Will Italy get a 250 billion Euro debt write-off from the ECB?

Up until now financial markets have been very sanguine about the coalition talks and arrangements in Italy. I thought it was something of calm before the storm especially as these days something which was a key metric or measure – bond yields – has been given a good dose of morphine by the QE purchases of the European Central Bank. However here is a  tweet from Ferdinando Guigliano  based on information from the Huffington Post which caught everyone’s attention.

1) Five Star and the League expect the to forgive 250 billion euros in Italian bonds bought via quantitative easing, in order to bring down Italy’s debt.

My first thought is that is a bit small as whilst that is a lot of money Italy has a national debt of 2263 billion Euros or 131.8% of its GDP or Gross Domestic Product according to Eurostat. So afterwards it would be some 2213 billion or 117% of GDP which does not seem an enormous difference. Yes it does bring it below the original 120% of GDP target that the Euro area opened its crisis management with but seems hardly likely to be an objective now as frankly that sank without trace. Perhaps they have thoughts for spending that sort of amount and that has driven the number chosen.

Could this happen?

As a matter of mathematics yes because the ECB via the Bank of Italy holds some 368 billion Euros and rising of Italian government bonds and of course rising. However this crosses a monetary policy Rubicon as this would be what is called monetary financing and that is against the rules and as we are regularly told by Mario Draghi the ECB is a “rules based organisation”. Here is Article 123 of the Lisbon Treaty and the emphasis is mine.

Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.

Now we hit what Paul Simon would call “troubled water” as the ECB has of course been very close to the highlighted part. The argument for QE purchases rested on the argument that buying in the secondary market was indirect and not direct or as the ECB puts it.

There will be no primary market purchases under the PSPP, regardless of the type of security, as such purchases are not allowed under Article 123 of the Treaty on the Functioning of the European Union.

It is a bit unclear as to when they become available but if I recall correctly as an example the Bank of England limit is one week.

The reason for this is to stop a national government issuing debt and the central bank immediately buying it would be a clear example of round-tripping. The immediate implication would be a higher money supply raising domestic inflation dangers  although there would be an initial boost to the economy. We did look at an example of this a couple of years ago in the case of Ghana and whilst we never get a test tube example in economics the Cedi then fell a substantial amount and inflation rose . Thus the two worrying implications are inflation and a currency plunge on a scale to cause an economic crisis.

Would this happen in the case of Italy? That depends on how it plays out. Inside the boundaries of the Euro maybe not to a  great extent initially but as it played out there would be an effect as Italy would not doubt be back for “More,More,More” once Pandora’s Box was open and of course others would want to get their fingers in the cookie jar.

Oh and if we go back to the concept of the ECB being a “rules based organisation” that is something that is until it breaks them as we have learnt over time.

Fiscal Policy

You will not be surprised to learn that they wish to take advantage of the windfall. Back to the tweets of Ferdinando Guigliano

5) The draft agreement would see the Italian government spend 17 billion euros a year on a “citizens’ income”. The European Commission would contribute spending 20% of the European Social Fund

That raises a wry smile as we mull the idea of them trying to get the European Commission to pay for at least some of this. Perhaps they are thinking of the example of Donald Trump and his wall although so far that has been more of a case of a “Mexicant” than a “Mexican.”

Next came this.

According to , the 5 Star/League draft document says there would be a “flat tax”… but with several tax rates and deductions

So flat but not flat well this is Italy! Also we see what has become a more popular refrain in this era of austerity.

Italy’s pension reform would be dismantled: workers would be able to retire when the sum of their retirement age and years of contribution is at least 100.

Over time this would be the most damaging factor as we get a drip feed that builds and builds especially at a time of demographic problems such as an aging population.

So a fiscal relaxation which would require some changes in the rules of the European Union.

The two parties want to re-open European Treaties and to “radically reform” the stability and growth pact. The coalition would also want to reconsider Italy’s contribution to the EU budget.

Market Response

That has since reduced partly because the German bond market has rallied. Partly that is luck but there is an odd factor at play here. You might think that as the likely paymaster of all this Germany would see its bonds hit but the reality is that it is seen as something of a safe haven which outplays the former factor. On that road it issued some two-year debt yesterday with investors paying it around 0.5% per annum. Also I think there is such a shock factor here that it takes a while for the human mind to take it in especially after all the QE anaesthetic.

The Euro has pretty much ignored all of this as I use the rate against the Yen as a benchmark and it has basically gone “m’eh” as has most of the others so far.

Comment

There are quite a few factors at play here and no doubt there will be ch-ch-changes along the way. But the rhetoric at least has been raised a notch this morning.

We are in favor of a consultative referendum on the euro. It might be a good idea to have two euros, for two more homogeneous economical regions. One for northern Europe and one for southern Europe. ( Beppe Grillo in Newsweek)

I do not that the BBC and Bloomberg have gone into overdrive with the use of the word “populists” as I mull how you win an election otherwise? If we stick to our economics beat this is plainly a response of sorts to the ongoing economic depression in Italy in the Euro era. Also it was only on Monday when the Italian head of the ECB was asking for supra national fiscal policy. For whom exactly? Now we see Italy pushing for what we might call more fiscal space.

Meanwhile if we look wider we see yet more evidence of an economic slow down in 2018 so far.

Japan GDP suffers first contraction since 2015

Very painful for the Japanese owned Financial Times to print that although just as a reminder Japan is one of the worst at producing preliminary numbers.

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Where next for the Euro exchange-rate?

As we start a new week the focus will be shifting to the Euro area and its economy and exchange-rate. The reason for this comes from my article of last Wednesday which concluded with this.

The ECB finds itself in something of a dilemma. This is because it has continued with a highly stimulatory policy in a boom and now faces the issue of deciding if the current slow down is temporary or not? Even worse for presentational purposes it has suggested it will end QE in September just in time for the economic winds to reverse course.

Such thoughts were strongly reinforced in the Thursday press conference when we started with an Introductory Statement mentioning moderation.

Following several quarters of higher than expected growth, incoming information since our meeting in early March points towards some moderation, while remaining consistent with a solid and broad-based expansion of the euro area economy

At this point we merely have the ECB Governing Council covering itself either way as if they economy picks-up they will emphasis the latter bit and if it slows down they will tell us they warned about moderation. But then in his replies to questions President Draghi took things a step or two further.

 It’s quite clear that since our last meeting, broadly all countries experienced, to different extents of course, some moderation in growth or some loss of momentum. When we look at the indicators that showed significant, sharp declines, we see that, first of all, the fact that all countries reported means that this loss of momentum is pretty broad across countries. It’s also broad across sectors because when we look at the indicators, it’s both hard and soft survey-based indicators.

As I pointed out on Friday if we translate from the language of central bankers the use of “significant sharp declines” is of importance as these days they consider it their job to stop that! If you had negative interest-rates and a balance sheet of over 4.5 trillion Euros it would give you food for thought. If we look at the next bit we can see that it did as it occupied so much time they did not discuss monetary policy at all.

 First of all, the interesting thing is that we didn’t discuss monetary policy per se. All Governing Council members reported on the situation of their own countries.

So they decided that as there is nothing they can do in the short-term and policy is already expansionary there was nothing to do. Also they were again caught on the hop.

And these declines were sharp and in some cases, the extent of these declines was unexpected.

Today’s monetary data

This will have attracted the attention of Mario Draghi and the Governing Council so let us start with the headline.

The annual growth rate of the broad monetary aggregate M3 decreased to 3.7% in March 2018,
from 4.2% in February.

Now let us compare it with the press conference Introductory Statement.

Turning to the monetary analysis, broad money (M3) continues to expand at a robust pace, with an annual growth rate of 4.2% in February 2018, slightly below the narrow range observed since mid-2015.

If we look through the rhetoric we see that it was already below the range that had led to the recent stronger economic growth. If we use the rule of thumb that broad money growth can be divided between economic growth and inflation we see that one of them will be squeezed. With the price of a barrel of Brent Crude Oil remaining around US $74 per barrel it seems that there will be upwards pressure on inflation from this source which may further squeeze output.

In terms of the immediate future then it is narrow money which gives us the best guide and it too was a disappointment.

The annual growth rate of the narrower aggregate M1, which includes currency in circulation and overnight deposits, decreased to 7.5% in March, from 8.4% in February.

This series peaked at just under 10% last autumn so we can see that from it we will be expecting something of a slow down over the next 6 months or so.

Is this the impact of QE?

The impact on March may well be the consequence of the reduction in monthly QE purchases from 60 billion Euros a month to 30 billion which began in January. The monthly numbers for M1 growth have gone 51 billion, 31 billion and now 20 billion so whilst it is not that simple as the numbers are erratic I think it added to an existing trend.

This leaves the ECB mulling the irony that it chose to do less as the economy weakened. Or that the expansion needs a continuous dose of the economic pick me up and cannot thrive otherwise.

What about credit?

When you consider that the taps are supposed to be fully open it was not that special.

The annual growth rate of total credit to euro area residents decreased to 2.9% in March 2018, compared
with 3.4% in the previous month.

Whilst it may not look like it from the number above but March was better than February if you look into the detail such as this one.

In particular, the annual growth rate of adjusted loans to households increased to 3.0% in March, from 2.9% in February, and the annual growth rate of adjusted loans to non-financial corporations increased to 3.3% in March, from 3.2% in February.

But such numbers are more of a lagging indicator than a leading one so we are left with a downbeat view.

Comment

In terms of first quarter data the score is 2-1. On the downside we have seen GDP ( Gross Domestic Product) growth in Belgium dip to 0.4% and more of a fall in France to 0.3%. On the other side Spain shrugged it off and grew by 0.7%. As even the German Bundesbank is expecting a slow down there it seems set to be a weaker quarter for Euro area growth and that will not have been helped by the weakness in the UK.

This means that two of the supports for the level of the Euro are weakening. The first is the fading and perhaps end of the Euroboom as the better economic growth data supported the currency. The second is a potential consequence which is the planned reduction in QE in September where eyes will soon turn to this bit from the ECB.

are intended to run until the end of September 2018, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.

Actually the inflation issue is also on the cards today after this from Italy.

In April 2018, according to preliminary estimates, the Italian consumer price index for the whole nation (NIC) increased by 0.1% on monthly basis and by 0.5% compared with April 2017.

So a long way from the just below 2% objective and Portugal at 0.3% was similar. Whilst I expect the new higher oil price to change things we could see a shake-up in the plans for QE in 2018. Whilst we know it is nor as simple as more QE or more negative interest-rates equals a weaker currency a shift like that seems likely to have an effect.

Meanwhile as ever life is complex as according to the oil trader @chigrl a higher oil price boosts the value of the Euro.

Thus the foreign currency reserve balances of these oil exporting countries, in a sense, is broadly reflected by the price of oil. ……However, data also shows that they invest part of their reserves in EUR, as they sell a large share of their production to the Eurozone.

Which leads to this.

Thus, when the price of oil falls, this means that a smaller portion of USD is transferred to EUR, thus contributing to a depreciation of the currency. Inversely, when the price of oil increases, a larger portion is transferred to EUR, contributing to the appreciation of the currency.

This gets exacerbated when some try to game this.

For this reason, many funds lock their positions in EUR/USD with those in crude oil.

 

There are economic consequences of Brexit for the Euro area too

After looking mostly over the past few days about the likely economic future for the UK post Brexit it is time to widen the perspective and look at the implications more widely in Europe. As it and the UK go through a phase of what Chris Martin and Gwyneth Paltrow described as “consciously uncoupling” there are many implications across Europe. This was on the mind of ECB ( European Central Bank) President Mario Draghi yesterday as he spoke at its summer conference at Sintra Portugal. We do not know if he toasted absent friends as US Federal Reserve Chair Janet Yellen and Bank of England Governor Mark Carney were late withdrawals from summer camp. So no chianti and chat with Mario this summer for them!

Mario wants alignment

The speech was revealing in the fact that whilst it explicitly avoided the word Brexit there was an implicit theme which addressed it. Let me explain.

So we have to think not just about whether our domestic monetary policies are appropriate, but whether they are properly aligned across jurisdictions.

This is quite a shift if you think about it. There was talk of aligning policy around currencies earlier this year but of course we have large economies both explicitly ( Japan) and implicitly ( China and the Euro area) trying to push their currencies lower. If we stay with the Euro area some would argue that the 80 billion Euros a month of QE and an official interest-rate of -0.4% have contributed to its fall. It’s trade-weighted exchange-rate has fallen from 104.5 in April 2014 to 94.43 now with the Brexit impact being around 0.5 of that. Just to explain whilst the Euro has risen against the UK Pound £ it fell against the US Dollar.

Still we do have a fall of the size Mario discussed in 2014.

Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points.

So he thinks it has raised inflation by circa 0.5% but you note that he does not mention economic growth here. That is because currency depreciations are very awkward for an economic entity which consistently posts current account surpluses.

The current account of the euro area showed a surplus of €329.5 billion (3.2% of euro area GDP) in 2015

After noting such factors it is hard to avoid the view that the phrase “exporting deflation” applies to the Euro area overall. Other nations and trading blocs may well be not entirely keen on “alignment” after the Euro area has already moved some chess pieces in its favour.

Globalisation

There was a clear attempt by Mario to shift the debate to world issues.

What I am saying here is that the same applies at the global level. We may not need formal coordination of policies. But we can benefit from alignment of policies. What I mean by alignment is a shared diagnosis of the root causes of the challenges that affect us all; and a shared commitment to found our domestic policies on that diagnosis.

There are various problems here as I have just pointed out. How can the Euro fall against the Yen or Yuan whilst they are falling against it for example? In fact Mario Draghi sounds rather like he has borrowed the TARDIS of Dr.Who and jumped back to 2008 to talk to Martin Wolf of the Financial Time and Bank of England Governor Mervyn King ( he wasn’t a Baron back then).

Indeed, to the extent that the environment in which we operate is more affected by the global output gap, and the global savings-investment balance, the speed with which monetary policy can achieve domestic goals inevitably becomes more dependent on others – on the success of authorities in other jurisdictions to also close their domestic output gaps; and on our collective ability to tackle the secular drivers of global saving and investment imbalances.

Is Mario singing along with Lilly Allen “It’s not me it’s you” and “It’s not fair”? Also you may note that he is agreeing with one of my themes which is that the credit crunch provided the coup de grace to “output gap” theories. He would not put it like that but you see it has now failed in countries ( UK for example) and now apparently we are told by default in the Euro area so now we have a world one! Please just think through the implications of that and let me offer just one. How would you possibly ever measure it?

Downbeat forecasts

As ever the more private thoughts meet a leaky vessel and let us hope that unlike in the past hedge funds were not given an “early wire” to this. But Bloomberg have picked up on some details.

Draghi sees cutting Euro GDP by as much as 0.5%, document shows

That is a little vague as there were mentions of three years and others used the word growth as we wait to see if that is total or annual. But there was more to come.

Draghi Warns Brexit Will Lead To “Competitive Devaluations”

I wonder if he managed to say that with a straight face! Also I note that the Brexit purdah did not last long. However there is more.

ECB’s Draghi: Concerned Brexit will lead to competitive devaluations, says its time to address bank vulnerabilities ( @DailyFXTeam )

The latter bit caught my eye as we have been told for the last 8 years or so that the ECB has been on the case of reforming the banks and time and time again we have been told that they are “resilient”, yet vulnerable is apparently the new resilient. Every ECB press conference Mario Draghi speaks about economic reform and each month it is the same groundhog day style statement. This if course comes back to the issue of how you can ever reform banks that know they will be bailed out?

The Italian banks

There is an obvious problem here as resilience morphs into vulnerabilities like the 360 billion Euros of sour loans at the Italian banks. This is a fast-moving situation where it appears that Italy has been informed that an outright bailout breaks the new Euro area banking rules. I am grateful to @liukzilla for pointing out that the vehicle below might be used.

CDP MAY HAVE ROLE IN BANKS CAPITAL RAISING: REPUBBLICA……yep, Cassa Depositi e Presiti

This is 80% owned by the state and seems at first sight to be an effort similar to Portugal where you help the banks but try to keep it off the national debt numbers. For now we seem to be left with the bad bank Atlante which cannot have much more of its 4.25 billion Euros left.  The problem with other banks putting money into it is that they are weakened too and this is similar if not the same to the way that some of the cajas in Spain hit trouble.

Any large-scale move here seems set to blast a hole in the Euro area banking union rules and post questions for the whole concept of it.

Comment

So we see one of the reasons for the equity market rally or what is called “risk-on”. There is no explicit “whatever it takes” phrase but Mario Draghi is hinting at yet more asset purchases. So we have a type of Mario “Put Option” for the equity markets. The danger is that he ends up turning fully Japanese and we end up with a Frankfurt Whale competing with the Tokyo Whale. The play King Lear has the image of a little old lady turning the wheel of fortune well each turn of this particular wheel is one more nail in the coffin of the concept of price discovery as instead markets front-run central banks.

Meanwhile we have gone beyond a drum beat and a bass line to a full orchestra playing one of the longest running themes of my work.

Since Thursday, global stock of negative-yielding debt has jumped $1 trillion to just under $11trn, says BAML ( Chris_Whittall )

There is more.

Global 10y sovereign bond yields tumble to record low 0.5826% after Brexit, according to Citi. ( @ReutersJamie )

I still remember going to a UK “think-tank” around 5 years ago and warning about this and noting it hit home. But everybody apart from me then forgot about it.

 

The economic consequences of devaluing the Euro

One of the features of current world economic policy is the implicit effort of the European Central Bank to gain a competitive advantage by driving the value of the Euro lower on the foreign exchanges. Yesterday there was another effort via Reuters.

A consensus is forming at the European Central Bank to take the interest rate it charges banks to park money deeper into negative territory in December, four governing council members said, a move that could weaken the euro and push up inflation.

Some argue that a deposit rate cut should even be larger than the 0.1 percent reduction currently expected in financial markets, the policymakers said.

Actually after the recent speeches of Mario Draghi it was already clear that a deposit rate cut of more than 0.1% was being considered. Or perhaps more specifically they want us to think is being considered. Reuters did however touch on what I consider is the real game here.

The euro fell by as much as half a cent in response to the Reuters story

Draghi’s Currency Wars

Back at the last policy meeting for the ECB it had a problem. The Euro effective or trade weighted exchange rate was in the low 94s which is where it was when it implemented a major expansion of asset purchases back in January. To be specific the value of the Euro had fallen sharply initially and had continued lower until it dipped below 89 in mid-April. But from then onwards it had risen back to pretty much where it had begun. If you look at this in terms of bang for your buck then treading water does not seem especially good value in return for 60 billion Euros of QE a month.

Thus we saw Mario Draghi respond with a salvo of Open Mouth Operations which have involved hints and promises about taking the deposit rate which is already at -0.2% lower and either a fast rate of asset purchases or extending the term beyond the current end date of 2016. In response the Euro has fallen again and has done so most markedly against the US Dollar where it is now in the 1.07s but if we look wider we see that it is at 91.55 on the effective index. Accordingly Mario’s jawboning has been a success in financial markets terms as the Euro has dropped, however for the real economy we need to take care as if you think about it investment decisions are based on estimates of where they think an exchange-rate will be over a period of years not weekly or monthly fluctuations.

Mario has not always been a soft currency supporter

Back in July 2013 we were told a rather different story. From Reuters.

Noting that the currency’s recent strengthening on foreign exchange markets was a sign of renewed confidence in the euro, Draghi told a news conference:

So the current weakening is a sign of a lack of confidence in the Euro which Mario is encouraging? Anyway a year later Mario had decided you could have too much of a good thing. From CNBC in July 2014.

The recent rise in the value of the euro could stifle the flickering signs of growth in the euro zone,

Such reminders raise a wry smile but to be fair they also indicate that too much pressure is on central banks these days in terms of economic policy. Thus they have morphed into political style behaviour.

Competitive Devaluation

Here is something that rarely gets a mention so perhaps it is another example of the military dictum that it is best to hide something in plain sight. In today’s complex world how do you define a competitive devaluation and indeed exporting deflation. Well I would suggest that acting to drive your currency lower via monetary expansion when you are in the process of announcing a quarterly current account surplus of 53.8 billion Euros is a clear example. Indeed fuel is added to the fire by the fact that the surplus was over 20 billion Euros larger than a year before.

Now we get to something even more awkward if we look at the trade colossus which is Germany. In the first quarter of 2015 it announced a trade surplus of 56.8 billion Euros which means that the lower Euro is benefiting one of the factors which those who look at balance sheet balances think got the world into its current malaise. Also I have argued on here in the past that claimed defeats for Germany on policy such as over Greece might be considered a price to pay for a Euro value much lower than where a Deutschemark would be now. There has been an enormous competitive devaluation here which is being added to.

Just for clarity the German numbers include intra- Euro area trade so are not a like for like comparison with the overall Euro area ones.

What about QE?

Fans of the Matrix series of films will recall the bit when the Frenchman tells us about “cause and effect”. Sadly for his eloquent description we see that in the QE era the effect becomes before the cause. In the UK the UK Pound had its 25% or so fall in 2007/08 before QE began in 2009 and the Euro fell in 2014 ahead of the QE announcement in January 2015. Expectations of monetary easing lead to a currency fall before the easing happens or if you like we see yet another example of markets front-running central banks.

Take your pick as to where you think this began but back in April 2014 we saw the Euro top out in the mid-104s in trade-weighted terms but the acceleration began from 100 on December 16th 2014. Either date presents a much bigger move that what has happened since and makes any regression analysis problematic.

The economic impact

Back in March 2014 Mario Draghi told us what the ECB thinks the impact is.

 Now, as a rule of thumb, each 10% permanent effective exchange rate appreciation lowers inflation by around 40 to 50 basis points. So we can say that between 2012 and today about 0.4 or 0.5 percentage points of inflation was taken out of current inflation because of the exchange rate appreciation. Having said that, we have to be cautious, because there was a previous depreciation of the euro.

If we look at where we are and compare to the nice round number of 100 of mid-December 2014 then so far if we assume the Euro remains where it is now for long enough for Mario to consider the move “permanent” then the maximum impact on the inflation rate is 0.4%.

The ECB has been much more reticent about the impact on economic growth but if we used the Bank of England rule of thumb we have seen a move equivalent to to 2% fall in interest-rates. If we make a larger jump and look at the numbers established by the US Federal Reserve yesterday then the Euro area would get a 2.2% rise in exports and a 0.6% rise in economic output or Gross Domestic Product. Now I rush to say that America is not the Euro area and we are ignoring gains from falls in imports as the Euro is not the reserve currency but it does give an impression. Also you could choose different dates to compare.

Also we have to factor in that the Euro area has lost some of the gains from the falling oil price as it fell too. Over the past year it has taken away about a third of the gains that would have otherwise taken place.

Comment

I will leave that to the Swedish Riksbank which has rather intriguingly trolled the ECB in its monthly minutes which were published earlier today.

The markets have also interpreted the latest communication from the ECB as a clear signal that further stimulus measures are to be expected in December……. The ECB has indicated that it may make its monetary policy even more expansionary.

Indeed is the next bit trolling or a threat?

Expectations of a more expansionary monetary policy from the ECB have, together with an appreciation of the Swedish krona in September, contributed to the majority of analysts expecting further easing measures from the Riksbank before the end of the year,

So the Riksbank is trolling both the ECB and analysts now? Anyway the Financial Times reported it this way.

Riksbank head ‘would not hesitate’ to intervene in FX (Foreign Exchange).

This is obviously in itself a localised issue in the sense that Sweden is so near to the Euro area and is relatively small. But we are faced if we look at the countries looking to lower their currency as well (Japan springs to mind) with the issue of who is going to import the deflation they export? Meanwhile Paul Krugman searches for David Bowie on Spotify.

Is there life on Mars?

Or for Jeff Wayne.

At midnight on the twelfth of August, a huge mass of luminous gas erupted from Mars and sped towards Earth