Das Kapitulation

The biggest market-moving event so far this year is undeniably the positive (so far) aftershock from Germany's capitulation on monetary expansion and as Michael Cembalest of JPMorgan goes on to note that the ECB, directly and indirectly, is giving its governments and its banks the money that the rest of the world has been taking away. Between the ECB's LTRO largesse and its 'crisis management' initiatives (for example: collateral standards, watered down Basel III, lower bank reserve requirements), it seems clear that the resignation of the German contingency (Stark and Weber) from the ECB last year was a signal of the laying-down-of-arms by the Germans relative to the Periphery (perhaps for fear of the 'powerful backlash' that Monti among other has warned about). While the JPMorgan CIO understands the market's positive reaction (as Armageddon risk is reduced/delayed) he remains a skeptic broadly given the structural reforms and any expectations of growth among most euro-zone economies this year. He reminds investors that it should not be lost on anyone that first prize in the Central Bank balance sheet expansion race is not necessarily one you want to win and we wonder just how aware the German press and public are that this is happening under their watchful (if not frustrated) gaze.

Topics: Germany capitulates, kicks can well into 21st century…or at least into 2013

Michael Cembalest, JPMorgan

There has been good news in the US (manufacturing, small business optimism, bank lending to businesses, some housing indicators), and in China (no hard landing yet, with strength in production and retail sales offsetting weakness in exports and capital spending). But the biggest market-moving event so far this year is undeniably the positive aftershock from Germany’s capitulation on monetary expansion. The mechanism: the long-term refinancing operations (LTRO) of the ECB, shown in the first chart. I did not foresee this kind of radical policy being put into place so aggressively and so quickly. The ECB is printing money, and lending it to just about any European bank against practically any asset it owns, for three years.

This has positive near-term implications for sovereign and bank financing pressures, the speed of deleveraging, and the EU recession. On the first point, as shown below, the front ends of Spanish and Italian yield curves have collapsed. With demand from national champion banks, and assuming continued ECB purchases of government debt, 2012 Spanish and Italian financing needs do not look as onerous as they did 3 months ago. On the second point, there has been a partial re-opening of core and peripheral bank debt markets. More importantly, a recent Morgan Stanley report estimates that some European banks used the LTROs to prefund 50% to 150% of their 2012 bond maturities assuming markets don’t reopen. And on the third point, based on this morning’s preliminary manufacturing and service sector surveys for January, the ECB’s actions may have slowed the severity of the EU recession as well. The bottom line is that the ECB, directly and indirectly, is giving its governments and its banks the money that the rest of the world has been taking away.

 

Combine the ECB largesse with the initiatives in Table 1, and you’ve got a region that appears determined to banish concerns about itself from financial markets this year.

 

It should not be lost on anyone that first prize in the Central Bank balance sheet expansion race is not necessarily one you want to win. After all, Europe is poised to surpass Japan, whose (admittedly belated) Central Bank expansion did not prevent bouts of low growth, asset price deflation and perhaps the world’s least attractive equity market returns over the last 10 and 20 years. Germany was reluctant to go down this road in 2011, a view I thought would prevail.

However, it’s clearer now that German resignations from the ECB in 2011 (Stark, Weber) were not, as I saw them, a reflection of a battle being waged between Germany and the Periphery. They were instead a reflection of a battle that Germany had already lost; the resignations were merely signs of the capitulation that followed. Italian Prime Minister Mario Monti actually went so far last week as to warn about a “powerful backlash” in the periphery against Germany, should Germany not do more to lower credit spreads in Italy. A chi dai il dito si prende il braccio…What kind of action is Monti demanding here?

Since Germany already surrendered on its insistence for ECB balance sheet control, perhaps he is referring to fiscal transfers through joint and severally guaranteed Eurobonds. Will Germany cave in on this as well? Who knows. I spoke last fall to a former Bundesbank member and professor of economics at Bonn University who organized the petition of 150 German economists in 1998 arguing for a postponement of the Euro, since conditions for monetary union were “most unsuitable” for it. He thought the idea of Eurobonds was absurd, but also thought the same thing about radical ECB balance sheet expansion.

The positive market reaction is understandable, given the reduction in Armageddon risk, and how cheap (and under-owned) European equities had become. The latest steps give Europe more time to try and sort through all of its structural problems (e.g., why is the level of German manufacturers reporting labor shortages close to the highest on record while unemployment in Spain is 23%?). I am still a considerable skeptic on this front, for reasons we have written about often, and I would be surprised if Italy or Spain grew at all over the next couple of years. I’m also not sure how many obligations Germany and France can really take on, given sovereign debt ratios above 80%. And of course, if the current strategy doesn’t work, the EU will simply have made the problem bigger for the ECB and EU banks. 

Southern Europe needs capital to finance both budget deficits and trade deficits. Private sector capital is going to need a reason to come back, and absent a much weaker Euro, downward pressure on wages and prices may be the only way to do it. For a project designed to reduce regional credit risk, growth and unemployment differences, the European Economic and Monetary Union sure has elevated them. As Marx noted in Das Kapital, the road to hell is paved with good intentions.

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