Blain’s Morning Porridge – July 5h 2022: The ECB in Crisis? Compromise means buy Italy on the dips!
“The greatest trick the devil ever pulled was convincing the world that he did not exist.”
This morning: Lots of comment about imminent crisis in the ECB and European Bond Spreads. Relax. It’s a difficult circle to square, but the politics mean its more likely solutions will be found, and its buy Italy, Spain and Greece on the dips!
There is lots on negative comment on Europe this morning – warning of a “new crisis” for European sovereign debt, “imminent stresses” in bond spreads, and a “predictable” policy impasse between the Euro members.
Last week, the ECB hinted it will reinvest the proceeds of maturing bonds from earlier stability programmes into bonds issued by weaker nations in order to backstop their bond yields – immediately upsetting some members. We are still waiting to hear what the proposed new “anti-fragmentation instrument” will look like – I suspect it will end up a camel; a horse designed by committee. As the ECB moves at the pace of an arthritic tortoise, it may all happen too slowly.. (But, even just saying it’s going to happen, kind of had the same effect..)
Yesterday, Bundesbank President Joachim Nagel warned against the ECB’s plans to stop divergence, aka “fragmentation”, in European bond spreads, stating it would be “fatal” for governments to rely on the ECB to control bond yields. Oh no! Germany on collision course with Europe… say the Euro Naysayers!
Relax. The Euro is not dead. The ECB is not about to disappear in a puff of logic. But its role will remain… challenging. There is plenty more debate and negotiation to come, but the ECB will most likely find a way. The costs of disillusion are too great to contemplate.
The challenge, as always, is for the ECB to square the circle of very different European nations all using the same currency. How can it stabilise European bond spreads to ensure all member nations benefit equally from the Euro? If rates are high for some, and lower for others, that will create long-term inequality, stress and conflict between them.
The problem has been that – surprisingly, apparently – the ECB has discovered all the Euro member nations are completely different in terms of productivity, demographics, tax base, industrial position, labour relations, governance, political reality, and a host of other factors. But, for the common currency, the Euro, to work we have to accept they are all the same.
That’s because currencies work on the basis they reflect the markets belief in a nation’s Virtuous Sovereign Trinity – how well its’ political economy (the issues I’ve listed above), bond markets and currency function together to create stability? For normal countries, all three legs of the Trinity move together creating long-term stability and facilitating investment and growth.
For members of the Euro, the currency leg is fixed, and for some it does not fit very well with their political reality. That means the bond leg of the trinity can become hugely distorted. And distorted bond prices are an invitation to trade! To maintain the illusion the trinity remains balanced, there have to be political compromises. For instance, promises that Italy will control its bond raising and government spending.. yeah… cos that is so going to happen.
The bottom line is high risk nations like Italy always paid a higher bond yield to reflect the weakness of their currency, caused by the relative weakness of the Italian political economy. German yields were tighter, and the Deutschemark stronger because the economy was stronger.. (German politics hardly mattered – they were dull, boring and predictable; exactly what international investors want to see! No longer the case – German politics are showing themselves in a more interesting, but not successful, light.)
The situation is made more difficult because for a shared common currency, there are further complications. First, there is a fourth leg of the Trinity…. (What? How can a tripod have four legs??) The ECB sets European interest rates. If it sets them low because Southern European economies are weak, then if bond spreads have become “fragmented”, ie much higher in Spain, Italy, Portugal and Greece, then the effect of low Euro rates is effectively nullified by higher borrowing costs. At the same time, low interest rates simply cause an already hot German economy to heat up even more, creating that most unacceptable of monetary conditions – inflation! (Which we all know is utterly, completely and absolutely unacceptable in Germany.)
And then there is a fifth leg of the Trinity (!) – European politics. Everyone in Europe wants European Unity…. but, on their terms. It’s not as simple as the French want European Unity to support French Farmers, the Germans want European Unity to support German manufacturers, or the Italians want European Unity because they need someone else to pay for Italy. The issue is each member government of the Euro has to demonstrate to their populations why being in the Euro is positive.
The simple answer is European unity provides a much bigger market. But that’s not helpful when nations start to worry about competition. Plus is going to be very difficult in Germany, the Netherlands, Sweden, and the rest of the rich north, if their taxes and savings raised in their rich and efficient nations end up paying the costs of the poorer, more profligate spendthrift nations of the South. It’s the old political adage about the secret of European success being able to persuade German workers to pay the pensions of Italians.
The result is something of an existential crisis across the Euro, including the following factors:
- The strong nations of Europe need higher rates to combat inflation.
- The weak nations of Europe need lower rates to stem recession.
- Inflation has been triggered by supply chain and energy costs, and needs to be addressed in stronger nations.
- Stagflation is the reality in weaker nations.
- Every Government wants to show its people they are winners within the Euro.
- A weaker Euro is bad for Europe in energy cost terms
- A strong Europe is bad for European exports
What’s the answer?
Mutualising European debt under the aegis of the ECB is already happening – during the pandemic the ECB served notice it was taking control by making absolutely clear that disbursements from the emergency pandemic funds would only be given to nations that toed the Brussels line. It confirmed financial sovereignty no longer resides in the national capitals of the Euro members, but with the ECB.
Debt mutualisation – the ECB issuing all European government debt, or guaranteeing it on a joint on several basis – would have several advantages. It would create a global debt market comparable to the US Treasury market. It would raise the importance of the Euro as a global reserve currency at a time when the mighty dollar is looking suspect and only remains the key currency because there is no alternative.
Unfortunately, I doubt we will see true Eurobonds in my career.
Debt mutualisation can’t work without closer political integration – which is largely off the political agenda across Europe at present. If the French government were seen to support closer integration it would simple fuel support for the right wing. The rich nations of the North see little point in using their credit to enable the ECB to address the root cause of the political economy failures of Southern Europe by directing regional aid. They would see that money as likely to be squandered.
Debt mutualisation is more likely to happen when the markets are stable, and politics is less fraxious – which aint on my mid-term horizon.
The key issue is the ECB is well aware of the problems it faces, and it’s Central Banking by committee. The fact its run by a competent politician – Christine Lagarde – is positive. The fact the national members, like Germany, are highlighting their concerns is also positive. So forget all the nonsense about imminent collapse, or a crisis enveloping Europe. Solutions/compromises will be found – and get ready to buy Italy as crises deepens on the basis the ECB will be forced to act.
Just a quick word on yesterday’s Porridge on the US: The US’s Past will determine its future
Because I had the temerity to write about America, as usual I came in for some pretty vicious trolling from Trumptards – yes, I know it’s an insult, and I hurl it deliberately.
I have many Republican friends with whom I argue on a calm and reasonable basis. But I won’t argue with Trumptards who still deny the election and don’t understand the basis of debate. A number of subscriptions cancelled yesterday. Sorry to lose them, but after being told to “stay within my lane” , or my comments “would be noted and remembered”, happy they have gone. Or how about “Jesus may love you, but I don’t.” Bovvered.
The Righteous Right in the US has a very simple view: don’t dare comment on America unless you share their view. I don’t, and will continue to comment, but I will always be happy to be guided by and engage with the Reasonable Right and Left of any nation. Understanding the politics of a nation is key to understanding its Virtuous Sovereign Trinity and how it will function in Bond and Currency Markets.
No time for five things this morning..
Out of time, and back to the day job..
Strategist – Shard Capital