ECB President Mario Draghi has been able to convince the world that the Euro’s problems have been contained and it is safe to re-enter the financial pool of credit assets throughout Europe. The July 2012 speech that proclaimed the ECB had no taboos and would “do whatever it takes” to preserve the euro has been a masterpiece of doing nothing while generating the desired outcome. The master plumber of all things credit (JA) alerted me to the ECB’s balance sheet (as seen on the Bloomberg terminal). After Mario Draghi pledged to offer the Outright Monetary Transactions (OMT) to any European country that contracted with the ESM or EFSF for help, the sovereign debt markets in Europe have quieted and yield spreads returned to a sense of normalcy. Many people believed that the euro currency would suffer from Draghi’s promise of massive liquidity to meet funding needs. The EURO shorts were wrong and the proof lies in the three charts I am providing.
Since September 2012, the ECB’s balance sheet has contracted from a high of 3.1 TRILLION EUROS (top) while the Fed’s has grown from to $3.84 TRILLION from $2.8 TRILLION (middle). Until this point, the markets have not tested Draghi and the initial provisions of the LONG-TERM REFINANCING OPERATIONS (Europe’s QE) have been paid down by many of the banks that took the cheap money. I am also posting the Bank of England’s balance sheet to illustrate that the BOE has been good to its word and held its QE at 375 BILLION POUNDS (bottom). When we see the great gap in liquidity provisions between the ECB and the FED it is no small wonder that the euro has confounded so many experts and rallied 14 percent since that July 2012 Draghi speech.
Why is this significant? It now seems that the result of the DRAIN IN LIQUIDITY COMBINED WITH FISCAL AUSTERITY have resulted in what we predicted is a powerful ADVERSE FEEDBACK LOOP. This is raising the specter of deflation in Europe. The possibility of a deflationary spiral at a time of record high unemployment and no real centralized political authority will result in a much more destructive deflation than Japan has had to endure. The media is suddenly rife with stories about the mal effects of a deflationary spiral taking hold of the European economy. The ECB meets Thursday and Mr. Draghi needs to look at two charts: EU unemployment and the ECB’s balance sheet. The EURO has dropped 2 percent following last week’s FOMC meeting. If Draghi fails to address the recent data showing declining inflation by announcing some “forward guidance” on a new liquidity program, the EURO will rally. President Draghi, you, like John Mayall “HAVE ROOM TO MOVE” (and not just a little). The ECB can address the market’s fear of a FED tapering and turn on the ECB’s monetary pumps.
***Tonight, the Reserve Bank of Australia announces the results of its meeting and consensus calls for the RBA to hold the official cash rate (OCR) steady at 2.5%. The recent economic data from Australia has been improving but Governor Stevens is fearful about the Aussie dollar becoming overly strong, especially as Australian inflation has been contained. Since the last RBA meeting the Aussie dollar has rallied about 1 percent against both the U.S. and KIWI dollars. The more important info from the RBA is about Chinese growth for the Aussies have been more reliable than the Chinese. Also, the world is on China watch this week as the third plenum of this politburo is meeting and purportedly going to lay out China’s plans for its future economic growth.
The main issue for the global financial system is how far China goes toward shifting its economy from an export machine to a much more domestic-oriented economy with a vast rise in consumer demand and a lower savings rate. Chinese leadership has discussed this transformation for a decade. Maybe the RBA’s statement tonight will offer some insight as to how it judges China under the leadership of president Xi. Again, no change from the RBA but maybe valuable insight.