Germany’s September ZEW survey provided yet more evidence that the feeling of “no pilot on the plane” when it comes to the EU’s management of its solvency crisis is destroying bank balance sheets. The institutional investor sentiment balance has fallen 47pts, from 90.6 to 43.6, in the three months between July and September, exceeding the 46.8pt collapse seen in the June-August period of 2008. The results bring further confirmation that the European banking crisis is back in the domain of the 2008 turmoil, which exerted extreme systemic pressure on banks’ capital and left vast segments of the financial system on life support from the ECB.
The ZEW current conditions balance suffered a near-10pts collapse on the month to 43.6. This represents a more than 50% contraction from the cycle peak of 91.5 reached in May and unwinds all of the gains seen in this series over the past year. The result will stoke recession fears, although the link between this indicator and historical swings in real GDP growth is relatively poor. Instead the strong message from this survey is that the recovery in Germany is a story of the past and once again a shock in the financial system results in a feeling of “falling off a cliff” for the real economy.
There are, however, important distinctions between the crisis in 2008 and its current phase. EU national budgets and taxpayers’ revolt against bailouts leave no room for maneuvre with respect to capital support for banks. International co-operation for boosting global demand has proven unachievable. Instead, the global capital market spillover from the euro zone crisis, an international bias towards currency protectionism and a political paralysis in the US challenge expectations for global demand growth in 2012. The potential for a new reflationary cycle for financial values via QE3 from the Fed appears low given current political-inflation considerations in the US. A weaker global growth scenario and the chronic pressures from the sovereign crisis on banks’ capital leaves little choice for financial institutions but to use the ECB’s life support to reduce cyclical exposure and leverage on their balance sheets, resulting in a more permanent medium-term shock to European capital markets and credit flows to real economies.
What should the ECB do?
Euro zone political-inflation dynamics have constrained the ECB’s ability to ease policy aggressively in a conventional way in the short term. The ECB’s September staff projections showed a downgrade to growth forecasts for the next two years which just about tilted the balance of risks to the medium-term inflation outlook from a hawkish towards a neutral direction. That said, the ECB has indirectly increased policy accommodation, via an expanded balance sheet and a growing concentration of financial and sovereign risk onto the central bank's balance sheet by virtue of its backstop operations in illiquid interbank and peripheral sovereign debt markets. The risk is that the intensifying banking and sovereign crisis will see the ECB’s assets and risk exposure rise further into the year-end as market stresses escalate. Although the ECB remains a reluctant buyer of last resort of market risk, the potential for restarting LTROs and unsterilized covered bond purchases over the coming months will facilitate a further easing of monetary conditions even if the Bank’s official inflation-targeting stance remains unchanged.
That said, with the probability of a euro zone recession growing and the financial system in turmoil, current elevated money market rate levels are becoming increasingly contractionary. Admittedly the problem is market liquidity and banks’ collateral valuations rather than the risk-free cost of borrowing from the ECB, though on this front the ECB is already fighting the fire through its sovereign bond purchases and unlimited liquidity provisions to the banking system. New ECB President Mario Draghi's first job will be to channel Eonia rates lower, either by signalling a refi rate cut or via nonconventional liquidity measures such as widening the marginal facilities corridor. The current ECB deposit rate, or the rate off which the market prices Eonia (the interbank swap curve) is currently 0.75%, which is 50bps above the record low established following the 2008-2009 banking crisis and looks unjustified.
The real challenge for the ECB will be how to calibrate its monetary policy to manage political influences over its sovereign bond portfolio on one side and stabilise market confidence on the other while healing differences within the Governing Council. With the ECB active on many fronts, the communication and credibility challenge for the central bank will be to balance the message of its inflation fighting credibility on rates against the expanding size and risk-weighting of its balance sheet. The chances are that the rifts on the Governing Council will widen before they can heal. We are looking for EUR/USD at 1.30 at the year-end.