Notes From Underground

On Tuesday, Mario Draghi, the Magician of Frankfurt, created a temporary maelstrom in global bond markets by hinting at a possible end to the ECB’s current QE program. While Draghi suggested that low rates were still a necessity to ensure that the European recovery remains on pace, the ECB president raised the issue that deflation was no longer a threat for the EU. Sovereign debt YIELDS rose dramatically as volatile hedge fund positions were liquidated and speculators sold bund, oat and BTP futures. On Wednesday, the ECB “explained” that Draghi’s statements were misconstrued and did not deviate from current ECB policy. ECB Vice President Vitor Constancio claimed Draghi was “totally” in line with existing ECB policy.

Months ago I wrote that the ECB would try to strengthen the EURO after the French elections in an effort to “smooth the runway” for German Chancellor Merkel’s September election. A strengthened EURO would weaken the arguments of the AfD ‘s criticism of the ECB, that it’s wreaking havoc on the European financial system. Draghi’s comments resulted in a 1 percent appreciation of the EURO against the U.S. DOLLAR, British pound and Japanese yen. Constancio’s comments initially weakened the EURO but by day’s end the currency strengthened against the DOLLAR.

In my opinion, the large move in European bond yields on was more of a result of the ECB‘s non-action rather than Draghi’s comments. Why? The ECB publishes its QE purchases for the previous week and monthly totals on Monday morning. The 60 billion euro allotment under the current QE policy showed that with five trading days left in June, EUR56.7 billion had been purchased, leaving a remaining 3.3 billion euros to be added to the balance sheet. We don’t know how much was transacted on Monday so the ECB may have been lacking the firepower to stem the rapid rise in yields. The ECB will reset its program July 3 and have a fresh 60 billion euros. If I am correct, any short positions will be subject to the enhanced firepower of Draghi’s printing press.

The ECB is very far from tapering because Draghi has to continue building the balance sheet, especially as there are Italian assets to be purchased. Draghi and company have to move non-performing loans onto the books of the Bank of Italy and the ECB. Lost in all the noise from Draghi, Yellen, Carney and Bernanke was the news of Rome’s 17 billion euro wind-up of Veneto Banca and Banca Popolare di Vicenza. Several German politicians voiced outrage that Rome’s bail-out plan violated the rules that Brussels put in place so taxpayers wouldn’t absorb the costs of any bank restructuring. The Italian bank rescue leaves the taxpayers on the hook for roughly 17 billion euros. The Italian Government argued that violating the Brussels rules was in the “national interest.” The senior bondholders in these two banks were small retail investors, which would be a political disaster for the present government.

The Italian economy has a high percentage of non-performing loans. With a debt-t0-GDP ratio of 132% the Italian state has little flexibility to absorb the vast amount of bad loans. National interest is a phrase of convenience to abrogate the rule of law. In a Financial Times article titled, “Germany Calls For Tighter Rules After Rome’s 17 bn Banks Wind-Up,” the reporter quotes Carsten Schneider, a Social Democrat Bundestag whip and budget policy expert. He said, “This decision will discredit continuing the completion of the banking union and moves the common deposit-guarantee scheme into the distant future.It cannot be that bank wind-downs under national rules offer better conditions for creditors tan under the European regime.” The ECB is far from tapering as the demands of several European countries for ECB efforts to do “whatever it takes” remain paramount.

Tags: ECB, Euro, Mario Draghi

This entry was posted on June 28, 2017 at 7:41 pm and is filed under Currency, Debt Market, ECB. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.