt to spread risk, and give the ECB something to buy that gets around its current Capital Key limits on sovereign debt buying.
The ECB reported that the slowdown in economic activity is now preventing banks in the Eurozone from issuing debt that will qualify for bail-ins in another financial crisis. This analysis is the key link to “Safe Bonds,” bank consolidation and the next phase of QE. Clearly, the ECB sees this crisis coming, and is happy for Philip Lane to proselytize the “Safe Bonds” solution to the bail-in problem. By inference the ECB will be happy to bail-out, those who have been implicitly bailed-in through fiscal integration, by buying up “Safe Bonds” when it Q-Eases again.
(Source: ECB, caption by the Author)
To illustrate the threat, which requires the solution of “Safe Bonds”, ECB Vice President Luis de Guindos colorfully illustrated the current plight of the Eurozone banking sector. Eurozone banks are allegedly turning away from cross-border activities, which he believes is creating a dangerous fragmentation in the banking sector. Said banks are simply lending to their sovereigns, thus enabling the “doom loop” connecting a sovereign debt crisis to a banking sector crisis and vice versa. This situation now makes the path to monetary policy normalization look very “challenging” to him. Clearly, “Safe Bonds” would make this path a lot easier to follow.
De Guindos’ view was underlined and restated by his fellow countryman and Governing Council member, Bank of Spain Governor Pablo Hernandez de Cos. De Cos spoke in great depth, about what he sees as the solution to the Eurozone’s current “fragile” and “fragmented” banking system. Needless to say, his solution involves a pooling of national economic and fiscal resources; in order to address the concentration of bank sovereign exposure within national borders. Both men would like to see banking union asap in order to mitigate this risk.
Having focused attention on the banking system, De Guindos then exposed its weakness further, thereby nudging further along his desired solution of deeper economic integration. He called upon the struggling banks to raise more capital, to deal with the impact of the softer Q1/2019 economy on their balance sheets. A pity that he didn’t call on them to raise this buffer when the economy was stronger in 2018! Evidently, he doesn’t really believe that they can raise expensive equity capital in either a strong or weak economic environment. Rather than raise capital, he just wants them to merge to create the same capital base through scale.
De Guindos does believe in the solution of “Safe Bonds” and deeper economic and fiscal integration however. Highlighting the fact that the banks cannot raise capital buffers, he is in effect telling them to cut back lending. Further economic weakness, based on less credit creation, will then call for a systemic solution. De Guindos is therefore telling the banks to weaken the Eurozone. This can only mean that this desired weakness is a stepping stone to a strategic objective. By then, Philip Lane may have his “Safe Bond” roadshow up and running with pooled bonds to go.
De Guindos and de Cos should also have noted that the current Capital Key rules force the ECB to turn away from the weakest Eurozone nations thereby exacerbating this risk. Pooled “Safe Bonds” are their solution to this growing systemic crisis. Instead of blaming the ECB and the Eurozone banks, De Guindos flatly blames Britain and Brexit for being the catalyst that triggers deeper Eurozone fragmentation. “Safe Bonds” become his savior and panacea, to a problem that the useful idiots of Brexit are being blamed for causing. Thus, legally mandated moral hazard becomes the solution to perceived moral hazard.
Once the other speakers had opined the case for “Safe Bonds”, Mario Draghi summarized the issue in his characteristic way. Now that he is relegated to the position of Lame Duck incumbent, Draghi’s commentary is becoming more personal and impassioned. His latest valedictorian speech appositely focused on the issue of deeper economic and fiscal integration. He now frames the debate, of risk sharing versus reduction, as a redundant exercise that is actually hindering the monetary policy transmission mechanism. He therefore flatly blames the EU political class for the economic headwind.
Draghi is being somewhat disingenuous. Debate is not hindering the integration process. It is simply redirecting liquidity from the weak indebted nations to the stronger less indebted nations of the Eurozone. Debate is therefore creating the environment in which (A) the less-indebted buy up the more-indebted or (B) the less-indebted share the risk with the more-indebted. Clearly, option (B) is more desirable to him.
Some of option (A) will have to be given to the less-indebted however, as an inducement to share their tax bases. This inclusion of option (A) will then be sold, to the credulous on all sides, as fiscal and economic restructuring. The details will now get negotiated, through consensus and price action, the way they always do in the Eurozone. Mario Draghi’s next job could well be as the political enabler and bundler of such a negotiated outcome. His valedictorian speeches are clearly a job application for such a role.
Draghi’s analysis is a more colorful and inflammatory picture of how the Eurozone is systemically unbalanced and prone to splitting as a consequence. He does however note correctly that a political decision, to transfer wealth through the integrated fiscal system from the indebted to the indebted, is a possible solution for public sector deficits. This can either be done by wealth transfer, through integration now, or through bail-outs in the future.
Unfortunately, Populists stand in the way of either solution right now; which means that the risk of Eurozone fracture is rising. The ECB uses this rising risk to nudge its own solution. The ECB must however be careful not to overplay its hand and push things beyond breaking point. A little bit of escalating crisis is a good agent of change. A massive systemic crisis can go either way, and is therefore sub-optimal.
(Source: The Author)
The ECB has promoted option (A) in the past. The ECB’s new Capital Key limits on QE purchases actually drive Euro liquidity to the larger less-indebted nations. This process then forces companies in the weakest nations into the hands of companies in the strongest. The ECB’s own Capital Key limits are in effect the broken transmission mechanism that Mario Draghi is blaming on the EU. This solution will work for private companies. It will not and is not however working for public sector deficits. That is one reason why option (B) is still required. Option (B) is also required because the ECB will need to enable fiscal integration with more QE. Since “Safe Bonds” are de facto and de jure fiscal integration, option (B) must be part of the optimal solution.
Populists effectively get in the way of the process. Populists in more-indebted nations want to run bigger deficits, and those in less-indebted nations wish to run austerity for all. All that the ECB has done, with its new Capital Key limits, is to force the systemic instability to a tipping point. At this point it is hoped that rational political decisions are made, over risk sharing in return for economic reform.
Draghi unfortunately miscalculated however. There is no rational debate to be had at the ECB-induced tipping point. All that occurs is emotive irrational Populism. Nudging nations to the rational tipping point, through applying Capital Key limits, has simply encouraged irrationality. The arrival of Philip Lane marks a point at which the ECB is now responding to the irrationality that it had not anticipated.
The ECB has therefore gone for Plan B, in the form of pooled “Safe Bonds”, which in theory there are no Capital Key limits on. The ECB intends to load its balance sheet with “Safe Bonds”. Once issued and purchased, these bonds are an effective ECB call on the pooled fiscal resources of the Eurozone. Fiscal integration, de facto and de jure, will then have been established through guile and stealth by the ECB.
There are still some members of the ECB who do not understand the new nuanced “Safe Bonds” Plan B being presented by Philip Lane.
Governing Council member Ardo Hansson signaled that there are some like him at the ECB, who will continue to try and force the banking sector into a privately funded consolidation solution. Hansson sees no case for a tiered interest rate mitigation solution being provided to Eurozone banks struggling with margin pressure. Neither does he believe that TLTRO III should be as generous as the previous rounds. He would thus like tough love for the banks from the ECB. This tough love would then be a precursor to the weak either going to the wall of being consolidated. Tough love however just makes the irrational Populists even stronger. Hansson is clearly an economist and not a politician.
Hansson’s view is not universally shared by his colleagues however. Governing Council member Bostjan Vasle corrected Hansson’s guidance, with an assurance that no decision on TLTROIII will be communicated at the next council meeting. He also made it clear that the provision of liquidity and associated terms in TLTRO III, will depend on conditions in the banking sector and not some ECB strategic agenda.
ECB presidential candidate “Preudomme” de Galhau has little sympathy for the banks either. His priority is for low interest rates to prevail, in order to get the economy through this current phase of weakness. In his opinion, the problems that this creates for the banks are wildly exaggerated. This exaggerated problem did however provide him with an opportunity, to telegraph how he will vote in the June Governing Council meeting. Allegedly, he needs time to assess the impact on the banks of what he has already called a wildly exaggerated problem. His need for time therefore neatly fits his desire, not to do anything with monetary policy in general at the next Governing Council meeting.
De Galhau’s play for time, on interest rates and the banking sector’s pain, resonates with the ECB’s latest announcements on financial stability. The ECB highlighted the threat in the corporate debt sector blowing from global and Eurozone slowdown. In this environment, the ECB expects banks to have profitability issues. Thus, on the one hand, the slowing economy needs lower interest rates. On the other hand, the banks will take a double hit from lower interest rates and slower economic activity though. De Galhau has not resolved which hand he should wave first, neither has the ECB. Bostjan Vasle confirms this, and suggests that the ECB will be informed by the actual levels of pain in the banking sector rather than expected levels of pain.
(Source: Investing.com, caption by the Author)
The last report noted various ECB speakers, with a clear interest in preserving the status quo, talking up the prospects of an economic bounce in the Eurozone. This economic bounce was classified as Dead Cat. Based on the latest Sentix Investor Confidence reading, Mr. Eurozone Market swallowed the Dead Cat bounce hook, line, sinker, rod and angler. He started to believe that, all is so well in the Eurozone that, the ECB can normalize monetary policy. It has taken, President Trump and Eurozone inflation data, little time to disabuse Mr. Eurozone Market about the contents of his stomach. His violent reaction may be just what the ECB needs to nudge its “Safe Bonds” a little closer to market.
German Finance Minister Peter Altmaier has swiftly disabused those concerned, and also those who were playing along with the charade that the German Cat is healthy. Speaking recently, he opined that the German Cat has not bounced back to previous health and beyond. In fact, the sustainability of the German bounce is conditional on extraneous factors at the global and Eurozone level. He did not speculate, on the condition of said extraneous factors; however, it is obvious that these are currently incapable of sustaining the German bounce.
Apparently, the IMF hasn’t fallen for the Dead Cat bounce optimism either. It refuses to raise its German growth numbers in light of recent stronger data. This may however be clouded by the IMF’s house view, and its pressure on Germany to enact a fiscal expansion and tolerate similar attempts in its Eurozone neighbors.
Outgoing ECB Chief Economist Peter Praet concurs with Altmaier’s summation. In Praet’s opinion, it is the global uncertainty itself that is the principal headwind.
“Preudhomme de Galhau” has taken up a middle of the road approach, in his campaign to succeed Mario Draghi as ECB President. This precludes him from doing anything more than reiterating the ECB’s current economic forecasts. Speaking recently, he referred to said forecasts as the reason that he believes that the ECB’s current stance is well calibrated and in no need of immediate change. Wisely, he also chose to avoid getting tangled up in “Rehnfeld’s” call, for a potentially embarrassing post-mortem on Draghi’s tenure in control of monetary policy setting.
Benoit Coeure, the other French hopeful for Draghi’s job, chose a similar neutral spin to that of his fellow countryman and rival. Coeure didn’t refute Herr Altamaier’s global comments; he simply noted that there may be further good news from the Eurozone itself. This implies that there may not be also.
Coeure differentiates his candidacy for ECB president, from that of his fellow countryman, by actually taking a stand on something. De Galhau could only suggest that the ECB review the cost and benefits of ZIRP/NIRP on the banking system. Coeure by contrast has a view. He believes that the impact of ZIRP/NIRP on the banks is “peanuts” in comparison to their other problems. If elected as ECB President, one can therefore expect Coeure to press on with ZIRP/NIRP and possibly to expand QE.
Governing Council member Ignazio Visco took a stronger line than his two French colleagues. The current status quo is clearly one which he sees deteriorating further. With this in mind, he reminded the markets that the ECB has not “disarmed” its monetary policy easing tools. He thereby challenges the notion, that there will be an economic rebound that will re-initiate the normalization sequence.
“Rehnfeld” has modulated his own guidance and call, for a review of the ECB’s monetary policy framework, since he was rebuffed by Mario Draghi and Peter Praet in the last report. “Rehnfeld’s” call for a review was seen as criticism of Draghi’s stewardship. “Rehnfeld’s” modulated guidance now focuses more closely on the inflation target. His policy review has been re-framed as an exercise in redefining what the symmetrical inflation target should be. This revised call for a review, is thus more specific and focused on numbers rather than individuals and the integrity of the ECB by default.
Rather than sound radical as before, “Rehnfeld” was also careful to toe the line on the current ECB house view of the Eurozone slowdown. This slowdown is not yet a recession in his book. This classification will depend upon its duration and magnitude. Should both metrics qualify it as a recession, he is certain that the ECB will respond with monetary policy vigor. For now, he will only talk about pushing future monetary policy tightening out into the future rather than handicapping the next ease.
The last report described the Eurozone’s descent into mob rule, with new fault lines opening up in the Baltic nation of Lithuania. The fault line now extends into neighboring Estonia, with white supremacists making up 18% of the parliament and firm control of the finance ministry.
Germany was also noted as a strategic economic and political fault-line in the last report. Both the EU and America are trying to convince the Germans, that their blocs export markets are more attractive than the other, in the upcoming EU-US trade negotiations. America recently softened its line on car tariffs, to show Germany a carrot to go with the tariff stick.
A telling sign of this German fault-line emerged recently, with the rumor that Angela Merkel has actually turned down a top EU job when she leaves the Chancellor’s office. Merkel is clearly aware of just how anti-EU political sentiment is in Germany, and doesn’t want to polarize German voters even more.
As the German economy slows, at some point, some commentator is bound to ask what the recent immigrants are doing for work, and what they will do to pay their way in the future. Someone will also ask who let them in. It’s a great question. Then some Far Right orator will say Merkel. Clearly, Merkel is currently trying to rewrite her and her own nation’s narrative. This leaves little room in the margins for the Eurozone.
This German fault-line is opening up division in the Bundesbank.
Bundesbank President Jens Weidmann played his German trade cards close to his chest, in responding to the EU and US opening gambits in the trade negotiations. He responded to America by saying that Germany’s trade surplus would not take a hit from US tariffs, therefore implying some German aligned interest with the EU. He then went on to say that tariff reciprocation would actually hurt America more than Germany.
Weidmann’s ECB cards were fully visible, and thereby not so friendly for his EU neighbors. Whilst admitting that Eurozone inflation is “stubbornly low,” he made it clear that he is still looking to press on with the normalization of monetary policy regardless. If anything, he sees inflation as the risk preventing further easing. On tiered interest rate mitigation for banks, he believes that the tiering process will counter-productively make interest rates even more negative. It will be tough love and tighter monetary policy for the Eurozone if he replaces Draghi.
It could be worse. If the sado-monetarist Bundesbank Vice President Claudia-Maria Buch were ever to become a gender balancing ECB President, it would be game over for the Eurozone economy as we know it. Her stoic reference to, the current collapse of German industrial output being a “dip,” makes Weidmann appear like a Dove.
Based on objective analysis, of Weidmann’s latest commentary, one may conclude that the Bundesbank wants Germany to plot a Germany First course. What Germany’s politicians have to say on this is not clear. Clearly, Merkel is wavering and wobbling towards some kind of Germany First meme. One must say that Weidmann’s line does play well to the political gallery on the streets in Germany though. Maybe the politicians will follow his cue.
Confirmation, that Germany is indeed following a Germany First agenda, was provided by its close neighbor Holland. Keenly aware that Germans play the European card when it suits their exports, yet are unhappy to support these exports if the German taxpayer is called upon, the Dutch finance minister spoke. Woepke Hoekstra finally called it the way it is from a European perspective. In a speech in Germany, he highlighted Germany’s parochialism. He likened it to the insidious Swiss neutrality, which lurks like a Trojan Horse within the Eurozone’s frontier.
This is pretty strong stuff and comes at a time when German politics is transitioning from the era of Merkel into an uncertain future. The top jobs in the EU and the ECB will not be going to Germans, unless the country responds with pro-Eurozone alacrity to its critics. The Spanish have also signaled that they will gang-up with the French, to address who gets the top jobs in the Eurozone. Germany is being marginalized politically, by its own actions and the reactions of its neighbors.
Providing context to the rumor that Markel has turned down a top EU job, it now transpires that she and Emmanuel Macron have fallen out. Allegedly, Merkel doesn’t trust her anointed heir Annegret Kramp-Karrenbauer either. Merkel has therefore decided to hunker down and re-align herself with Germany First politics. She has thus switched from Globalist to purported Populist. No wonder Macron is unhappy.
Such a switch will alienate her traditional supporters and fail to convince her Populist detractors. Hopelessly out of touch, she has taken a leaf out of the Theresa May book of delivering everything to everyone and no-one at the same time. We all know how this ends. Merkel still believes that the nation trusts her to take care of its interests. Let’s see if the nation does in that case.
Germany is falling like a stone economically and politically. The outcome is unpredictable. Germany does however have a historical track record of surprising with the extreme outcomes when it feels threatened. The portents and current situation are ominous, if one believes that past performance is indicative of or a guarantee of future performance. Europe and the world have seen Germany First twice before already.
Despite threats to its position, Germany is still being courted by its Eurozone partners. The EU has drawn a red-line around the issue of car quotas in trade negotiations with America. The German car industry is clearly the main beneficiary of this red-line drawing. German interest has thus been escalated to the highest level of EU interest. If the Germans fail to acknowledge this solidarity, by responding with alacrity to their Eurozone colleagues, it would be egregious.
Following a Germany First line at the Bundesbank does not however make for a consensus at the German central bank. There are clearly divisions over how Germany First is best served. Following the stinging Dutch rebuke, the Bundesbank’s latest monthly report stood in stark contrast to the views of its president and sado-monetarist vice president. The monthly report opined that the slowdown is not a temporary dip. Problems in the auto-sector are also expected to worsen. The battle for the hearts and minds of Germans clearly rages within the Bundesbank also.
The recent EU Parliament elections provided something for everyone who is not an EU establishment figure. The diversity and inclusion, that the EU establishment has promoted, finally turned round and bit the hand that has nourished it. There was success for minority parties, from both ends of the political spectrum plus the Greens, at the expense of the center ground.
Although the minority parties may claim victory, they remain minorities and hence are not victorious at all. The EU is rapidly degenerating into a tyranny of minorities who must form coalitions, often with those they despise, in order to have any governmental representation. The gridlock and chaos, that this will create, will eventually bore those who wanted change and thought that they had achieved it. Then, the pendulum will swing back to the middle ground where a consensus can be formed. In the meantime, said middle ground will try and subsume the less virulent minority parties into its broad pro-EU church. Politics and economics is going nowhere in the EU. It is simply spinning its wheels, whilst the political elites re-align and divide the spoils once again.
(Source and caption by the Author)
Italian Deputy Prime Minister Matteo Salvini claimed that his victory was an EU mandate for greater fiscal slippage. It is in fact an Italian attempt to bribe and cajole the EU into accepting Italian fiscal slippage. This is therefore a mandate for horse-trading rather than for change. Salvini was forced to accept that he must still partner with Five Star to govern the nation.
(Source and caption by the Author)
Controversially anticipating Philip Lane’s “Safe Bonds” agenda, Italy would now like a seat on the Executive Board of the ECB. From this seat it intends to then direct the central bank, to guarantee and then to monetize its own infrastructure deficit bonds. The first step in this process would be an explicit ECB guarantee for said bonds. From here, it is then a small step for the ECB to then monetize Italy’s social security and pensions deficits; in a general wealth transfer from its balance sheet to the Italian people. Italy is becoming a microcosm of this EU tyranny by minorities who expediently form coalition governments. “Rehnfeld” immediately ruled out Italy’s plans as “forbidden.”
The EU’s response to Italy provided a clear picture of how it has adapted to the new Populist Realpolitik raging through the Eurozone. The EU intends to scrutinize Italy’s finances going forward, which may lead to a fine for limit breaking. This is the stick.
There is however a carrot. The EU will extend the period, over which Italian banks can avail themselves of state guarantees on the sales of the debts on their balance sheets. The EU is thus happy for the Italian state, to address its non-performing loan problem by, bending Stability Pact fiscal rules rather than breaking them.
On the one hand, the EU tries to limit the size of the Italian budget deficit with Stability Pact rules. On the other hand, it is happy to enable the expansion of said deficit if it is in the interest of the Eurozone banking sector in general. “Safe Bonds” are also congruent with this general carrot and stick, practical thesis. The rule is that there are no rules in the Eurozone. Everything is negotiable practically speaking. The new political dialectic has made this practical flexibility even more important.
The next ECB President must also be flexible therefore by default.
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.