Notes From Underground: Will Europe’s Declining CPI Deflate Draghi’s Ego?

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.

ECB Balance Sheet       fed-gif


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.

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8 Responses to “Notes From Underground: Will Europe’s Declining CPI Deflate Draghi’s Ego?”

  1. asherz Says:

    Question for Yra-
    Scenario 1-, you have a fiat currency.Deflation overwhelms the economy and leads to financial and economic collapse.
    Scenario 2- The same currency. In reaction to deflationary pressures this country’s central bank turns on the monetary spigot and bloats its balance sheet creating huge quantities of liquidity.

    What happens to the value of that currency in each case?

  2. yra Says:

    Asherz—the questions you pose are of course the riddle of the sphinx to global macro traders or better yet the search for the alchemists stone.Scenario one is Japan except you leave out the elements of a huge pool of savings,domestic owned debt and a very homogenous society and polity;scenario two leaves out the element of the world’s reserve currency status and other elements .Remember,our analysis is always dynamic so this will certainly be a work in progress.Also,GOLD does not go up in either scenario because of present inflation but the fear of debasement of the fiat currency.Bernanke and his fellow board members are ’37ers and will not allow deflation to set in—

  3. asherz Says:

    Yra-My query was in reaction to the statement “The ECB can address the market’s fear of a FED tapering and turn on the ECB’s monetary pumps.” ( AKA kicking the can down the road). Of course traders want to see the meltup in the bond and stock markets continue, and don’t care much about the long term implications of what will be endless money pumping. But when fiat currencies are debased almost everyone loses. A debt problem’s solution is not creating more debt.
    You are right. Bernanke has only one dragon to fight, deflation. But he is in the same position as the poor NYU student who was stuck between two buildings 10 floors up. QE will continue until market forces put an end to it, and then apres moi le deluge. And unlike the student there are no fireman nor alchemists to save him.

  4. Alex F Says:

    At these suppressed levels I think EURUSD has priced in much of the dovish news already. Draghi’s own description of the recovery – “weak, fragile, and uneven,” is a very accurate assessment.

  5. Mario Says:

    Everyone feedback has been lacking.Send in your favorite Underground articles that have played integral parts in the market we live in. Your opinions matter please bring them out.…..

  6. Chicken Says:

    Hopefully the market is FINALLY prepared to embrace a growth path such as eurozone LTRO…..

  7. Nate Says:


    I am starting my own blog/website. Do you mind if I put a link to this blog on my “LINKS” page?



  8. yra Says:

    I would be honored–thanks for the compliment

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