BEWARE THE WRITING ON THE WALL, Degree of sub-zero bond yields in Europe indicates proximity of bank crisis
· Jackson Hole and G-7 mute on European monetary hazards and related financial system alert but loud on “Trump trade woes”
· Implosion of European banks, stemming from the perpetual misfortune of a deeply flawed monetary union, long administered by the Merkel-Draghi axis, would drive global economy into great recession
· The Trump Administration will not move against negative rates in Europe (or Japan), for fear of setting off a sharp decline in asset markets now dependent on “haven buying” from income-starved Europeans (and Japanese). Nor does the Administration wish to upset the low-cost mega financing of US government deficits by taking issue with the ECB (or Bank of Japan).
· UK’s escape route from Brexit jam to multiple free trade agreements, including US and EU, closes as PM Johnson kicks opportunity at Gibraltar and Biarritz to forge immediate US alliance. Actions and declarations in support of US aims, vis a vis Iran and China, were starkly missing. GBP cheers now (“no deal” exit less likely”), but expect these to fade.
Why investors in negative yielding bonds are not crazy
Maybe all these investors – holding 17 trillion of negative yielding government debt, spread across Europe and Japan – are not as crazy as the narrators of the bond bubble story would have us believe. Rather they are frantic to find shelter from the looming storm to engulf the European financial system.
Given the sickly and fragile state of European banks – according to some pundits, the condition of Japanese banks is not much better – and the ECB’s pegging of the interest rate on central bank reserves at below zero (now at -0.40% p.a, and expected to fall next month to -0.55% p.a.), it could well be that holding top European sovereign debt at slightly negative yields for 10 years (and substantially negative yields for short maturities) makes very good sense.
If reserves, which banks hold at the central bank, were non-interest bearing (i.e. paid zero under all conditions as was the case under the Deutsche mark regime or indeed in the US up until late 2008), then ailing banks would have to pay substantially positive interest rates to sustain (hopefully) their deposit base. These bank rates would be at a big premium above the interest rate (zero or positive) on sovereign bills in the same currency.
In today’s European environment, by contrast, the yield on short-maturity top quality government bills is pressed below zero by the reality of arbitrage between these and negative rates on reserve deposits (and speculation that negative rates will persist for a long time ahead, becoming more extreme in the interim).
Profits squeeze on ailing banks: don’t blame negative rates
Investors, concerned about a bank crisis in the future, drive the yields even further into negative territory (below what could be justified by rate expectations alone, taking account of some tendency towards normalization several years from now), in their flight to safety. The spread of the yield on these bills, below the average rate paid on bank deposits, is a measure of general anxiety; when elevated it erodes bank’s profits.
The erosion of bank profitability, due to average deposit rates rising well above the yield on safe bonds, is common to all ailing bank situations; it is not unique to the negative interest rate regime.
According to official data on EURIBOR and EURIBID, banks are bidding around -0.40% p.a. for deposits in euros in the wholesale markets; but we know that most depositors (not just retail) are in fact paid zero or even slightly positive rates; the negative rate applies only in general to non-resident funds whose footloose owners have little or no relationship to the given bank; even for “footloose” funds, many banks would pay above those official recorded EURIBID rates.
In essence the EURIBOR measures are for an interbank market which has severely shrunk in importance as a consequence of massive QE operations.
By way of illustration of the above, take the -0.90% yield for example at present, on 2- and 5-year Bunds (German government bonds).
This yield is most likely below (more negative than) the average expected level of the ECB deposit rate over the next few years (including eventual re-bound from crisis lows).
The depth indicates the extent to which such paper is in demand as an insurance against deposit loss in crisis. (The premium is the extent to which the yield is below such expectations).
Some investors, rather than seeking safety exclusively in substantially negative yielding short-maturity bills or bonds, look to reduce the burden of the safety premium by taking a term risk position, say choosing to buy 10-year rather than 2-year or 5-year Bunds.
The five-year forward five-year rate implicit in the term structure for Bunds is now at around -0.45% p.a. compared to -0.90% p.a. for the spot 5-year.
Whether the given investors in fact economize on the premium for safety, by shifting funds into 10-year paper, depends on the error of these forward rates in forecasting future rate levels over the intended holding period, say the next year.
Evidently for now, their bet is that expectations of rates will shift even further into sub-zero range, most likely as banking dangers increase and recession deepens.
The same sort of illustrative calculation can be made in the French Government bond market (OATs).
A 5-year spot yield of -75bp compares with a 5 year forward 5-year spot rate of 0.
Investors hoping to economize on the safety premium (against bank default) implicit in today’s 5-year yield can move into 10-year paper where they will gain, so long as the forward rates do not rise above present implicit estimates.
Pessimism on the European economy and banks may make this seem like a reasonable bet in the next year.
Why is there such concern about the European banks?
It is widely known that the “clean-up” after the vast European financial bubble of the last decade (driven by ECB monetary inflation and related euphoria about the opportunities of European integration in the new monetary union) has only gone so far (far less than the US, where the extent of bubble and bust in the banking sector was in retrospect less severe than in Europe last time round.
In the further episode of monetary inflation in the present cycle, there are new challenges to worry about (exposure to bubble real estate in some countries, including Germany and UK; exposure to export sectors where much of the mal-investment is based on expectations of continuing Asian economic boom, world trade boom, ever cheap European currencies).
We should also note that many of the credit bubble risks (which are outside the banking system in the US, because of the depth of non-bank credit markets), are on the European and Japanese balance sheets.
Finally, if and when the first break-up of the euro-zone occurs, investors can only imagine the banking losses which will occur with the inevitable “unscrambling the egg” phase.
No doubt, member or ex-member governments will make good (to some degree) deposits at too “big to fail” banks, in their new currencies – but will all categories of deposits (domestic, foreign, corporate, government) be on an equal playing field – surely not!
So yes, negative yields on European and Japanese bonds are telling us about severe banking risks (Japan is a story for another day, but as a forerunner, recall that banks there bought huge amounts of European bank assets after the sovereign debt crisis of 2010/12; and regional banks starved of profitable opportunities have been by all accounts raking up huge positions in speculative strategies; all reflected in Japanese banking sector having a huge funding exposure in US dollars which could leave it gravely exposed).
Europe’s failed monetary union is the driver of global recession
But let’s move on to the recession risks which underpin the banking risks. Where do these come from in the main?
NOT from the US-China “trade war”, whatever you (the reader) may have picked up from the media reporting of Jackson Hole and G-7.
Europe is the main driver of the global economy into the next recession, and it has that position (and disruptive power) due to the explosive nature of its continuing wild experiment of monetary union.
This was not meant to be so.
The architects of EMU promised that this would be a bulwark against US-led monetary instability. Not just Europe but the global economy would benefit from this.
The reality has been quite different. Yes, the Bundesbank under the DM-dominated European Monetary System was some type of bulwark, on key occasions refusing to follow the US down the path of monetary instability and accepting in consequence huge appreciation of its currency.
The ECB has never done this.
Its senior officials from the start have been loyal members of the global central bankers’ club, espousing the same dominant philosophy, rooted in the 2 per cent inflation standard and neo-Keynesian doctrine.
The ECB (its chief acting with highly sensitive political antenna tuned to Berlin and Paris) has never been ready to contemplate a huge appreciation of the euro which would be the result of defying the US monetary hegemon.
In consequence, the ECB in its first decade or so took the euro-zone into the epicentre of the monetary inflation of that period, expressed most of all in rampant asset inflation. In Europe, the huge speculative excess was in the financial industry, export industries, and in some countries real estate.
Into this cycle the ECB followed the Fed in creating a huge new monetary inflation (camouflaged in goods and services markets by digitalization, globalization – the latter especially important for economies in direct competition with emerging markets such as Italy).
The implicit aim has been to “ease” otherwise painful adjustments (widespread bankruptcies related to malinvestment in the first decade) whilst providing giant revenues in the form of monetary repression tax to governments. We should also note the central (unstated except by ex-senior ECB officials) aim of manipulating the euro downwards and promoting rapid export growth.
Result: the European cyclical re-bound, especially from the sovereign debt crises of 2010-12, was highly unsound, driven by intense monetary manipulations. All the symptoms were there: dependence on an export boom to the global epi-centre of bubble (Asia), the German real estate and related construction boom, an arrestation of Schumpeterian creative destruction most of all in Italy, and a deeply ailing banking system, whose condition in some senses become much worse in consequence of the new wave of asset inflation and malinvestment.
This is not how the European chapter of the central bankers club – their global fellow-members and their political masters – see the present situation.
Central Bankers Club in shameful denial over European danger
The chorus of voices, small and large, from Jackson Hole and from the G-7 summit, was that the Xi-Trump “trade war” is the biggest threat to the global economy. The European financial and monetary debacle and the growing threat from that did not even get a mention. This is understandable; in the case of ex-top officials in Washington who climbed the ladder under the Clinton Administration (whether as US appointee to the IMF Vice-Chair seat or as Treasury Secretary).
Why wouldn’t Professors Summers and Fischer take shots at President Trump, and blame present economic financial woes on him? They are hardly going to admit that when in power (in Washington) they completely failed to diagnose that the monetary union being set up in Europe was deeply flawed and instead framed supportive diplomacy for the euro’s birth; nor are they going to say that they were blind to the problems of China’s entry into WTO at the time.
Why White House tolerates negative rates in Europe and Japan
But Fed Chief Powell, or Treasury Secretary Mnuchin, or even President Trump himself, might we not have heard them name the real culprit?
Of course, there is a widespread view that Europe’s problems are Europe’s problems not the US’s, and the US consumer will keep the Trump economy going and the stock market in the US up at least until election day. Much more likely, though, the gathering storms in Europe and Asia (not primarily the Xi-Trump trade war) will spread via contagion to US financial markets and from there ultimately, on to the US consumer – with US business capital spenders playing an additional important catalyst role.
How can we explain the blindness or reluctance (as the case may be) of Trump officials and of the President himself to cite the ECB and EMU as a key threat to global prosperity, turning the tables absolutely on those petulant critics (especially in Berlin and London) of the Administration’s trade policies?
Quite simply if the ECB were really to walk back from its present monetary radicalism, abandoning negative rates on deposits in the process, the US government bond market could fall sharply and also the US credit and equity markets. The fact that the Trump Administration has been able to run 5% of GDP fiscal deficits at the peak of the cycle has been related in large part to the flight of capital out of Europe where monetary repression tax has been reaching new highs.
Better to bang the table and threaten tariffs on European exports, citing sometimes currency manipulation, than tackle the currency manipulation problem and global instability at its source – the giant failure of Europe’s money.
The same considerations apply to not making Japan’s negative rate policies the subject of direct attack (from Washington); but it is understandable in this context why Washington is balking at Tokyo’s demand that in the Free Trade Agreement (now on the table), a guarantee be given against auto tariffs.
President Macron unlike PM Johnson puts India first not China
Surprising to some, French President Macron has not been amongst the most prominent calling for a “trade peace” between China and the US.
Perhaps for now, Paris is focusing on its agenda for taxing the great US digital monopolies; or on its relationship with India, with France according to one expert (Aparna Pande, Hudson Institute) writing that France has replaced Russia as India’s new best friend, and citing Paris’s instant approval of PM Modi’s action in Kashmir (despite Beijing’s strong objections).
As always, French foreign policy has as one aim: armaments, armaments and armaments (a phrase immortally coined by Raymond Barre). It was left to PM Boris Johnson at Biarritz to join the non-US G-7 chorus moaning about President Trump’s China tweets.
US-UK deal has sailed away (Gibraltar and Biarritz)
At a deeper level, one less (commented on) key aspect of the Biarritz Summit was the consummation of total failure of the new British Prime Minister to forge a rapid new alliance with President Trump. This will have profound consequences for Brexit.
The best hope for the UK to drive the EU towards a “reasonable deal” was to conclude a US deal first – inspiring great fear not least amongst German exporters (about loss of market share in the key UK market). Towards a rapid conclusion London would have had to align itself with US foreign policy objectives – most importantly as regards Iran but also China – whilst moving out of Berlin’s orbit on such matters. This is at a time when the Iranian menace has mutated into even more serious form (see “The Iran-Israel War is here” by scholar Jonathan Spyer in Wall Street Journal, 28.8).
Instead PM Johnson was caught unaware joking with the French President , an advocate of appeasing Iran, about dealing with President Trump.
When the Iranian oil super- tanker sailed out of Gibraltar (on the UK’s watch), despite last ditch efforts of the Trump Administration to stop this suspected contravention of its Iranian sanctions, pessimists warned that a US deal had also vanished over the horizon.
This conclusion seems even more pertinent after Biarritz – where PM Johnson was inadvertently taped joking with President Macron (about difficulties of President Trump) and where he joined Berlin in complaining about the trade war threat. China is to the Conservative Party what Russia is to Germany’s SPD – full of crony links extending up to an ex PM and Finance Minister.
After Biarritz, the sun is setting on a US-UK alliance. The opportunity there for a Johnson-Trump summit which was to blaze the way forward, withered to nothing. The new PM chose to make his diplomatic demarche earlier in Berlin.
The way forward for PM Johnson appears to be a looming withdrawal deal from the EU with nothing changed, except for the Irish backstop. The next few weeks will tell whether this is obtainable.
Even if the withdrawal agreement is achieved in the next two months, an EU-UK trade deal by the end of the transition period as fixed in the withdrawal treaty could well prove elusive.
After all the tens of billions in the withdrawal agreement have been disbursed by London and the transition period as foreseen has come to an end, the UK would find that a free trade deal with the EU without customs union is just not on offer.
· Investors should tone down the noise from the Xi-Trump trade war chorus and focus on the rising dangers from Europe.
· Negative yields on 17 trillion of government debt are symptom “number one” of the ailing condition of banks in Europe. There is no bubble here – though there may be some desperation to economize (or find counterpart) to the size of insurance premium paid against loss in the next banking crisis.
· Sterling may bounce on the news of a deal on the Withdrawal Agreement. But in the bigger picture, PM Johnson’s failure to secure a US deal will weigh heavily on both the UK’s long-run economic prospects and on the GBP. Finally, it is bad news for Europe in general, where a US-UK deal could have been the catalyst to much needed reform.
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European monetary and banking malaise is the number one danger in the global economy today.
The degree and extent of negative bond yields in Europe are indicators of that threat.
It is bizarre that the danger from Europe did not feature on the agenda at Jackson Hole or at the Biarritz G-7 summit.
In part, the silence is explained by acquiescence of the Trump Administration in the extraordinary policy of the ECB as for now it sustains global asset price inflation and helps finance giant US budget deficits.
A reinvigorated US-UK alliance, together with a trade deal, would have been the best scenario for Brexit and European reform. It is evident now that this is not the strategy of UK PM Johnson.