Thoughts through the cycle: W5 May ’20

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  • In this week’s hit-parade of contrived historical analogies, Europe has claimed the top spot. To much rejoicing in the press, it seems that the joint Franco-German announcement of a €500b pandemic recovery fund on the 18th May was Europe’s ‘Hamiltonian moment’ when the decisive shift to joint bond issuance (and therefore burden sharing) was made. In 1790, Alexander Hamilton proposed that the debts from the American war of Independence owed by individual US states be amalgamated and paid off by a shared, US Treasury. Perhaps it is too early to speculate whether Angela Merkel and Emmanuel Macron will, after their moment of triumph, have an opera written about them as Hamilton has. First, it is necessary to cut through hyperbole to analyse what has happened so far and what happens next.
  • Context is everything. The recent ruling by the German Constitutional Court (GCC) suggesting the ECJ has failed in its oversight of the ECB’s execution of monetary policy has clearly been a major shock and one which potentially means the Bundesbank’s participation in ECB policy cannot be taken for granted. The ECB is assessing how (or even if) it will respond, and the clock is ticking on the three-month deadline set by the GCC. Germany takes over Presidency of Europe on the 1st July, heightening the focus on the country. The dire progress being made by the European Commission (EC) with respect to Brexit negotiations might well provide another salutary reminder of the centrifugal forces being applied to Europe, not least when the UK is a major export market for Germany.
  • What about the actors? France’s Macron has long been pushing for closer fiscal union expressed through joint budget commitments, so there is no real change of tack from him, although the size of the current proposal (€500b) seems modest given his previous assertions of what is necessary. More interesting is the German Chancellor, Merkel. It seems the joint Franco-German announcement on the 18th May amounted to a considerable volte-face for Merkel, surprising her German colleagues, although many have since rallied around her, most notably the arch-hawk of the Eurozone crisis, former German Finance Minister, Wolfgang Schaüble. Merkel has form with respect to spectacular announcements of unilateral policy decisions – foremost on this list is her politically-disastrous decision in 2015 to declare Europe’s borders open to Syrian refugees without consulting her neighbours. There is also a sense that the ‘push-me-pull-me’ nature of European policy sometimes demands major assertion which is then followed by consensus-building to the backdrop of disagreement courting market disapproval and therefore disaster. Mario Draghi was the master of this, both in his 2012 ‘whatever it takes’ speech, as well as his announcement at last year’s Sintra meeting of the resumption of quantitative easing (QE) without having consulted his colleagues on the ECB board.
  • There is also a special significance to joint announcements by France and Germany. Diplomatically, it is very hard to resist the combined weight of these two countries acting in unison. The ‘Merkozy’ duo of Angela Merkel and Nicolas Sarkozy provided the fulcrum of decision making during key moments of the Eurozone crisis, most notably during the bailout of Greece in May 2010 and with respect to forcing Italy’s colourful Prime Minister, Silvio Berlusconi, from office in 2012. While the ‘frugal four’ (Austria, Netherlands, Denmark and Sweden) immediately responded to the recent Franco-German proposal by insisting on loans and not grants, one wonders how long this resistance can hold out against the usual back-room arm-twisting that goes on. It is also worth noting that the 2010 Greek bailout turned out to be a bailout of the French and German banks, which left Greece as a ‘debt colony’. More time needs to be spent thinking about how France and Germany now benefit from these proposals, especially France with its colossal debt mountain of over 320% of GDP[1] (public and private).
  • So what was actually announced? A €500b recovery fund with a digital and green focus to aid recovery from the Covid-19 pandemic. This would come from the EC budget and would not be allocated according to budget contributions although repayment would be proportional to this. The proposed fund can be levered, giving the EC new powers to issue bonds. The German press release did not mention grants (as opposed to loans), while neither Merkel nor Macron seemed to mention grants during the press conference. Indeed, Macron’s actual words were, “This recovery fund of €500b is not going to be a grant to a region or sector, but it is going to be a budgetary aid.” Despite this, the declaration was widely reported as Germany advocating grants that need not be repaid, and that this meant shared debt issuance and the road to joint-and-several issuance (such matters would likely mean treaty changes, unanimous parliamentary approval across the EU-27 and also specific approvals from the likes of the German Constitutional Court – no matter though). The immediate response from those opposed to mutualisation (Netherlands et al) was that aid had to be in the form of loans not grants, suggesting either that the proposal was about grants, or that they were laying out their opposition to grants as this matter had yet to be finalised. With the formal EC proposal on the 27th May, the next European Council meeting is on the 18th June, so there is clearly some time for this narrative to develop.
  • What has the reaction been? The EC is clearly elated as any bureaucracy would be with the addition of bond buying to its suite of capabilities. The ECB is also once again on the front foot, with economist and board member Philip Lane hinting strongly in a speech on 22nd May that the ECB will announce further bond buying at its June board meeting. This has to be taken as a poke in the eye to the GCC and a further assertion of the ECB’s power. It is worth noting that the ECB will be able to buy up to 50% of the bonds issued by the EC (higher than the 33% limit on sovereign issuance).
  • Italy’s Prime Minister Conte has already said that the new pandemic fund would mean Italy would not need to access the politically-toxic European Stability Mechanism (ESM) for funds. It is worth noting in passing how easily a fund like the €540b ESM can be thrown on the scrap heap without having been accessed. This is particularly true in Italy where the cheap funding of the ESM (average 0.76%[2] since inception) has been ignored in favour of the market (note a €22.3b Covid-19 emergency ‘retail’ issue by Italy at 1.4% on 21st May). Clearly this is an example politics trumping purely budgetary considerations.
  • The ‘frugal four’ are clearly digging in for a fight over the issue of grants versus loans. In a radio interview on 23rd May, Austrian Chancellor Sebastian Kurz said, “We believe that there needs to be a discussion about how much of those 500 billion are grants and how much are loans…how we give this aid [demands] a clear and binding time limit, so that we don’t have a full debt union as the next step…At the end of day there needs to be a compromise, that’s how the EU works,”. A predictable reaction – loans not grants, limited scope, limited time-frame, no mutualisation. So not quite a done deal yet it seems.
  • Most importantly, what about the market? If this is the start of a major European reflation effort, the market is being a bit half-hearted in its response. Euro 5y5y inflation (5yr inflation in 5yrs time) has risen 6 basis points to 0.90% (NB the ECB’s medium-term target is 2%). The graph below shows German 10yr yields having risen 5bps or so since 18th The 10yr spread between Italy and Germany has tightened a little to around 210bps, but this is far short of a real ‘convergence’ trade, and probably little more than some short covering.

Source: Bloomberg, 25th May 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • Perhaps the muted response is due to a combination of immediate dissent from some member states (and accession countries such as Poland) as well as the modest size of the fund at € The EC was suggesting a €1T fund. Spain was demanding a recovery fund of €1.5T. The US has already executed a combination of fiscal and monetary intervention in excess of $10tn. In any case, the new EC fund, should it be agreed, will only become active in 2021 and it may provide relief, but that is a somewhat lethargic interpretation of ‘emergency’. The delay is because the fund is part of the ongoing multiannual financial framework (MFF) budget negotiations. These were already floundering over how the gap left by the UK after Brexit would be filled. One senses that further extending this budgetary scope is not going to make for easy negotiations in the midst of a deep recession.
 
  • The press reaction has been euphoric at times. In an article entitled ‘Europe’s Hamiltonian Moment’ for Project Syndicate (21/05/2020[3]), the economist Anatole Kaletsky co-opts George Soros’ recent suggestion that Europe should issue perpetual bonds and goes on to speculate that;

“To put it another way, if the EU borrows €500b this year for a European recovery fund, then it could easily borrow another €1 trillion next year for a digital inclusion fund, and then maybe €2 trillion for a vehicle electrification fund or €3 trillion for a comprehensive climate-change fund. Such simple calculations show why European economic and political conditions could be completely transformed by the Merkel-Macron plan’s financial innovations.”

Adding that:

“a compromise acceptable to both sides should not be difficult to forge. The size of the recovery fund could be increased to something near the €1tn recommended by the European Commission without imposing any strain on the EU budget. But in exchange, the Frugals could insist on offering 50% of the support through loans instead of grants.”

  • While such vaulting ambition is to be admired, it does tacitly admit that the current €500b is completely inadequate for the job in hand. If Kaletsky is suggesting that this is just a precedent and therefore some sort of Trojan horse for joint-and-several issuance, he may want to consider more closely not only the existing opposition from the ‘frugal four’ but also the recent judgement of the GCC on the ECB’s QE. It seems most unlikely that the German constitution and the Lisbon Treaty can be bypassed in a single session of EC budget negotiations. It is worth noting too that Germany has already pledged over a trillion euros to relief efforts in its own country – the appetite for infinite financial engineering would seem to go against the grain of much of German politics.
  • More broadly, for those who want to seek out precedents for the effect of aggressive fiscal spending on growth and inflation, one need to look no further than Japan. This is a country with many bridges to nowhere and very fast trains travelling over them, but with a 10yr zero coupon inflation swap (a good market indicator of long-term inflation) which has fallen to -0.18% in 2020. Fighting debt-deflation with more debt might not be an obvious choice to reflate an economy.
  • Were this Franco-German proposal to pass and become part of the EC’s budget, then from a €500b fund Italy might get 1 or 2% of GDP in terms of grants (or loans – we don’t yet know for sure). This is not a huge amount of money. Perhaps this is why the market seems a little less enthusiastic than the pro-European press corps. It is sometimes suggested that for real burden sharing (joint-and-several issuance, common bank deposit insurance, a substantial EC budget beyond its current levels etc), then there would be spread convergence between EU bond yields. One suggestion as a rule-of-thumb would be that overall, the French and Italian yields would meet somewhere in the middle. 10yr France yields -0.05% and 10yr Italy 1.58%. There is clearly some way to go here.
  • What awaits us is the high drama of the EU budget agreement, now given special significance by the Franco-German proposal. As ever with Europe, it is not only a question of doing the right thing, but enough of the right thing before it’s too late.

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