How will Italy cope if its economy shrinks again?

Over the past few says the Standard and Poors ratings agency has been running its slide rule over Italy and yesterday in his final press conference Mario Draghi of the ECB indulged in some trolling.

No, of course not. Things have changed completely and frankly, everybody now in Italy said and stated that the euro is irreversible. So while there may have been hypothetical doubts in one part of the governance of the country, there aren’t any more, so it’s been accepted.

I am not sure if that was a promise or a type of threat! The problem with this sort of rhetoric though had already been highlighted by Mario himself.

 Incoming economic data and survey information continue to point to moderate but positive growth in the second half of this year.

It was in the bit where he felt the need to point out that growth would be positive and was perhaps a response to this from Markit earlier that day.

The eurozone economy started the fourth quarter
mired close to stagnation, with the flash PMI
pointing to a quarterly GDP growth rate of just
under 0.1%………Optimism about future prospects deteriorated further in October to the lowest for over six years,

They had even dragged Mario into it.

The survey indicates that Mario Draghi’s tenure at
the helm of the ECB ends on a note of near-stalled
GDP, slower jobs growth, near-stagnant prices and
growing pessimism about the outlook.

As you can see they gave a different picture which was of marginal/no growth that looked set to deteriorate. Actually Mario was worried about that too if we look further down his speech.

The risks surrounding the euro area growth outlook remain on the downside. In particular, these risks pertain to the prolonged presence of uncertainties, related to geopolitical factors, rising protectionism and vulnerabilities in emerging markets.

Also whilst Markit did not give specific detail for Italy this was troubling.

The rest of the euro area saw a near-stalling of
growth, with output rising at the weakest pace since
the current upturn began in August 2013

What about Italy?

This reminds me of something from the French statistics office that I quoted on Wednesday.

Italian economic growth has remained almost non-existent for more than a year (0.0% in Q2 after +0.1% in Q1).

If you are already not growing and things are getting worse that has a clear implication and it takes us back to our “Girfriend in a coma” theme for Italy. This is where it does not fully participate in economic upswings but sadly does in downswings.

If we look at the area that causes the most concern around the world right now the Italian statistics office told us this earlier this month.

In August 2019 the seasonally adjusted industrial production index increased by 0.3% compared with the
previous month. The change of the average of the last three months with respect to the previous three
months was -0.3%.  The calendar adjusted industrial production index decreased by 1.8% compared with August 2018 (calendar working days being 21 versus 22 days in August 2018).

The manufacturing sector declined by 2.8% on a year ago and the manufacture of transport equipment fell by 6.9%.

So the pattern here was of recovery in 2015 followed by growth in 2016 and 17 but the growth slowed at the beginning of 2018 and has turned into declines. The underlying index is at 104.9 where 2015=100 so we see that the growth spurt is slip-sliding away.

The problem is that there is another catch.

The unadjusted industrial new orders index decreased by 10.0% with respect to the same month of the previous year (-4.0% in domestic market and -16.3% in non-domestic market).

This meant that the seasonal adjustment needed to do some quite heavy lifting to get us to this.

The seasonally adjusted industrial new orders index increased by 1.1% compared to July (+1.1% in domestic market and +1.0% in non-domestic market); the average of the last three months decreased by 1.6% compared to the previous three ones.

The Banks

If Italy is to change its economic path then it needs a reformed banking sector but as this from Reuters highlights we are back to the same old problems.

 Italy wants to shield Monte dei Paschi (BMPS.MI) from bad loan losses as it prepares the bailed-out bank for a sale, but faces resistance from European Union competition authorities, two sources close to the matter said.

Yep we are back to the world’s oldest bank which to link to the start of this story has operated much of this century under what are called the Draghi Laws. As ever the can is being kicked via a Special Purpose Vehicle or SPV.

Sources have told Reuters the Treasury wants to lower the impaired debt ratio to 5% by spinning off some 10 billion euros in problem loans that would be merged with the assets of Treasury-owned bad loan manager AMCO.

We find ourselves taking a trip into a type of fantasy land yet again.

Monte dei Paschi values debts unlikely to be repaid in full at just over half their nominal value and its worst performing loans at 38%.

That compares with an estimated average price of 27% of nominal value for soured loan transactions in Italy this year, a Banca IFIS report states.

How much? Well here is another way of putting it.

One of the sources said a sale would imply a 1.5 billion euro loss for Monte dei Paschi, hurting the bank’s minority shareholders but not the Treasury, which would benefit from the lower transfer price since its controls 100% of AMCO.

This is a situation that we have observed time and time again in the Italian banking crisis. This is where fantasy numbers are used to fudge the situation but sooner or later they end up facing reality. In this case it is minority shareholders in Monte Paschi who would take the punishment and remember they may well recall being told by Prime Minister Renzi that the bank was a good investment.

Fiscal Position

On Monday we got a reminder that it is not the fiscal deficits that are a problem for Italy.

The government deficit to GDP ratio decreased from 2.4% in 2017 to 2.2% in 2018. The primary surplus as a percentage of GDP was 1.5% in 2018, up by 0.2 percentage points with respect to 2017.

The government debt to GDP ratio was 134.8% at the end of 2018, up by 0.7 percentage points with respect to the end of 2017.

We have had a lot of political rhetoric about it borrowing more but overall Italy has not. The picture has been confused by Eurostat’s inability to produce seasonally adjusted numbers for Italy but the unadjusted ones are if anything lower than in 2018.

In the short-term it remains very cheap for Italy to borrow with its ten-year yield being a mere 1.01%. That is amazingly cheap in the circumstances and can only represent the expectation of being able to sell to the ECB at a higher price as there is a genuine danger of a downwards spiral in an economic slow down.

Comment

We find that the ongoing Italian economic weaknesses such as low growth in the good times and a banking sector full of zombies ready for Halloween leave it exposed to any economic downturns. It is a lovely country and on some viewings has economic strengths as the Bank of Italy reports.

Exports continued to increase in the second quarter, despite the contraction in international trade. The current account surplus rose further, to 2.8 per cent of GDP; foreign sales may have faltered in the following months.

But this leads to another fail for economics 101 as this should lead to economic dynamism except in Italy it never does.

Economic activity in Italy increased only slightly in the second quarter and, in the light of the available data, it could have remained almost stationary in the third……..There is still the risk that the unfavourable developments in industry will be transmitted to the other sectors of the economy.

Any further weakness in economic growth will put even more pressure on this.

The Government estimates net borrowing at 2.2 per cent of GDP this year, the same as in 2018. The debt-to-GDP ratio is expected to rise from 134.8 to 135.7 per cent of GDP.

So whilst I wish Mario Draghi a happy retirement it is also true that his tenure at the ECB has done little for his home country and via the way policy has been tilted towards an increasingly zombified banking sector may in fact have made things worse.

the next fact can be swung several ways.

Since 2015, the resident population has been decreasing, setting up a phase of demographic decline
for the first time in the last 90 years. At 31 December 2018 the population amounted to 60,359,546
residents, over 124 thousand less than the previous year (-0.2%) and over 400 thousand less than four
years earlier.

On the positive  side it helps GDP per person and fewer people must help the green agenda. On the negative side an ageing and shrinking population is less able to deal with the sizeable national debt.

 

 

 

 

 

 

 

The Times They Are A-Changing For Inflation Targeting

The concept of inflation targeting had its roots in the abandonment of the gold standard in 1971. The world of fiat money requires some sort of anchor and we have seen various ways of providing this such as fixed exchange-rates and controlling the money supply. None of those were entirely satisfactory and some were complete failures so in the 1990’s we saw the concept of inflation targeting begin and a combination of Canada and New Zealand saw us end up with one of 2 per cent per annum. It is important to note that 2% per annum was chosen because it seemed right not that there was any particular logical thought process. Also it is important to note that the definition of inflation varies much more than you might think and in some cases quite widely. So for example 2% per annum in the United States is very different to 2% per annum in the Euro area as the former has owner-occupied housing costs ( albeit via the Imputed Rent route) and the latter does not.

Price Stability

Central bankers have tried to push the line that 2% per annum is price stability. For example Mario Draghi of the ECB told us this only yesterday at the ECB press conference.

Our mandate is price stability

This is quite an Orwellian style abuse of language and let me illustrate this with Mario’s own words.

On the inflation side, we basically saw inflation which is below our aim and we see projected inflation that says that convergence is further out in time, though as I’ve said on another occasion, the informational content of market-based inflation expectations has to be assessed, taking into account certain technical conditions of these markets. However also in the SPF, the Survey of Professional Forecasters, inflation expectations have gone down so that’s what led the Governing Council to these proposals, to the various proposals.

As you can see “inflation which is below our aim” would give Euro area workers and consumers more price stability but Mario and the ECB do not want it. This is why he was hinting so strongly at policy action in September although there is a catch in that. After all he only stopped QE in December and we still have negative interest-rates in the Euro area yet inflation is doing this.

Euro area annual HICP inflation increased to 1.3% in June 2019, from 1.2 % in May…….Looking through the recent volatility due to temporary factors, measures of underlying inflation remain generally muted. Indicators of inflation expectations have declined.

So here are a couple of thoughts for you. We are being told price stability is the objective when they are doing the opposite and they are using methods which in spite of extraordinary sums ( 2.6 trillion Euros of QE) have not had much impact. Care is needed with the latter conclusion because we know so many asset prices have surged but the Euro area in particular has gone to a lot of effort to keep them out of the consumer inflation numbers. They spent the last 2/3 years promising to put house prices in the numbers and then in December did a handbrake turn, which was so transparent as being what they planned all along. Or if you prefer another version of kicking that poor battered can into the future.

As an aside I have regularly warned about these over time and am pleased that the ECB is finally admitting this.

the informational content of market-based inflation expectations has to be assessed,

It is somewhere between slim and none which is very different to the impression the ECB has previously created.

The Times They Are A-Changing

The ECB interest-rate announcement told us this and the emphasis is mine.

Accordingly, if the medium-term inflation outlook continues to fall short of its aim, the Governing Council is determined to act, in line with its commitment to symmetry in the inflation aim.

That was brand new off the blocks so to speak and as you can imagine led to speculation about what the ECB planned next. For example, as it has been below its 2% per annum target for some time would it plan some “catch-up” in the manner suggested in the past by some members of the US Federal Reserve? So a type of average inflation targeting.

Yet a bit more than 45 minutes later ( Mario was late) there has been some ch-ch-changes.

the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term.

As one cannot be symmetrically below there is a problem here. Unusually for Mario Draghi he got into quite a mess explaining this.

On the other point: no, there isn’t any change really.

Yet he then confessed there was one.

In fact, it’s true it’s not there in the first page; it’s in the fourth page, it’s just what it is.

The idea that the change just appeared there is laughable and we then found out more about the state of play.

But we had a discussion about symmetry and there is a sense in the Governing Council that there should be a reflection on the objective: namely is it is close to but below 2%, or, should we move to another objective?

There you have it as they had for a while created the impression they had changed it. For clarity the ECB target is unusual in that it sets it for itself. The more common procedure is that the relevant government sets it for the central bank in the way that the Chancellor of the Exchequer does for the Bank of England. The present ECB target has been in place since 2003 and perhaps the advent of Christine Lagarde has Mario wanting to restrict how much damage she can do. After all it was apparent that the gushing praise she received, somehow in an inexplicable oversight omitted her competence for the role,

Whatever the rationale Mario was somewhat discombobulated.

 In the meantime, however, the main thing in this introductory statement is that the Governing Council – I think I have said this many times, but now it’s in the introductory statement – reaffirmed its commitment to symmetry around the inflation aim, which in a sense is 1.9 – it’s close to, but below, 2%.

So he was trying somewhat unconvincingly to sing along with Maxine Nightingale.

Ooh, and it’s alright and it’s coming along
We gotta get right back to where we started from

 

Comment

So we see that the ECB is joining an increasingly global trend to change its inflation target and typically for Ivory Tower thinkers they are missing the main point. After all the advent of the credit crunch which is still causing economic after-effects posed serious questions for the whole concept. Yet the main driver we are seeing is heading towards even easier monetary policy as opposed to a revision of the concepts involved. The same monetary policy that has failed to create much consumer inflation at all and may even have weakened it, although this comes with the caveat that much of this comes from the way inflation is measured.

The establishment remains determined to ram this home. Let me hand you over to the Wall Street Journal.

A higher Federal Reserve inflation target ahead of the 2007-09 recession likely would have given the central bank more room to lower interest rates and resulted in a “substantially” faster economic recovery, a group of economists has found.

If the Fed had set its inflation target above its current 2% level, that would have led to higher inflation over time, which would have caused interest rates to climb higher than they did before the recession, according to a paper by economists Janice Eberly, James Stock and Jonathan Wright.

Missing is anybody pointing out that the higher inflation would have made us all poorer. No doubt in the Ivory Tower scenario the wages fairy would have rescued us but we know in the real world that he or she is always hard and sometimes impossible to find these days.

That is before we get to the point I started with which never quite seems to be received in the thin air at the top of the Ivory Towers that the inflation measures used are at best an approximation and at worst simply wrong.

 

 

 

 

Will it be a parallel currency or a parallel world for Italy?

A feature of the credit crunch has been the way that certain ideas keep popping back up and never seem to quite disappear. So let us step back in time to September 2017.

Three of Italy’s four largest parties – the anti-establishment 5-Star Movement, the right-wing Northern League and Silvio Berlusconi’s Forza Italia – propose introducing a parallel currency after an election due early next year. ( Reuters)

I think Silvio was more trying to take the wind out of the sails of his opponents as if he really believed the suggestion below he could have tried it when he was in power.

Investors sold off Italian government bonds last month after Berlusconi said he was in favor of printing a “new lira” for domestic use, to pump money into the economy. Under his plan euros would still be used for all international transactions and by tourists.

Bur back then Reuters reported on something that has had if not a rave from the grave made something of a reappearance over the past fortnight.

The Northern League’s Borghi said Italy “has to be ready for the euro’s collapse,” which he sees as only a matter of time.

He is the architect of the party’s proposal – which Berlusconi has also hinted he would support – called “mini-BOTs”, named after Italy’s short-term Treasury bills.

Borghi says initially some 70 billion euros of these small denomination, interest-free bonds would be issued by the Treasury to firms and individuals owed money by the state as payment for services or as tax rebates.

That was his proposal back then and if we stay with Reuters we can jump forwards in time to last Saturday.

The so-called “mini-BOT” scheme, named after Italy’s Treasury bills, was drawn up by the far-right, eurosceptic League party and was unexpectedly endorsed by parliament last month in a non-binding vote.

Money,Money Money

As it happens Abba summed up the plan rather well back in the day.

Money, money, money
Always sunny
In a rich man’s world
All the things I could do
If I had a little money
It’s a rich man’s world

You see another name for a “small denomination, interest-free bond” is a bank note. One more bit is required in that the Treasury Bill would need to be perpetual or much longer than the usual term ( often 90 days but sometimes of a year or so). Then you are mostly there and the government can then effectively take advantage of what is called “seigniorage”. This is where the ability to print money leaves you with a rather large profit as your 1000 Lira bill costs if we use US Federal Reserve data say 1% to print so 99% is profit. What’s not to like about that?

So at this point of the 70 billion Euros equivalent printed we have 69 billion or so left to spend, or rather the Italian government has.

What could go wrong?

This starts at the central bank as seigniorage is usually their preserve. Looked at like that they are one of the most profitable institutions in the world. Of course politicians spotted that long ago and thus the cash flows to the national treasuries with a deduction for expenses as for example the cake trolley does not fill itself.

Thus it was no surprise to see ECB President Mario Draghi saying this at the last press conference.

Now about the mini-BOT, I think I’ve answered this question in the past when the possibility was raised; they are either money and then they are illegal, or they are debt and then that stock goes up. I’ll stop here.

So he is pointing out that there is supposed to be only one form of money in the Euro area, which is the Euro itself. What he did not say but was clearly referring to it as being legal tender as in you can always settle a debt using a Euro. Also he points out that if they are debt then they will be added to the calculation of the national debt, which is what the proposal is trying to dodge.

Oh and he did not stop there he could not resist something of a dig.

Certainly the reading that people have and markets have of this mini-BOT doesn’t seem to be very positive, but I’m only just stopping at what I said; it’s either money or debt. I don’t think there is a third possibility.

Later he did explain his position in an answer to a different question.

Well, it’s very difficult to foresee hypothetical events where you assume that the President of the ECB doesn’t behave in a way to preserve the euro.

So he and his successor ( as his term ends in October) will always look to protect the Euro and will therefore always be against any such scheme. After all it is in his job description.

The debt issue

The problem is that Italy has such a large public debt, which is also large relative to its economy. The 2.32 trillion Euros is 132.2% of annual economic output or GDP. Those who have followed my “Girlfriend in a Coma” articles will know that rather than being an over spender Italy has arrived at this situation mostly because its has failed to grow its economy. In the good times it rarely grows at more than 1% per annum but sadly in the bad times it falls as much as its peers, so ground is lost. That is highlighted by the current position where over the last year GDP has fallen by 0.1%.

Thus even what is not a relatively high deficit for the public finances leads to trouble. The 43.1 billion Euros borrowed in 2015 fell to 37.5 billion in 2018 but we find that it breaks the Euro area rules. Back to Mario Draghi.

The Commission has concluded that Italy must reduce its debt-to-GDP ratio and this opinion will go to the Council. By then the Italian Government will produce – and that’s what’s been asked – a medium-term plan for reducing debt-to-GDP ratios.

Bond Yields

There are two ironies here. Let me give you one which is there was an even better situation in late 2017 and early 2018 as Italy was being paid to issue some short-term debt. Some of that will be maturing soon and investors have escaped although in terms of risk/reward they have had a shocker. The latter irony is that the current “enemy” Mario Draghi headed an organisation which bought some 366 billion Euros of Italian government bonds known as BTPs. So he made debt issuance very cheap.

In spite of the current impasse and debate Italy can still borrow cheaply in historical terms with its benchmark ten-year yield being 2.37%. The problem is that in its current malaise that starts to look rather expensive.

Comment

This is one of those situations where the phrase stuck between a rock and a hard place applies virtually perfectly. Also there is an element of denial on both sides. This is because the real issue is the inability of Italy to grow its economy and whether that can be changed? If not then all the stimuli you can think of will not change things much. Indeed Italy could be worse off as whatever the presentation of it this new plan will leave it with more debt than before. Or a higher effective money supply which when we have seen it elsewhere in places like Ukraine has ended up in trouble.

On the other side of the coin the Euro establishment needs to face up to the fact that the promises of convergence which in this instance would mean towards the economy of Germany were false. In fact there has been divergence. We will never know how Italy would have performed if it had not joined the Euro but we do know that it has not been an answer to its lack of economic growth. The latest proposals via what are called “sauces” and some words from Olli Rehn are for more bond purchases and further interest-rate cuts. But if they worked we wouldn’t be here would we?

So we are definitely seeing parallel worlds, one of which may yet have a parallel currency

 

 

 

Central bankers are warming us up for more inflation again

A feature of the credit crunch era is the repetition of various suggestions from governments and central banks. One example of this has been the issue of Eurobonds which invariably has a lifespan until the nearest German official spots it. Another has been the concept of central banks overshooting their inflation target for a while. It is something that is usually supported by those especially keen on ( even more) interest-rate cuts and monetary easing so let us take a look.

Last Wednesday European Central Bank President Mario Draghi appeared to join the fray and the emphasis is mine.

Well, on your second question I will answer saying exactly the same thing. We don’t tolerate too low inflation; we remain fully committed to using all necessary instruments to return inflation to 2% without undue delay. Likewise, our inflation aim doesn’t imply a ceiling of 2%. Inflation can deviate from our objective in both directions, so long as the path of inflation converges towards our medium-term objective. I believe I must have said something close to this, or something to this extent a few other times in the past few years.

Nice try Mario but not all pf us had our senses completely dulled by what was otherwise a going through the motions press conference. As what he said at the press conference last September was really rather different.

In relation to that: shouldn’t the ECB be aiming for an overshoot on inflation rather than an undershoot given that it’s been below target for so long?

Second point: our objective is an inflation rate which is below, but close to 2% over the medium term; we stay with that, that’s our objective.

As you can see back then he was clearly sign posting an inflation targeting system aiming for inflation below 2%. That was in line with the valedictory speech given by his predecessor Jean-Claude Trichet which gave us a pretty exact definition by the way he was so pleased with it averaging 1.97% per annum in his term. So we have seen a shift which leads to the question, why?

The actual situation

What makes the switch look rather odd is the actual inflation situation in the Euro area. Back to Mario at the ECB press conference on Wednesday.

According to Eurostat’s flash estimate, euro area annual HICP inflation was 1.4% in March 2019, after 1.5% in February, reflecting mainly a decline in food, services and non-energy industrial goods price inflation. On the basis of current futures prices for oil, headline inflation is likely to decline over the coming months.

So we find that inflation is below target and expected to fall further in 2019. This was a subject which was probed by one of the questions.

 It’s quite clear that the sliding of the five-year-to-five-year inflation expectations corresponds to a deterioration of the economic outlook. It’s also quite clear that as the economic outlook, especially the economic activity slows down, also markets expect less pressure in the labour market, but we haven’t seen that yet.

The issue of markets for inflation expectations is often misunderstood as the truth is we know so little about what inflation will be then. But such as it is again  the trend may well be lower so why have we been guided towards higher inflation being permitted.

It might have been a slip of the tongue but Mario Draghi is usually quite careful with his language. This leaves us with another thought, which is that if he is warming us up for an attitude change he is doing soon behalf of his successor as he departs to his retirement villa at the end of October.

The US

Minneapolis Fed President Neel Kashkari suggested this in his #AskNeel exercise on Twitter.

Well we officially have a symmetric target and actual inflation has averaged around 1.7%, below our 2% target, for the past several years. So if we were at 2.3% for several years that shouldn’t be concerning. #AskNeel

Also he reminded those observing the debate on Twitter that the US inflation target is symmetric and thus unlike the ECB.

Yes, i think we should really live the symmetric target and not tap the brakes prematurely. This is why I’ve been arguing for more accommodative monetary policy. But we are undertaking a year long review of various approaches so I am keeping an open mind. #AskNeel

As you can see with views like that the Donald is likely to be describing Neel Kashkari as “one of the best people”.  If we move to the detail there are various issues and my initial one is that inflation tends to feed on itself and be self-fulfilling so the idea that we can be just over the target at say 2.3% is far from telling the full picture. Usually iy would then go higher. Also if your wages were not growing or only growing at 1% you would be concerned about even that seemingly low-level of inflation.

If we consider the review the US Fed is undertaken we see from last week’s speech by Vice Chair Clarida a denial that it has any plans to change its 2% per annum target and we know what to do with those! Especially as he later points out this.

In part because of that concern, some economists have advocated “makeup” strategies under which policymakers seek to undo, in part or in whole, past inflation deviations from target. Such strategies include targeting average inflation over a multiyear period and price-level targeting, in which policymakers seek to stabilize the price level around a constant growth path.

As the credit crunch era has seen inflation generally be below target this would be quite a shift as it would allow for quite a catch-up. Which of course is exactly the point!

Comment

Central bankers fear that they are approaching something of a nexus point. They have deployed monetary policy on a scale that would not have been believed before the credit crunch hit us. Yet in spite of the negative interest-rates, QE style bond purchases and in some cases equity and property buys we see that there has been an economic slow down and inflation is generally below target. Also the country that has deployed monetary policy the most in terms of scale Japan has virtually no inflation at all ( 0.2% in February).

At each point in the crisis where central bankers face such issues they have found a way to ease policy again. We have seen various attempts at this and below is an example from Charles Evans the President of the Chicago Fed from back in March 2012.

My preferred inflation threshold is a forecast of 3 percent over the medium term.

We have seen others look for 4% per annum. What we are seeing now is another way of trying to get the same effect but this time looking backwards rather than forwards.

There are plenty of problems with this. Whilst a higher inflation target might make life easier for central bankers the ordinary worker and consumer faces what economists call “sticky” wages. Or in simple terms prices go up but wages may not and if the credit crunch is any guide will not. My country the UK suffered from that in 2010/11 when the Bank of England “looked through” consumer inflation which went above 5% with the consequence of real wages taking a sharp hit from which they have still to recover.

Next comes the issue that in the modern era 2% per annum may be too high as a target anyway. In spite of all the effort it has been mostly undershot and as 2% in itself has no reason for existence why not cut it? Then we might make progress in real wage terms or more realistically reduce the falls. That is before we get to the issue of inflation measures lacking credibility in the real world as things get more expensive but inflation is officially recorded as low.

Meanwhile central bankers sing along to Marvin Gaye.

‘Cause baby there ain’t no mountain high enough

Podcast

https://soundcloud.com/shaun-richards-53550081/notayesmanspodcast21

 

 

Mario Draghi and the ECB look for more expansionary Euro area fiscal policy

As we travel the journey that is the credit crunch era we pick up some tasty morsels of knowledge along the way. Some were provided by Mario Draghi and the European Central Bank yesterday which announced this.

we decided to launch a new series of quarterly targeted longer-term refinancing operations (TLTRO-III), starting in September 2019 and ending in March 2021, each with a maturity of two years. These new operations will help to preserve favourable bank lending conditions and the smooth transmission of monetary policy.

As ever “the precious” otherwise known as the banks is prioritised ahead of everything else. Also I was asked if this meant the ECB “knew something” to which the answer is simple, if they did then they would have done it last summer. But there was a much bigger pivot.

This happens in a context where the debt to GDP ratio in the eurozone is actually falling.

There was a move towards making a broad hint for more fiscal policy or easing here. Mario also went out of his way to point out that borrowing for Euro area governments is very low.

The simple action of maintaining the stock unchanged in this context actually is a continuous easing because interest rates are pushed downward by this action. You can see this because since we decided in June last year, interest rates have gone down, they keep on going down, the term premium is negative, so conditions are very, very accommodative.

Not only that but he intends to keep it that way.

If you add to this what I’ve just said, it’s the chained element of this, of the horizon over which we’ll carry out purchases to keep the stock unchanged moves together with the forward guidance.

So Mario is pointing out to government’s that if they borrow the ECB will in general be there to help keep borrowing costs low or as we shall see in a bit negative. After all we now live in a world where even Greece can do this.

On Tuesday 5thMarch the Hellenic Republic, rated B1 Moody’s/ B+ S&P/ BB- Fitch/ BH DBRS (stb/ pos/ stb/ pos), priced a €2.5 billion 10-year Government Bond (GGB) due 12th March 2029. The new benchmark carries a coupon of 3.875% and reoffer yield of 3.900%, equating to a reoffer price of 99.796%. Joint bookrunners on the transaction were BNP Paribas, Citi, Credit Suisse, Goldman Sachs Intl, HSBC and J.P. Morgan. ( Note the past behaviour of Goldman Sachs in relation to Greece seems to be no barrier at all to future business…..)

Why so cheap? Well there are two main factors. One is that it is looking to run fiscal surpluses and the other is that whilst it is not in the ECB QE programme it may well be in a future one and that is looking more likely by the day. As to the economy it is with a heavy heart that I point out this which speaks for itself.

The available seasonally adjusted data
indicate that in the 4 th quarter of 2018 the Gross Domestic
Product (GDP) in volume terms decreased by 0.1% in comparison with the 3rd quarter of 2018,
while in comparison with the 4th quarter of 2017, it increased by 1.6%.

Mario also gave us a reminder of the scale of Euro area bond buying so far.

Just to give you an idea, the balance sheet of the ECB is about 42 – 43% of the eurozone GDP. The Fed is about half of it now. In order to keep this stock unchanged, we continue purchasing something in the order of €20 billion a month of bonds.

Here are more hints on the subject with also I think a nod to his home country Italy.

Regarding fiscal policies, the mildly expansionary euro area fiscal stance and the operation of automatic stabilisers are providing support to economic activity. At the same time, countries where government debt is high need to continue rebuilding fiscal buffers. All countries should continue to increase efforts to achieve a more growth-friendly composition of public finances.

Bond Yields

Let us start with the largest Euro area economy with is Germany. We saw bond prices rise and yields fall quite quickly in response to this. The German ten-year yield fell from 0.12% to 0.06% which makes us wonder if we may see another spell of it going negative like it did in the summer and autumn of 2016? It would not take a lot as the nine-year yield is now -0.1%.

So Germany can borrow essentially for nothing should it so choose over a ten-year horizon. That is in nominal terms and if we see inflation in this period then the real cost will be negative. Yet if you read through the cheerleading it is aiming for a fiscal surplus.

The general government budget surplus
will fall from roughly 1½% of GDP in
2018 to roughly 1% of GDP in 2019.
In 2019 and subsequent years, a fiscal
impact will be made in particular by
the priority measures contained in the
Coalition Agreement and other measures.
The implementation of these measures
will reduce the federal budget surplus. ( Draft Budget October 2018).

Although those numbers are already suffering from the TalkTalk critique and on that subject RIP Mark Hollis.

Baby, life’s what you make it
Celebrate it
Anticipate it
Yesterday’s faded
Nothing can change it
Life’s what you make it

Why? Well we have indeed moved on since this as the German economy shrank in the second half of 2018.

which forecasts a real growth rate of 1.8% in both 2018 and
2019. This means that Germany’s economy is expected to keep growing at a pace that slightly exceeds potential output.

Also if we look around we see that European supranational bodies can borrow very cheaply too. Maybe not at German rates but often pretty near. After considering that now let us return to Mario Draghi yesterday.

Now, Philip Lane is an excellent acquisition for the ECB but we are not going to ask him about this Eurobond thing. The Eurobond is again not something that the ECB can force or just decide about; again it’s an inherently political decision. And of course this doesn’t detract at all from the argument that it’s absolutely rational to have a safe asset at European level.

We have seen the Eurobond case made many times and so far Germany keeps torpedoing it, but we also know that in Europe these sort of things tend to happen eventually after of course a forest of denials and rejections.

Comment

We have seen quite a few phases now of the Euro area crisis. For a while it looked like “escape velocity” had been achieved but now we see to be facing many of the same problems with quarterly economic growth having gone 0.1%, 0.2% and looking like being around 0.2% in the first quarter of this year. Although he tried to downplay such thoughts yesterday it is hard not to think of this from Mario Draghi last November.

 I’ll be briefer than I would like to be, but certainly especially in some parts of this period of time, QE has been the only driver of this recovery.

Ironically he is avoiding the subject just as the evidence is pointing that way. For the moment monetary policy is to coin a phrase “maxxed out” although in this instance it is more timing than not being able to do more, as it would be an embarrassing U-Turn. So for now if Euro area government’s and especially Germany were to embark on a fiscal stimulus the ECB would turn its blind eye towards it I think.

 

 

Economic growth in Germany converged with that in Italy in the latter part of 2018

As we arrive in the UK at “meaningful vote” day which seems about as likely to be true as a Bank of England “Super Thursday” actually being super the real economic news comes from the heart of the Euro area. So here it is.

According to first calculations of the Federal Statistical Office (Destatis), the price adjusted gross domestic product (GDP) was 1.5% higher in 2018 than in the previous year. The German economy thus grew the ninth year in a row, although growth has lost momentum. In the previous two years, the price adjusted GDP had increased by 2.2% each. A longer-term view shows that German economic growth in 2018 exceeded the average growth rate of the last ten years (+1.2%)……….As the calendar effect in 2018 was weak, the calendar-adjusted GDP growth rate was 1.5%, too ( German statistics office )

A little care if needed as these numbers are not yet seasonally adjusted. But we do have price-adjusted numbers have gone 2.2% (2016) then 2.5% (2017) and now 1.5%. This immediately reminds me of the words of European Central Bank President Mario Draghi at his last press conference.

 I’ll be briefer than I would like to be, but certainly especially in some parts of this period of time, QE has been the only driver of this recovery. There are lots of numbers that we can give about how it did change financing conditions in a way that – in many ways. But let’s not forget that interest rates had dramatically declined even before QE but they continued to do so after QE…….. We view this as – but I don’t think I’m the only one to be the crucial driver of the recovery in the eurozone. At the time, by the way, when also other drivers were not really – especially in the first part, there was no other source of growth in the real economy.

This comes to mind because if you take that view and now factor in the reduction in the monthly QE purchases and then their cessation in 2018 then the decline in GDP growth in Germany was sung about by Radiohead.

With no alarms and no surprises
No alarms and no surprises
No alarms and no surprises
Silent, silent

In essence if we switch to the world of football then 2018 was a year of two halves for Germany because if we go back to half-time we were told this.

Compared with a year earlier, the price adjusted GDP rose 2.3% in the second quarter of 2018.

At that point economic growth seemed quite consistent at around 0.5% per quarter if we ignore the 1,1% surge in the first quarter of 2017. So Mario’s point is backed up by German economic growth heading south in the second half of 2018 which if we now look wider poses an implication for another part of his speech.

 Euro area real GDP increased by 0.2%, quarter on quarter, in the third quarter of 2018, following growth of 0.4% in the previous two quarters.

We do not have the final result for the second half of 2018 but the range seems set to be between -0.1% and 0.1%. Ironically it means that the quote below from the Italian economy minister is rather wrong.

*TRIA: EU TO FACE POTENTIAL COLLAPSE IF POLICIES FEED DIVERGENCE

As we stand the German economic performance has in fact converged with the Italian one.

Detail

There has been quite a slow down in domestic consumption because at the end of the second quarter we were told this.

Overall, domestic uses increased markedly by 0.9% compared with the first three months of the year.

Whereas now we are told this was the situation six months later.

Both household final consumption expenditure (+1.0%) and government final consumption expenditure (+1.1%) were up on the previous year. However, the growth rates were markedly lower than in the preceding three years.

That is not an exact comparison because investment is not in the latter and it has remained pretty strong but nonetheless there has been quite a fall in domestic consumption. Also investment has not turned out to be the golden weapon against an economic slowing.

Total price-adjusted gross fixed capital formation rose 4.8% year-on-year.

Also a usual strength for the economy was not on its best form.

German exports continued to increase on an annual average in 2018, though at a slower pace than in the previous years. Price-adjusted exports of goods and services were up 2.4% on 2017. There was a larger increase in imports (+3.4%) over the same period. Arithmetically, the balance of exports and imports had a slight downward effect on the German GDP growth (-0.2 percentage points).

In terms of the world economy that is a good thing as many have argued ( including me) that the German trade surplus is an imbalance if we look at the world economy. The catch is how you fix it and shrinking it in a period of economic weakness is far from ideal. Also another number went against the stereotype.

 For the first time in five years, short-term economic growth in industry was lower than in the services sector.

Lastly these are not precise numbers but output per head of productivity growth seems to have slowed to a crawl.

On an annual average in 2018, the economic performance in Germany was achieved by 44.8 million persons in employment whose place of employment was in Germany. According to first calculations, that was an increase of roughly 562,000 on the previous year. This 1.3% increase was mainly due to a rise in employment subject to social insurance.

1.5% is not much more than 1.3%.

Fiscal Policy

This is not getting much attention but you can argue that Germany has made the same mistake in 2017/18 that it made in 2010/11 in Greece albeit on a much smaller scale.

General government achieved a record surplus of 59.2 billion euros in 2018 (2017: 34.0 billion euros). At the end of the year, central, state and local government and social security funds recorded a surplus for the fifth time in a row, according to provisional calculations. Measured as a percentage of the gross domestic product at current prices, this was a 1.7% surplus ratio of general government for 2018.

It has contracted fiscal policy into an economic slow down and thereby added to it.

Comment

As these matters can get very heated on social media let me be clear I take no pleasure in Germany’s economic slow down. For a start it would be illogical as it will be a downward influence on the UK. But it has been a success for the monetary analysis I presented in 2018 as the fall in the money supply was both an accurate and timely indicator of what was about to happen next.

Official policy has seen a dreadful run however. I have dealt with fiscal policy above which has been contracted in a slow down but we also see that the level of monetary stimulus was reduced. Apart from the obvious failure implied by this there are other issues. The most fundamental is a point I have made many times about Euro area economic growth being a “junkie” style culture depending on the next stimulus hit. That has meant it has arrived at the next slow down with the official deposit rate still negative ( -0.4%) as I have long feared. Still I suppose it could be worse as the Riksbank of Sweden managed to raise interest-rates in this environment after not doing so when the economy was doing well.

Let me post a warning to avoid the Financial Times article today about UK Index-Linked Gilts. No doubt this will later be redacted but in the version I read the author was apparently unaware that the RPI inflation measure not CPI is used for them.

What will happen to Bank Carige of Italy?

One of the longest running themes of this site has been the ostrich like behaviour of Italy about its banks. The official view has been that a corner is just about to be turned on what keeps turning out to be a straight road. I still recall Prime Minster Renzi assuring investors that shares in the trouble Monte Paschi di Siena were a good purchase. Here is an example of this from him in Il Sole from January 2016 via Google Translate and the emphasis is mine.

“The recent turbulence around some Italian banks indicates that our credit system – solid and strong thanks to the extraordinarily high savings of Italian families – still needs consolidation, so that there are fewer but stronger banks (…) Today the bank it is healed, and investing is a bargain. On Mps has been knocked down speculation but it is a good deal, has gone through crazy vicissitudes but today is healed, it is a nice brand. Perhaps in this process that will last a few months must find partners because it must be with others “.

Since then the bank has seen the Italian state take a majority stake and the share price is a bit less than forty times lower than when Renzi made his statement. This has been a familiar theme of the crisis where investors have been encouraged to stump up more money for troubled banks with promises of a brighter future. But it kept turning out that the future was ever more troubled rather than bright as good money followed bad in being lost.

Even worse the whole sector was weakened by the way that other types of bailout were provided by the banking sector itself. For example via the Atlante or Atlas fund which saw banks investing to recapitalise other banks and to buy bad loans. Regular readers will recall that the establishment view was that the purchase of bad loans by this and other vehicles was something of a new dawn for the sector. The reality was that as things got worse there was Atlante 2 before the whole idea got forgotten. It is rude to point out that the subject of today Bank Carige was considered strong enough to put 20 million Euros into the first version of Atlante.

A deeper perspective can be provided by the fact that the Italian banking laws are called the “Draghi Laws” after the President of the European Central Bank Mario Draghi. In his new role he has undertaken three policies which have helped the Italian banks. They have been particularly large beneficiaries of his liquidity operations called TLTROs which have provided cheap ( the deposit rate is -0.4%) for banks. Then the QE programme boosted the price of Italian government bonds benefiting the Italian banks large holdings. Then more opaquely at least in terms of media analysis it bought covered bonds ( mortgage bonds) in three phases and still holds around 271 billion Euros of them.

The catch of this from Mario’s point of view is that liquidity is only a short-term solution and soon falls short when the real questions are about solvency. Even worse the way this umbrella shielded the banks from the rain meant that the promised reforms never happened and the path was made worse rather than better. Also if we think of this from the point of Italy and its economy we see that we have part of the reason for its ongoing economic lost decade style troubles. The banks have helped suck it lower. Also and hat tip to Merryn Somerset Webb for this a letter to the FT today has on another topic covered the issue really rather well.

ECB can’t solve problems because to attempt to do so would be to admit that problems exist.

Carige

If we go back to 2017 we see that as well as a worrying departure of board directors and the beginning of an attempted asset sale which was to include bad loans there was this in December.

Italy’s Banca Carige said on Friday it had raised 544.4 million euros ($645 million) following its recently concluded new share issue, topping minimum regulatory demands. ( Reuters)

There were various features to this of which the first is that existing shareholders took a right caning or as the Italian regulator put it.

The Banca Carige capital increase has characteristics of hyperdilution.

In return there was the implication that the ECB had approved this and a corner had been turned. Less than a year later this all went sour as the ECB decided that Bank Carige needed yet another rights issue in yet another example of the themes described above. This time in spite of statements to the contrary no-one seemed silly enough to believe the official promises and this rumbled on until the New Year when the ECB decided that the first business day of 2019 was an opportune moment to do this.

The mass resignation of Carige directors that followed has given the ECB an opportunity to be creative. The central bank has used its powers of early intervention to step in to stabilise the bank’s governance. It has appointed three special administrators, including Innocenzi, tasked with restoring capital requirements. ( Reuters)

If you want some gallows humour this was described as “temporary” when it was pretty much certain to be anything but as a major shareholder ( Malaclaza) decided it had lost enough. It was hardly likely to believe the ECB again.

The Italian Government

This found itself in between a rock and a hard place as the Five-Star movement has consistently opposed both bailouts and bail-ins. Yet the government of which it is a member took I am told only 8 minutes to decide this last night.

The decree, signed off on Monday after a surprise cabinet meeting, will allow the bank to benefit from state-backed guarantees for new bond issues and funding from the Bank of Italy.

The lender, which last year failed to secure shareholder backing for a capital increase, will also be able to request access to state-backed precautionary recapitalization, if needed.

So yet again in a choice between the interests of the people and the interests of “the precious” we see that the same old status quo continues to play.

Whatever you want
Whatever you like
Whatever you say
You pay your money
You take your choice
Whatever you need
Whatever you use
Whatever you win
Whatever you lose

One of my longest-running themes of this website gets another tick in the box and we even get some Italian style humour.

EU rules permit such a scheme only if the bank is solvent.

So solvent in fact that they can no longer find anyone willing to put their own money into it. Also seeing as Bank Carige cannot even see its own nose I doubt this will be a barrier for long.

According to a financial source close to the matter, Carige would only consider a request for precautionary recapitalization if new and unforeseen problems arose.

Comment

The issue here is that on a generic basis the events described above are so familiar now that even the use of phrases like groundhog day does not do the situation justice. There are always going to be problems because regulators invariably end up being captured by the industry they regulate and banking is perhaps the worst example of this. But changes were promised so long ago and yet the Italian taxpayer will find him/herself on the hook in addition to the 320 million Euro hybrid bond that the deposit protection fund bought late last year. Even worse they may end up backing this enough for someone else to be willing to take it over and profit from. Oh and so much for hybrid!

Meanwhile in a land far, far, away I see that the Financial Times has interviewed the head of the Euro area banking resolution body.

Speaking to the FT to mark three years since the SRB became fully operational at the start of 2016, Ms König said a page had been turned in how the bloc handled bank failures — not least after its first intervention, at Spain’s Banco Popular in 2017 — but that the system remained a work in progress.

There is no mention of Italy at all which is really rather breathtaking, although there may be an implied hint.

Making sure that bank crises could be contained without resorting to taxpayer help was “an ongoing challenge”, she said.

Some claim the lack of contagion is progress, but you see there is a clear flaw in that as the problems here were evident as long ago as 2014 so what is called the “smart money” will have gone long ago. In some ways this makes things worse because in another shocking failure of regulation Italian retail depositors were encouraged to buy bank bonds.

 

Mario Draghi and the ECB prepare for a change of course next month

After a week where the UK has dominated the headlines it is time to switch to the Euro area.  This is for two reasons.  We receive the latest inflation data but also because a speech from European Central Bank President Mario Draghi has addressed an issue we have been watching as 2018 has developed. We have been waiting to see how he and it will respond to the economic slow down that is apparent. This is especially important as during the credit crunch era the ECB has not only been the first responder to any economic downturns it has also regularly found itself to be the only one. Thus it finds itself in a position whereby in terms of negative interest-rates ( deposit rate of -0.4%) and balance sheet ( still expanding at 15 billion Euros per month ) and credit easing still heavily deployed. Accordingly this sentence from Mario echoes what we have been discussing for quite a while.

The key issue at stake is as follows: are we witnessing a temporary “soft patch” or a more lasting deterioration in the growth outlook?

The latter would be somewhat devastating for the man who was ready to do “whatever it takes” to save the Euro as it would return us to discussions about its problems a major one of has been slow economic growth.

Some rhetoric

It seems to be a feature these days of official speeches that they open with what in basketball terms would be called a head fake. Prime Minister Theresa May did it yesterday with an opening sentence which could have been followed by a resignation and Mario opened with what could have been about “broad based” economic growth.

The euro area economy has now been growing for five years, and we expect the expansion to continue in the coming years.

Of course central bankers always expect the latter until there is no other choice. Indeed he confirms that line of thought later.

There is certainly no reason why the expansion in the euro area should abruptly come to an end.

As we move on we get an interesting perspective on the past as well as a comparison with the United States.

Since 1975 there have been five periods of rising GDP in the euro area. The average duration from trough to peak is 31 quarters, with GDP increasing by 21% over that period. The current expansion in the euro area, however, has lasted just 22 quarters and GDP is only around 10% above the trough. In contrast, the expansion in the United States has lasted 37 quarters, and GDP has risen by 21%.

The obvious point is whether you can use the Euro area as a concept before it even existed?! Added to that via the “convergence” promised by the Euro area founders economic growth should be better now than then, except of course we have seen plenty of divergence too. Also you might find it odd to be pointing out that the US has done better especially as the way it is put which reminds us that for all the extraordinary monetary action the Euro area has only grown by 10%. Even that relies on something of a swinging ball as of course he is comparing with the bottom of the dip rather than the past peak as otherwise the number would be a fair bit weaker. Mario is leaving a bit of a trap here, however, or to be more precise he thinks he is.

How have we got here?

First we open with two standard replies the first is that whilst any growth is permanent setbacks are temporary and the other fallback is to blame the weather.

The first is one-off factors, which have clearly played an important role in the underperformance of growth since the start of the year. In the first half of 2018, weather, sickness and industrial action affected output in a number of countries.

Actually that makes the third quarter look even worse as they had gone by then yet growth slowed. He is on safer ground here though.

Production slowed as carmakers tried to avoid building up inventory of untested models, which weighed heavily on economies with large automobile sectors, such as Germany. Indeed, the German economy actually contracted in the third quarter, removing at least 0.1 percentage points from quarterly euro area growth.

This is another marker being put down because it you are thinking that you might need to further expand monetary policy it is best to try to get the Germans onside and reminding them that they too have issues will help. Indeed for those who believe that ECB policy is essentially set for Germany it may be not far off a clincher.

There is something that may worry German car producers if they are followers of ECB euphemisms.

The latest data already show production normalising.

After all the ECB itself may not achieve that.

Trade

This paragraph is interesting on quite a few levels.

The second source of the slowdown has been weaker trade growth, which is broader-based. Net exports contributed 1.4 percentage points to euro area growth in 2017, while so far this year they have removed 0.2 percentage points. World trade growth decelerated from 5.2% in 2017 to 4.6% in the first half of this year.

Oddly Mario then converts a slow down in growth to this.

We are witnessing a long-term slowdown in world trade.

As we note the change in the impact of trade on the Euro area there are several factors in play. You could argue that 2017 was a victory for the “internal competitiveness” austerity model applied although when we get to the collective that is awkward as the Euro area runs a large surplus driven by Germany. From the point of view of the rest of the world they would like it to reduce although the preferable route would be for the Euro area ( Germany ) to import more.

Employment

Mario cheers rightly for this.

Over the past five years, employment has increased by 9.5 million people, rising by 2.6 million in Germany, 2.1 million in Spain, 1 million in France and 1 million in Italy.

I bet he enjoyed the last bit especially! But later there is a catch which provides food for thought.

 But since 2013 more than 70% of employment growth has come from those aged 55-74. This partly reflects the impact of past structural reforms, such as to pension systems.

Probably not the ECB pension though as we are reminded of “Us and Them” by Pink Floyd.

Forward he cried from the rear
And the front rank died
And the general sat
And the lines on the map
Moved from side to side.

Also whilst no doubt some of these women wanted to work there will be others who had no choice.

The share of women in work has also risen by more than 10 percentage points since the start of EMU to almost 60% – its highest level ever

Put another way this sentence below could fit into a section concerning the productivity crisis.

 In addition, countries that have implemented structural reforms have in general seen a rise in labour demand in recent years compared with the pre-crisis period. Germany, Portugal and Spain are all good examples.

There is a section on wages but Mario end up taking something of an each-way bet on this.

But in the light of the lags between wages and prices after a period of low inflation, patience and persistence in our monetary policy is still needed.

Money Supply and Credit

This is how central bankers report a sustained and considerable slow down in the money supply.

The cost of bank borrowing for firms fell to record lows in the first half of this year across all large euro area economies, while the growth of loans to firms stood at its highest rate since 2012. The growth rate of loans to households is also the strongest since 2012, with consumer credit now acting as the most dynamic component, reflecting the ongoing strength of consumption.

Also the emphasis below is mine and regular readers are permitted a wry smile.

Household net worth remains at solid levels on the back of rising house prices and is adding to continued consumption growth.

Comment

We are being warmed up for something of a change of course in case it is necessary.

When the Governing Council met in October, we confirmed our confidence in the economic outlook………….When the latest round of projections is available at our next meeting in December, we will be better placed to make a full assessment of the risks to growth and inflation.

As if they are not already thinking along those lines! The next bit is duo fold. It reminds us that the Euro area has abandoned fiscal policy but does have a kicker for the future.

To protect their households and firms from rising interest rates, high-debt countries should not increase their debt even further and all countries should respect the rules of the Union.

The kicker is perhaps a hint that there is a solution to that as well.

In conclusion, I want to emphasise how completing Economic and Monetary Union has become more urgent over time not less urgent – and not only for the economic reasoning that has always underpinned my remarks, but also to preserve our European construction………….more Europe is the answer.

There Mario leaps out of his apparent trap singing along to Luther Vandross.

I just don’t wanna stop
Oh my love, a million days in your arms
Is never too much (never too much, never too much, never too much)

Podcast

https://soundcloud.com/shaun-richards-53550081/notayesmanspodcast2

 

Can Mario Draghi and the ECB help Italy?

Yesterday was quite an extraordinary day especially in Italian markets. However I wish to move on to consider things from the new tower of the European Central Bank. So as we move geographically to the Grossmarkthalle in Frankfurt we would have seen concern and probably not a little panic. The phone lines would have been burning between Frankfurt and the Bank of Italy as they discussed how to respond. At first this would have been on a tactical level about the ongoing QE ( Quantitative Easing) bond buying programme but of course the higher echelons and strategy would pretty quickly have been in play. However you spin it the billion Euros or so a week of buying of Italian bonds might have lasted all of thirty minutes if that if it was spent all in one go! I do not know if the weather was the same as in London but the storms were appropriate.

There was no formal Governing Council Meeting but I am sure that President Draghi and the Executive Board would have been in contact and others would have taken an interest. Some may have had a wry smile as up to this week the main issue would have been the location of the meeting next month in Riga Latvia. There the issues would be corruption, money-laundering and in some respects the ECB trying to put itself outside the legal system. Now the question on everyone’s minds would be Italy and the political crisis triggered there and in particular the impact on debt markets

What could the ECB do?

The obvious first move concerns the QE bond buying. This is something of a new situation as it is the first case of a major bond market facing a price rout with both flow QE as in ongoing purchases and a stock of it as the ECB has bought around 342 billion Euros of Italian government bonds so far. Thus the latter would not be sold and it would have been bought mostly from those who might have done in the situation unfolding. Yet it was not enough and the ECB has tied its own hands.

What I mean by this is that in order to get its 19 constituent nations to agree to the QE plan it buys according to their Capital Key. This is the effective shareholding of each country and reflects factors such as their relative GDP and Italy is approximately 17.5% so that is what it gets. There is scope to vary this but not a lot as Mario Draghi explained in January.

 The ECB doesn’t favour certain countries over others in its PSPP purchase programme implementation. As you know, purchases are guided by the ECB’s capital key, which takes into account GDP and population. Now, focusing excessively on any particular purchase period, for example on 2017 only, could result and yield wrong interpretations. The overall stock of Eurosystem PSPP holdings is the relevant metric for any assessment of the programme and not the recent purchase flows.

Back then too much German debt was held and too little Portuguese.

These flows can differ as the design of the programme is flexible and the distribution of actual purchases often deviates from the ECB capital key.

So whilst there is flexibility there is nowhere near enough especially as the numbers would be released next Monday and everyone would see. Actually I think the flexibility was used up last Wednesday when the ECB in baseball terms stepped up to the plate and then withdrew. No doubt there were discussions about modifying the programme but I doubt they got far and the word nein would not have been needed.

Some have been suggesting the ECB could buy more but at the moment that is a non-starter. Of course we have seen such things change but persuading German and other taxpayers to potentially bankroll a new coalition government in Italy hoping to “spend spend spend” will not be easy.

Securities Markets Programme

This was used in the Euro area crisis.

About e220 billion (bn) of bonds (par
value, excluding redemptions) were acquired from 2010 to early 2012. Greece, Ireland, Portugal, Spain, and
Italy.

As described it does seem to fit the bill.

First, purchases within the SMP occurred during a severe sovereign debt crisis, when sovereign yields in several euro area countries were high, rising, and volatile.

Of course you could argue that in spite of yesterday’s surge in Italian bond yields with the ten-year around 3% as I type this that is not high compared to the 7% of the Euro area crisis. Also the programme is shown as terminated on the ECB website although 84 billion Euros of bonds are still held.

However it is worth noting because the replacement called OMTs or Outright Monetary Transactions have never been used.

Outright Monetary Transactions will be considered for future cases of EFSF/ESM macroeconomic adjustment programmes or precautionary programmes as specified above.

That is an issue because Italy is not in one and you could hardly see Mr. Sissors persuading the Italian parliament of much at all right now let alone this. That is unfortunate from the point of view of the ECB because like the SMP it operates like this.

Transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years.

This matters because there have been some extraordinary events in short dated Italain government bonds. As recently as the fifteenth of this month the two-year yield was negative reflecting the easy ECB monetary policy and the -0.4% Deposit Rate. Yesterday it rose as high as 2.8% and today it is 2%. So some extraordinary moves with t hose who bought a fortnight ago feeling rather silly I guess.

Wider Moves

The issue here for the ECB is that not only has it been tapering its QE programme but it has been hinting at its end. That makes it awkward to fire it back up. Of course should the current weaker patch for the economy persist then it might provide an excuse/reason but it is just as true that the effect on inflation from the higher oil price is pushing in the opposite direction.

Comment

The ECB finds itself between a rock and a hard place in two respects. The first is that additional bond purchases might turn out to be an own goal if the likely governing coalition returns to its proposal involving the ECB writing off 250 billion Euros of it.Next comes the issue of Greece which does not qualify for QE in spite of enormous efforts and it might reasonably ask how a fiscally expansionary government in Italy qualifies?

There could be specific efforts to help the Italian banks although of course they have received an extraordinary amount of help as it is! Most still seem to be troubled and burdened with bad and sour loans. Mario Draghi was always very keen on buying Asset Backed Securities which I always thought was a way of helping the Italian banks in particular but as we look we see a barrier.

At the time of inclusion in the securitisation, a loan should not be in dispute, default, or unlikely to pay. The borrower associated with the loan should not be deemed credit-impaired (as defined in IAS 36).

Here is my suggestion for the ECB loudspeakers from The Sweet.

Does anyone know the way, did we hear someone say
(We just haven’t got a clue what to do)
Does anyone know the way, there’s got to be a way
To blockbuster

 

Meanwhile the Euro has recovered a bit today and is above 1.16 versus the US Dollar.

 

 

The Italian bond and bank crisis of May 2018

Oh what a difference a couple of days can make, especially in Italy right now. However we can see the cause of this quite easily and have done so more than a few times in the past. Back at the end of the last century when the Euro currency concept was being prepared its supporters argued that it would bring economic convergence to its member countries. The reality for Italy has been this if we look for an individual measure of economic performance.

GDP per capita in IT is:
1. Flat since 2000 2. Diverging from Germany
This widening gap shows the pressure on Italian politicians to discuss the #euro +structural economic measures. #Italy pic.twitter.com/VXSMnQ0y3Z

— Geert Noels (@GeertNoels) May 28, 2018

The convergence issue has been a disaster for Italy. Ironically it seemed to be holding station with Germany before the Euro began but since it the German locomotive has powered ahead leaving the Italian carriage in a siding. If you had set out to diverge the two economies it would have been hard to do better ( worse?) than this. Also my theme that Italy struggles in the relatively good times was at play in the early part of the century. Then it was hit hard by the credit crunch and the Euro area crisis and sadly has still not fully sorted its banking problems.

Poverty

Another way of observing the Italian economic experience has been provided in a paper from the Universities of Modena and Rome which point out another reversal.

The paper explores the changing risk of poverty for older and younger generations of Italians throughout the republican period, 1948 to the present day. We show that
poverty rates have decreased steadily for all age groups, but that youth has been left behind. The risk of poverty for children aged 0-17, relative to adults over 65, has
increased steadily over time: in 1977, children faced a risk of poverty 30 percent lower than the elderly, but by 2016 they are 5 times likelier to be poor than someone in the age
range of their grandparents.

It is easy to always look at the bad side so let us take a moment of cheer as we note that in general poverty has fallen since the second world war and mankind has stepped forwards. However the rub as Shakespeare would put it is that the times may be a-changing and the poverty we see now in Italy is concentrated in younger age groups. This reminds me of another statistic.

Youth unemployment rate (aged 15-24) was 31.7%, -0.9 percentage points over the previous month.

So as the overall unemployment rate is 11% then the youth unemployment rate must be treble that of older age groups. Which means that they have gone back to the future.

As a matter of fact, young Italians today face approximately the same risk of poverty as their equals in age in the 1970s. No economic miracle has happened for them, and none is expected.

This seems to have been a deliberate policy as we note this.

 Our analysis points to the welfare state, which offers better protection for the elderly than it does for
the young and their families………More importantly, the
elderly continued their march towards a poverty-free existence, while the youth did not.

This leads to a rather chilling statement.

Overall, in the last seven decades, Italy has become no country for young people.

Some of this is an international issue as for example the UK had the triple-lock for the basic state pension but some is specifically Italy.

National Debt

This is an issue but not in the ordinary way. This is because what can be described as the third biggest national debt in the world has not be caused by fiscal recklessness. In recent times Italy has been restrained. The problem has been the one described above which is the lack of economic growth. On such a road to nowhere even small fiscal deficits see the national debt rise in relation to economic output or GDP (Gross Domestic Product).

Perhaps the new Prime Minister will live up to his “Mr. Scissors” nickname in this area but it will be hard for a man facing a confidence vote to do much I would think.

Italian bonds

As you can imagine this has felt just like old times for me and in spite of yesterday being a glorious bank holiday at least until the evening thunderstorm I was transfixed for a while by what was happening. Two old rules of mine worked as well.

The one part of Rational Expectations that works. A rally to set up a drop……

— Shaun Richards (@notayesmansecon) May 28, 2018

I like the idea of applying something I was taught at the LSE albeit with a personal spin as so much has found its way into the recycling bin. Nobody seems to pick it up either which means it is set fair for the future. The other is that you buy an intraday fall of more than two points. That worked as well but with the caveat that it was a case of the “quick and the dead” and you would have been stopped out today.

Moving to the state of play as I type this we see what has become a bloodbath. The Italian BTP bond future has fallen 5 points to a low of 124 and this compares to a bit over 139 as recently as the 7th of this month. Putting it another way the ten-year yield has risen from 1.76% to 3.1%. This may not seem large moves so let me explain the issue in the QE ( Quantitative Easing) era.

1. They are bigger than you think and an example of this is the way the US Treasury Bond market used to have a trading halt after two point moves. Annoying at the time but does give a breather.
2. In the QE era there is the view that the central bank will bail things out and that to quote Flo “the dogs days are over”
3. This may have tempted investors to increase position size to make a profit which of course would now be in trouble.
4. As implied volatilities fall it is tempting not only to put on derivative positions but to increase their size as human nature is particularly vulnerable at such times.

We have two clear examples of such events. One I traded through which was the LTCM crisis of the late 90s which was a case of intellectual arrogance and of course we had the travails of the VIX index earlier this year.

Whatever It Takes

The famous saying from ECB President Draghi from the summer of 2012 of course had to save the Euro as an implication but some translated it as “to save the Italian banks”. We have followed over time the multitude of issues here but as we looked at last week another problem emerged on Thursday. From @YanniKouts.

The minute the markets will realize that Italy will restructure its debt, the Italian banks and eventually the economy will collapse. Corralito.

Since then the share prices of the Italian banks have moved into yet another bear market. Our old friend Monte Paschi the world’s oldest bank is at 2.32 Euros down 5% today or 1 Euro lower than a fortnight ago. Those of a nervous disposition might like to look away now as I point out that compares to a pre credit crunch peak of more like 7700 Euros. In a way the Italian financial crisis can be summed up by Prime Minister Renzi saying it was a good investment. Oh and as Polemic Paine reminds us a past theme is in play right now.

Waiting for second round effects from all the private hands that clamoured to buy the Italian banks’ dodgy debt.

These days the role of the ECB has increased as of course it is also the banking supervisor which I think is a bit like being Liverpool’s goalkeeping coach.

Comment

There is much to consider here and let me throw in something from this morning’s data which will not help. From the ECB.

The annual growth rate of the narrower aggregate M1, which includes currency in circulation
and overnight deposits, decreased to 7.0% in April, from 7.5% in March.

Another hint of an economic slow down albeit broad money was a little better. Moving to the financial crisis this will be felt by individual Italians as they are savers and for example around 64% of Italian debt is held by domestic hands. So they are losing and whilst overseas investors are in a minority that is still some 685 billion Euros due to the size of the market. Thanks to the Bruegel group for the data. This is of course before we get to the stock market and those holding bank debt. Remember when we were told what great deals the bank debt was? Also the “protecting savers” part from President Mattarella not only goes into my financial lexicon for these times but will be part of what historians will call the Mattarella Error.

As a final though this has answered a question we have been asking for a while. What would get the Euro to fall? This has been answered as we note it has dropped to 1.15 and a bit versus the US Dollar and even the UK Pound £ has nudged a little higher to the nearly the same number.