The focus in Europe has been Catalonia’s push for independence and the attempt by Madrid to prevent it. Tomorrow’s ECB meeting, where more details about next year’s asset purchases, is also awaited. There are three developments that we suspect have been overshadowed but are still instructive.
First, the ECB reported that its balance sheet shrank last week. With the ECB set to take another baby step toward the exit, many are seeing convergence, though we argue that divergence of interest rates and balance sheets has not peaked. The reasons why the ECB’s balance sheet fell are completely different than what the Fed is doing.
The Fed has begun refraining from reinvesting the full amount of Treasury and MBS that are maturing. This quarter, the Fed will not recycle $10 bln a month. The balance sheet will shrink by $30 bln. The pace will gradually increase to reach $50 mln a month in Q4 18.
The ECB’s balance sheet shrank by 8.2 bln euros last week. It was not a function of a change in the actions of the Eurosystem. It was that member banks took down about 17.3 bln euros fewer at the weekly refi operation than previously. Recall that refi money is available at a zero interest rate, though collateral must be provided.
What we know is that while the Fed’s balance sheet will shrink by $30 bln in Q4, the ECB’s balance sheet will expand by around 180 bln euros. We expect tomorrow to be informed the size of next year’s operation. If we assume $30 bln a month for nine months, as news wires surveys suggest, the ECB’s balance sheet will expand by 270 bln euros, while the Fed’s balance will shrink by $270 bln over the same period.
The second issue that may have been missed is that earlier today the European Stabilization Mechanism (ESM) issued its first dollar-denominated note today. The 5-year note it sold raised $3 bln at a 2.201% yield. It is about 10-11 bp on top of swaps. The proceeds were believed to have been swapped back into euros to avoid currency risk.
Why would the ESM issue dollar-denominated debt? The rationale seems similar to other debt managers. It wants to broaden the investor base and diversify its liquidity risk. Today’s offering is likely to be the first of several more dollar issues it plans (two, three, and five-year maturities have been discussed).
Many observers who continue to harangue about the dollar’s international status is in terminal decline. And if isn’t the euro or the Chinese yuan, it will be a cyber-currency that supplants the dollar. We remain dubious. The dollar’s role in the global economy has barely changed since before the Great Financial Crisis. China and the ESM have both issued dollar-denominated debt instruments. That seems to a prima facie case of the greenback’s ongoing role as the numeraire. It is admittedly far from perfect, and Triffin’s Dilemma of a national currency is the primary reserve asset has not been resolved, but the alternatives are even less perfect.
The third development is more conceptual, but many investors do not yet appreciate that Europe is about to begin a two-year period that is going to see a new set of leaders emerge. This is not about national elections. It is about various European institutions. Moreover, it is not particularly helpful to think of these as individual events as the way Europe decides things; the many moving parts are taking into account to preserve a balance. European institutional appointments are meant to balance creditors and debtors, small countries and larger countries, west, and east and political right and left.
The first position up is the head of the Eurogroup of finance ministers. Dijsselbloem’s five-year term is up, and there has been a change in the Dutch government, and he has lost standing. In any event, there will be an election among the different finance ministers. The most experienced finance minister now that Germany’s Schaeuble is now the head of the lower house of the German parliament is Spain’s de Guindos. However, reports suggest he is angling for the Vice President of the ECB. The Vice President of the is currently Portugal’s Constancio, whose term ends in the middle of next year.
If de Guindos is not the next Eurogroup head, it could boost the chances of Slovakia’s Kazimar, who is from the center-left but with the type of austerity credentials that may appeal to the creditors. The issue that some have raised is whether he has the gravitas for the role that requires consensus building.
It is also important that the ECB Vice President is chosen by the President. Recall that five years ago, Merkel supported Constancio’s candidacy for Vice President of the ECB. It was understood that with a small peripheral debt in the number two slot, that the presidency could still go to a large creditor after France’s Trichet. This bolstered the candidacy of Germany’s Weber, who, in the end, quit rather than fight. The other German on the ECB board at the time, Stark, also stepped down, which paved the way for Draghi.
Draghi’s term is up in 2019. Many see it as Germany’s turn next. However, in addition to the economic skills, the head of the ECB must also be a consensus builder. This would seem to rule out Weidmann, who testified against the ECB before the European Court of Justice (and lost). Still, Weidmann appears to have begun re-inviting himself. He is still an articulate defender of German interests and the interests of creditors, without antagonizing his colleagues. It is not clear whether this has been sufficient.
In the same year that Draghi leaves, the terms of the European Council President (Tusk) ends as does the European Commission (Juncker). This will also create more chits that can be traded and easier to preserve the balance that Europe values than if there was only one position. Moreover, there are deputy positions too that allow more horse trading. For example, the deputy of the Eurogroup head is a very important operational position, currently held by Wieser (Austrian and American). If the Eurogroup head is from a small, eastern country, the deputy can come from a larger western country such as France.
The point is that the while much attention is given to the changes at the Federal Reserve, and perhaps the BOJ, where Kuroda’s term ends next year, there is a significant change taking place in Europe. This analysis can be broadened to include the Bank of England, where Carney will step down in 2019 and the European Parliament election the same year. When the EU’s chief Brexit negotiator indicated he would step down before Brexit, it was not a personal issue; it was about the European Commission itself. It is not immediately clear if the UK fully took this into account.