Click here to read this article in pdf format: September 10 2012

 

We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12^th. We believe they will be relevant.

On Thursday, Draghi told us he intends (1) to purchase sovereign debt in the secondary market, (2) that before he does so, the issuing country must submit to certain conditions within a fiscal adjustment program, (3) that when he finally buys the debt, he will buy any debt (new or outstanding) with a maturity lower than three years, (4) that after buying it, he will sterilize the transaction, (5) that the collateral pledged so far for liquidity lines will not be subject to minimum credit ratings any longer, (6) that the ECB will accept to rank pari-passu with other creditors going forward, and (7) that the Securities Market Programme will be terminated, with the purchased debt held until maturity. According to Mr. Draghi (but not toGermany), buying debt with a tenor lower than three years does not constitute government financing. The number three, it seems, is a magical number.

We will mince no words: Mr. Draghi has opened the door to hyperinflation. There will probably not be hyperinflation because Germanywould leave the Euro zone first, but the door is open and we will explain why. To avoid this outcome, assuming that in this context the Eurozone will continue to show fiscal deficits, we will also show that it is critical that the Fed does not raise interest rates. This can only be extremely bullish of precious metals and commodities in the long run. In the short-run, we will have to face the usual manipulations in the precious metals markets and everyone will seek to front run the European Central Bank, playing the sovereign yield curve and being long banks’ stocks. If in the short-run, the ECB is the lender of last resort, in the long run, it may become the borrower of first resort!

The policy of the ECB resembles that which the central bank of Argentinaadopted in April of 1977, which included sterilization via issuance of debt. This policy would result in the first episode of high inflation eight years later, in 1985 and generalized hyperinflation in 1989. Indeed, Argentina’s hyperinflation was not caused by the primary fiscal deficit of the government, but by the quasi-fiscal deficit suffered by its central bank. We will not elaborate on a comparison today, but will simply show how the Euro zone can end up in the same situation. To those interested in Argentina as a case study, we recommend this link (refer section II.2 “Cuasifiscal Expenditures”, page 13 of the document)

Mechanics of the sterilization

In the chart below, we describe what we think Draghi has in mind, when he refers to sterilization. In stage 1, the governments whose debt will be bought by the ECB (EU governments) issue their bonds (sov bonds, a liability), which is purchased by the Euro zone banks (EU banks). These bonds will be an asset to the banks, which will in exchange create deposits for the governments (sov deposits, a liability to the banks and an asset to the EU governments).

In stage 2, the EU banks sell the sov bonds to the European Central Bank. The ECB buys them issuing Euros, which become an asset of the EU banks. The EU banks have thus seen a change in the composition of their assets: They exchanged interest producing sov bonds for cash. Until now, selling distressed sov bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate.

The sterilization is seen in stage 3: The ECB issues debt, which the EU banks purchase with the Euros they had received in exchange of their sov bonds. Currently, the ECB is issuing debt with a 7-day maturity. Should the situation worsen (as described further below), this will be a disadvantage that could make high inflation easier to set in.

We can see the result of the whole exercise in stage 4: The ECB is left with sovereign bonds, with a maturity of up to three years, as an asset financed by its 7-day debt. The EU banks own the ECB 7-day debt, and need a positive net interest income to profit from the deposits (sov deposits and also private deposits) that support that ECB debt (their asset).

What could go wrong

As can be observed in the chart above, at the end of the sterilization, the ECB is left with two assets which will generate a net interest income: Interest receivable from sov bonds – Interest payable on ECB debt.

If the interest payable on the ECB debt was higher than that received from the sov bonds, the European Central Bank would have a net interest loss, which could only cover by printing more Euros. This would be a spiraling circularity where the net interest loss forces the ECB to print euros that need to be sterilized, issuing more debt and exponentially increasing the net interest loss. This perverse dynamic of a net interest loss born out of sterilization affected the central bank of Argentina, although for different reasons, beginning in 1977. It generated a substantial quasi-fiscal deficit which would later morph into hyperinflation in 1989. Without entering into further details about the Argentine experience, we must however ask ourselves under what conditions could the Euro zone befall to such dynamic. That is the purpose of this article.

As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone. Secondly, within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target.

Now, for simplicity, let’s say that the discovered yield cap, which going forward will be a floor, is 4%. This 4% will be a risk-free rate, which in a world of ultra-low interest rates, will look very tempting. The problem is that the risk-free condition holds as long as the bond is bought by the European Central Bank. In the zombie banking system of the Euro zone, where the profitability of banks has been destroyed, banks will not be able to survive if they pass this risk-free yield on to the central bank, unless….unless the central bank compensates them for that lost yield with a “reasonable” rate on the debt it issues during the sterilization. And no, we are not thinking of 75bps!

What is then a reasonable rate? Well, a rate that leaves a profit after paying for deposits. Yes, we know that that is not a problem today, in the context of zero interest rates. But if the floor sovereign rate for the whole Euro zone converged to a relatively significant positive number, banks would only be able to attract the billions in deposits they lost –which are needed in the first place to buy the sovereign bonds in the primary market- at rates higher than the sovereign floor rate received by the ECB. Why higher? Firstly, because unlike the holders of sovereign bonds, depositors do not have the explicit backstop of the European Central Bank on their deposits, which are leveraged multiple times. The liquidity lines provided by the European Central Bank may disappear at a moment’s notice, which is why money left the periphery to the core of the EU zone. An alternative to the European Central Bank, if the deposits from the private sector did not stop falling, would be to keep lending to the EU banks. But this is not feasible in the long run, given the shortage of available collateral. Secondly, as the yield cap becomes the convergence floor, the market’s inflation expectations crystallize into a meaningful expected inflation rate.

Therefore, should fiscal deficits persist in the Euro zone, it is conceivable that as these so-called Outright Monetary Transactions (OMT) develop, we may eventually see net interest losses run by the European Central Bank. It is clear that a net interest loss would be expansionary of the monetary base, because in order to pay for that interest loss, the central bank would have to print more euros, which would need to be sterilized, increasing its debt and interest losses exponentially. It should be noted that once the market’s expectations adapt to this rate of growth in the supply of money, a net interest gain by the central bank, for whatever reason, would be seen contracting the supply of money and therefore, deflationary!

Having said this, we think that the time frame for such a result would be considerable. It would take years for this to unfold and it is very unlikely that it ends in hyperinflation because Germany and the rest of core Europe would leave the Euro zone before it gets there. We present another chart below, to visualize our thoughts:

Additional conclusions

If we were to see a process like the one just described, it would be very hard for the Fed to engage in an exit strategy that would lift interest rates. If it did, the interest rates both the European Central Bank and the EU banks would have to pay on its debt and to attract deposits, respectively, would increase meaningfully. The contagion risk to the USD zone would be very significant and the Fed would have to “couple” its balance sheet to that of the Euro zone via currency swaps. The segmentation seen today in the Eurodollar market, with Libor being a completely useless benchmark, would only accentuate.

This thesis, if proved correct, is bullish of EU banks in the short-to-medium run (before the private sector collapses in a wave of defaults due to higher interest rates, beginning with the sovereign risk-free floor validated by the ECB last Thursday) and very bullish of precious metals and commodities in the long run.

Martin Sibileau