Friday, September 5, 2014

Draghi’s War on Savers and the Euro

by Pater Tenebrarum

ECB Cuts Rates From Nada to Zilch (and Less), Announces QE

In his Jackson Hole speech, Mario Draghi already hinted at further ECB interventions, pointing out that 5 year forward inflation breakevens indicated  that long term inflation expectations had fallen below 2% (i.e., 2% CPI rate of change). Consumers would of course see this as a reason to rejoice, but not our vaunted planners. It was already widely expected than an ABS purchase program would eventually be announced, as preparations for this have been underway for several  months.

Frankly, we thought that given that the TLTROs are beginning in September, the ECB would likely wait for their impact before announcing additional interventionist steps. As it turned out, they announced so many things at once on Thursday, they actually managed to surprise not only us, but apparently the great majority of market participants.

The announcement included: further rate cuts; with the repo rate now at 5 basis points, which we might as well call zero, this avenue is now rapidly closing. Since all rates were cut, they also increased the bizarre penalty rate on excess reserves to minus 20 basis points. All this measure achieves is that it costs the banks money. It's not going to make them more eager to lend, but it will lead to them cutting the paltry interest they pay to savers even further. So the war on savers is continuing at full blast.

As to these rate cuts, we would note that the central bank has been trying to “rescue” the economy with rate cuts for quite some time. It hasn't worked so far, but that is of course not stopping them from doing more of what hasn't worked.  This may be properly called “central planning insanity”. Even so, it is not clear to us why they believe another 10 basis points can possibly make a difference. Even if one erroneously thinks that economic growth can actually be spurred by monetary pumping, this appears to be an utterly futile gesture.

More surprising was that the ABS purchase program was announced concurrently, and along with it a covered bond purchase program. In his press conference Draghi promised a “substantial increase in the ECB's balance sheet”, which can actually be fairly easily achieved with this latter monetization initiative. Euro area covered bonds consist of two types, they are either backed by mortgage bonds, or by public sector debt securities (including agency debt). This is a big market, and there are very large covered bond programs out there, which can be used to add further to the already large supply of such bonds. Draghi pointed out that this will inject additional money directly into the economy.

Apparently the decision was not unanimous, and we can guess who the dissenters were (hint, the name of one of them starts with a “W”).

From experience we know that ECB refinancing operations do tend to lead to money supply growth acceleration in the short to medium term, and the combination of TLTROs and QE will surely have a noticeable effect with respect to that, unless the decline in private sector lending actually accelerates concurrently. For all the talk about “inflation being too low” (which is a totally absurd assertion anyway, since consumers can only benefit from the fact that prices are only rising slowly for a change), euro area-wide monetary inflation recently stood at 5.6% (narrow money supply). This is what we regard as the actual “inflation rate”.


Monetary inflation in the euro area. Note the y/y growth rate in blue. Thank God our central planners are able to implement such long term stability! – click to enlarge.

Bowing to Mercantilism

There has been a lot of yammering by various Mercantilists in Europe about the allegedly “too strong euro” (government minions in France are usually especially vocal about this). A strong euro benefits consumers and countless businesses that buy goods and services from abroad, while a weak euro is solely to the strictly temporary benefit of a small group of exporters. In other words, the idea is to help a small sector of the economy for a limited period, in exchange for hurting a much larger sector of the economy permanently. Brilliant.

Naturally, this is part for the course for our modern-day economic planners. They have evidently learned nothing in the past 450 or so years.  Why anyone would think it actually makes economic sense to weaken the euro is completely beyond us. Not a single nation on the planet has ever, in all of history, devalued itself to prosperity. The belief that this is possible is simply idiotic, not to put too fine a point to it. However, what can one conclude from the ECB's actions but that it wants to weaken the euro? Note here that Draghi has actually joined the chorus of complainers about the euro's strength around June already, so it appears he agrees that one can devalue oneself to prosperity. Anyway, it appears market participants were duly surprised by the announcement and decided to sell the already extremely oversold euro further. However, this move seems very long in the tooth by now, at least in the short term:


Note the gaps in this chart -  a break-away gap at the beginning of the move lower, and now there could be an exhaustion gap in evidence.  The euro has only twice been this oversold on a daily basis: when it crashed in the fall of 2008, and now – click to enlarge.

It should also be pointed out that speculators currently hold the second largest short position in euro futures in the currency's history. Amazingly, this 200,000 contract position (which is quite chunky in notional terms) is approaching the all time high net short position speculators held back in 2011/12, when the very survival of the euro appeared to be in doubt. The chart below shows the net long position of commercial hedgers, i.e., the obverse of the speculative net short position.


Speculation against the euro has become extreme.

The fact that the euro was in danger of breaking up a mere two years ago makes it especially strange that anyone in an official position would want to weaken it. Should they not be glad it has found willing buyers and holders again?

“Price Stability”

Lastly we want to briefly comment a bit more on the ECB's so-called “price stability” policy. First of all, this mandate implies that monetary inflation will go into overdrive every time the imaginary “general price level” isn't reflecting a devaluation of the currency's purchasing power by at least 2% per year. This naturally invites all the consequences a sharply rising money supply brings about.

While in the short term, an illusion of prosperity can be created, in reality real wealth will be redistributed, capital will be malinvested and increasingly consumed, and the economy will weaken on a structural level. It is not possible to lastingly increase society-wide prosperity by printing money.  Even if all the negative effects of monetary inflation did not exist, not one iota of real wealth could be brought into existence by printing more money.

However, what strikes us as especially irksome is that Draghi, similar to other monetary central planners, feigns concern with the unemployed and other victims of the last bubble the ECB aided and abetted with loose monetary policy. If they are all so concerned, then why are they deliberately taking steps that are aimed at debasing the currency?  When people struggle in difficult economic times, it seems especially important that their money should retain its exchange value. Making it worth less will only add to their troubles.

Such a policy can only be justified if one indeed assumes that money printing makes the economy “better”. In that case one not only needs to consciously reject sound monetary and economic theory, but must also cavalierly gloss over about 2,000 years of history, which show quite clearly that such policies have failed over and over again. Some of this history is fairly recent to boot.


After the last major inflationary push by the ECB (the LTROs of 2011/12), a brief surge in money supply growth triggered a temporary and evidently illusory spurt in economic activity. This Potemkin village quickly crumbled again, the very moment money supply growth declined back toward 5% y/y. The measures announced this Thursday may well achieve a similar Pyrrhic victory – but what then? Indeed, what Pyrrhus of Epirus is said to have remarked in the context of his victorious battles against the Romans can probably be applied in this context as well.

One only needs to adjust his saying a bit:

“If we are victorious in one more battle with the faltering recovery, we shall be utterly ruined”.

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