Thoughts through the cycle: W3.2 April ’20

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  • In Italian it is known as ‘Lo Spread’ – not any old spread, but ‘The Spread’. This is the spread of the 10yr yield of Italian BTPS government bonds over German 10yr Bunds (graph below). It is the bellwether for financial distress in Italy, both with respect to the banks and the sovereign itself (the two issues were linked during the Eurozone crisis in what was known by some commentators as the ‘doom loop’). A 1%-spread is the all-clear. A 5%-spread marks bank and sovereign apocalypse; the last time the spread reached these levels was in 2012 when the ECB stopped purchasing Italian government debt through the Securities Market Programme (SMP) as a means of Chancellor Merkel (Germany) and President Sarkozy (France) engineering the resignation of Prime Minister Berlusconi of Italy. Such is the great game of European diplomacy. We are currently therefore somewhere between normality and the end-of-days.

Source: Bloomberg, 17th April 2020

  • There should be two main concerns for the world right now, and unsurprisingly they are the two biggest currencies, the dollar and the euro. While issues around the dollar are primarily monetary and relate to the cost of dollars domestically and their availability beyond US shores, the issues around the euro always seem to have a more political character. This is unsurprising as the eurozone is a half-finished edifice of monetary union without fiscal (and therefore political) union.
  • The focus on Italy is not simply because of the heavy burden some of its northern regions such as Lombardy have had to endure in the current pandemic. The macro-economic set-up for Italy heading into this crisis was particularly poor: high structural unemployment; low growth; low productivity; poorly capitalised banks; and most importantly, government debt-to-GDP that stood around 135% heading into this crisis. It is the last point which is critical. If one imagines the US to be doing whatever-it-takes and likely to hit a budget deficit of 25-30% in 2020, how on earth can Italy, with its less dynamic economy and higher stock of debt, run a deficit like that (if that is what is needed) without completely panicking the markets?
  • Running monster primary deficits requires bond issuance and more importantly, someone to buy those bonds. In the US, the Fed is doing that job – currently at a run-rate of $50bn per day. For the week ending 11th April, the ECB bought in aggregate across European sovereigns €37bn as part of its Pandemic Emergency Purchase Programme (PEPP). There is clearly a vast gulf here. While Germany is acting with largesse with respect to emergency measures within its own borders, Italy is having to be far more measured, even with the announcement of a potential additional €70bn of relief measures to be voted on in Parliament in the coming weeks. Germany can probably find new buyers for its bonds because of the perceived underlying strength of its economy. Italy has no such luxury.
  • This explains the reason for countries such as Italy and Spain calling for ‘corona bonds’ or some kind of joint-and-several issuance to spread the burden of financing between Eurozone to alleviate the economic pain in weaker countries. Spain may well be one of the worst affected given its heavy reliance on tourism (in 2019, 12% of Spanish GDP came directly from tourism).
  • The Eurogroup meeting of finance ministers on the 9th April failed to make any substantive progress. While emergency loans from the European Stability Mechanism (ESM) with ‘light’ conditionality were touted along with potentially more European Investment Bank (EIB) issuance, details remained scant and clearly the underlying disagreements remain extant such that only a few days later, Italy’s foreign minister and head of the 5-star party Luigi di Maio felt it necessary to write an open letter to the Financial Times demanding Europe-wide cooperation.
  • Opposition to corona bonds appears to be led by the Dutch, with the Germans, Austrians and Finns in tow. The reasons cited usually reflect domestic political concerns about the EU becoming a transfer union in which the austere north has to pay for the fiscally-profligate south. Likewise, opposition to ESM loans in Italy by The League’s Salvini always focuses on the loss of political liberty likely to result from the reform measures enforced as conditions for the loans. What is notable this time though is that even more moderate politicians in Italy are taking up a more anti-EU stance. Even Italy’s prime minister, the mild, former law professor Giuseppe Conte, recently alluded to Italy ‘taking matters into their own hands’ in an op-ed written for the Spanish newspaper El Pais.
  • Inaction, like threats of taking matters into one’s own hands, has consequences. One can track this through the Target 2 balances within the euro-system. Data below shows Italy’s Target 2 balances rising as euros leave Italy and head elsewhere – mainly to Germany. Target 2 balances are ledger entries which reflect credits and debits between the constituent central banks of the Eurozone, and are its dirty secret. Pre-2008, the balance was zero; the emergence of sovereign credit risk in the Eurozone might well be described as a slow-motion bank-run characterised by money leaving countries at perceived risk. Italy owes the rest of Europe (mainly Germany) €492b as of 17th It is worth noting the previous peak in Target 2 was mid-2018 when the newly formed 5-star / League government was threatening a parallel currency.

Source: Bloomberg, 17th April 2020

  • In a properly functioning single currency, Target 2 balances ought to be zero. Sovereign credit risk from 2011 onwards saw money move from at-risk to safe countries. This process slowly reversed following then ECB President Mario Draghi’s ‘whatever it takes’ speech in July 2012, only to re-emerge in 2015 when the ECB started quantitative easing (QE). This was because at German insistence, over 80% of QE purchases were done by the national central banks, not the ECB in Frankfurt, and this meant that the euro started to morph from being a single currency to more of a currency board given the split in ownership of assets between the national central banks and the supra-national ECB. As it stands in 2020, countries like Italy are therefore technically in the position of having to think about how you finance a huge primary deficit in a currency where you can’t print money because it’s not fully your own. This is the problem.
  • There are some mutterings that the ECB will have to step up its purchases. The PEPP is €750bn, and given that the timing of the end to lockdowns is unknown and even after that, the timing (or even the eventuality itself) of a return to normal, it is unclear whether this is in itself enough. Certainly relative to what the Fed is doing, the ECB’s efforts look insufficient, and given reports that Dutch and German ECB board members opposed even the PEPP, it looks to be divided at the highest level at a time when a unity of purpose and the confidence that stems from determination is most needed. This is the moment when Mario Draghi’s ‘whatever-it-takes’ vow is being tested out. Whether it is right or not, monetary financing of fiscal deficits is currently necessary given the nature of the lockdown and the decision to send the whole workforce home.
  • What of Germany? Chancellor Merkel is currently opposed to shared debt issuance, and this has long been the stance of the CDU. If one wants to get a wider tone of how Germany is thinking, one need look no further than Bundesbank President Jens Weidmann’s comments below from a Bloomberg interview on the 17th These aren’t exactly the words of a man on the verge of abandoning fiscal and monetary conservatism to embark on the de facto central bank monetisation of fiscal deficits like the Fed and the Bank of England:

*BUNDESBANK’S WEIDMANN: MUST FOCUS ON REDUCING DEBT AFTER CRISIS

*WEIDMANN: EUROPE PROVIDING `SIGNIFICANT, IMPRESSIVE’ FISCAL AID

*WEIDMANN: ECB WILL CONTINUE TO PLAY ITS ROLE IN HELPING ECONOMY

  • What of France? In the Eurozone crisis, the ‘Merkozy’ alliance was the rock upon which EU policy was built. This week, France’s President Macron abandoned his reform programme (including the controversial pension reforms) as he repositioned himself as someone willing to spend to help the French people in their time of need. Germany has always made it clear that fiscal responsibility was a necessary prerequisite for closer fiscal union. Macron’s actions this week ought therefore to be interpreted in this light, and the chances of corona bonds weighed with similar scepticism.
  • It is perhaps with this in mind that Macron allowed an extensive interview with the Financial Times to be published on the 17th April: the key Council of Ministers meeting occurs on the 23rd April in which Italy’s Conte will once again beg for Eurobonds. France is calling for a shared, €400bn fund to fight the coronavirus and aid the recovery. If the Germans and Dutch again refuse to play ball at the Council of Ministers, Macron can at the very least say he tried. He may also be thinking of issuing debt not backed by all EU countries; there have been rumours of this on the newswires over the past month. This might be the gateway to a two-speed Europe.
  • The great worry for the world is debt-deflation – spiralling stocks of debt however cheaply financed eventually end up reducing debtors’ abilities either to increase consumption or, in extremis, even to service those debts. ESM and EIB bonds are just debt instruments and arguably aren’t terribly helpful for a country like Italy at a moment like this. While anathema to the ordo-liberalism of the Bundesbank, money printing may in this instance be the only answer. The graph below shows Euro 5y5y inflation (5yr inflation in 5 years’ time). Ominously, it is rolling over even after the big fiscal moves and central bank interventions we have seen so far.

Source: Bloomberg, 17th April 2020

  • If Italy and Spain get no further help, there may be an increased chance of solvency issues becoming rife at a household and corporate level, further pressurising both sovereign debt spreads and bank solvency. In this instance, one would expect the euro to weaken as money left the Eurozone. This would further strengthen the dollar, and this in turn would tighten global monetary conditions, exacerbating any deflationary trends. The way national politics impinges upon collective decisions always muddies the waters in Europe – Henry Kissinger was once quoted as saying: “Who do I call if I want to speak to Europe?” Sometimes one feels it is not so much a question of whether Europe will do the right thing but whether it will do anything at all. Given the gravity of the situation, the importance of substantive action at the meeting of the Council of Ministers on the 23rd April is starting to feel like a key moment in the reality of the ‘whatever-it-takes’ doctrine.

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