Thread by @GeneralTheorist

Though I blogged, I didn’t tweet my reaction to last week’s ECB meeting; but since the Eurogroup meeting just concluded does little to offset the glaring holes in euroarea policies that were opened up, its worth repeating.
thegeneraltheorist.com/2020/03/13/ecb…

So, the good news is that the ECB meeting contained some sensible innovations. In particular, providing LTRO initially at -50bps and the TLTRO at (potentially) -75bps for the first time decouples repo lending from money market rates.

This is a massive innovation, and it’s only possible to imagine how excited @ericlonners is. The key point is, the TLTRO lending could be set at much lower levels without lowering money market rates and decoupling banks. Say, -100bps. Amazing stuff.

In addition, ECB did not cut rates. But I think this makes sense because — although they never say it — the current system is a series of transfers from Core (surplus liquidity) banks to Peripheral banks (larger TLTRO access). As such, cutting rates would have further rankled.

Moreover, excess liquidity did not really allow for a tiering increase to compensate the Core, since this would have pushed liquidity into the “nonlinear” part of the EONIA-OIS spread versus excess liquidty relation. In other words, a rate cut and tiering could have backfired.

In addition, the ECB is relying for excess liquidity increasingly on LTRO and TLTRO3 take up, which is outside their direct control. So it was right to way on the rate cut until circumstances allow.

Things went wrong, of course, with the reference to not “closing the spreads” in the press conference in the context of a question about OMT. This suggested in fact Lagarde sees OMT as the solution to pressure on yields after all.

The cat and the bag are no longer in close proximity.

This therefore raises once more the existential crisis that once plagued the euroarea. How will threats of breakup be resolved: answer, ESM and program with debt sustainability analysis tagged on. Not good for holders of BTPs.

That said, there was the EUR120 billion exceptional envelope which can be used at full discretion. Lagarde confirmed in the press conference capital key will only be met “at the end of APP” which implies deviation from capital key up front.

For the case the EUR120bn were used on Italy, then I calculate that in the event APP lasts through end-2022, then there would be selling of BTPs in 2021 and 2022 to rebalance capital keys.

But what’s most worrying about this program is that there is now a finite stock of buying that investors can “tear” by selling. The ECB has created a first generation currency crisis.

Scenario. And let’s be clear, the shock from COVID-19 is not only about Italy, but system wide. So it ought to be used to support all euroarea countries (poor Greece!)

But let’s imagine they use the EUR120bn on Italy; there is about EUR750bn in nonresident claims on Italy, and even if some of these are de facto domestic, there is still at least 3 times this buffer in nonresident claims that could flee.

Moreover, we have no idea what the impact on current account transactions is. At the moment, evidence from China in February points to a deficit opening up in her trade balance surplus — exports fall more than imports.

This, Italy could face a growing current account deficit with financial outflows, and a finite buffer to protect sovereign yields.

One argument against this is that banks can repeat the VLTRO carry trade of better terms to support govvies. But that only works if banks are sure the sovereign credit is sacrosanct. The OMT response suggests it might not be. So it might not be rational to take that route.

Finally, it’s time to acknowledge the fiscal deficits that could emerge in Q2 this year could be huge — Hubei apparently only generated “sporadic” revenues in February, but the Federal government in China provided the financing.

The euroarea remains incapable of providing this sort of support. So, for all the noises at the eurosystem press conference right now, there were only two actions that ought to matter to investors. Fiscal risk sharing, or changing OMT/ESM rules to remove conditionality...

And sustainability. Since these were not forthcoming, it’s rational for investors to run on the periphery until there is some meaningful change of policy. Either that, or the European institutions are willing to use the biggest health emergency in 100 years...

... to force Italy into a program. Which would be a disgrace. And let’s not forget about Spain, Greece and maybe even France. END OF RANT.

*”test”