Euro’s collapse was inevitable

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The ECB is in crisis on quite a few fronts at once

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The twin towers of the ECB in Frankfurt are probably a bit empty at the moment due to the summer holiday season, but for those that are there pretty much everything is going wrong. In a way it is symbolised by this.

NEW YORK, Aug 22 (Reuters) – The U.S. dollar rose across the board on Monday, driving the euro back below parity……..The euro fell following Russia’s announcement late on Friday of a three-day halt to European gas supplies via the Nord Stream 1 pipeline at the end of this month.

The Euro is feeling the strain and whilst the US Dollar is strong across the board at the moment, it has also been slip-sliding away versus the UK Pound £, which has gained about 0.5% versus it so far this week. A basic function of a central bank is to defend the currency and that is not going well. Another way of looking at it is that we are back to levels last seen in 2002 versus the US Dollar.

The Economic Situation

We can start with Germany where the Bundesbank monthly report brought some grim news. First on economic prospects.

Economic output in Germany stagnated in spring 2022……..According to the current assessment, German economic output in the third quarter is therefore likely to more or less stagnate again.

Their reasoning is below.

The economists write that catch-up and backlog effects in the use of previously restricted services will probably bolster private consumption in the third quarter as well. However, high price increases are further reducing households’ purchasing power and concerns about a looming shortage of gas in the winter are weighing on consumer sentiment, the experts explain.

Essentially the cost of living crisis is weighing on people as prices rise and they realise that worse is on its way. The same pattern is being seen by businesses.

High energy prices and concerns about a gas shortage also had an impact on enterprises. The Ifo business climate index declined significantly in July compared with the second quarter. Business expectations saw a particularly steep fall and were the lowest they had been since April 2020, the experts explain.

Looking further ahead it is a case of “it’s a gas,gas,gas” as the Rolling Stones put it.

According to the experts, economic developments in Germany will be affected in the third quarter and beyond by unfavourable developments in the gas market. Therefore, the economists believe that the probability of GDP declining in the approaching fourth quarter of 2022 and the first quarter of 2023 has increased considerably.

So if we translate the central banker speak they are expecting a recession and maybe a sharp one. At this stage the solution appears simple cut interest-rates and restart the QE bond buyer. A bit awkward as they have only just raised the former and ended the latter and as I am about to point out there is an elephant in the room.

Inflation

In some ways an even bigger bombshell from the Monthly Report came here.

 The inflation rate could climb up to around 10% in the autumn, the experts write.

That really rather scotches any monetary policy response to the economic downturn for now. There are various factors here and the first is the expiry of the various government schemes which suppress recorded inflation.

The economists expect new records for the inflation rate in the autumn, with another marked rise expected once the measures contained in the relief package expire in September.

The language is interesting there as the statistics office has in the detail it has given suggested that each of the moves are only a 0.1% impact on inflation whereas this hints at more. Also they too will be noting the dip below parity with the US Dollar.

 According to the report, the increase in the general statutory minimum wage and the depreciation of the euro will bring additional cost pressures in the coming months.

Plus there is this.

 In addition, a levy on gas tariffs is to be introduced in October, while the VAT rate on gas is to be lowered at the same time.

This just looks confused from the German government as it raises one tax and cuts another at the same time.

Now let me add in more recent developments as this happened yesterday.

German 1-year forward power contract now at €666 per MWh

Nothing to worry about. ( @JavierBlas )

Poor old Javier took a week off and returned to find that the contract above was 36% higher.

The wider Euro Area

Germany is the biggest economic player but many of the issues above are generic. So if we start with the economic downturn.

August saw a second successive monthly reduction in
business activity across the euro area, according to early
PMI survey indicators, amid a further decline in new
orders. ( Markit )

This means that Markit thinks this.

The latest PMI data for the eurozone point to an
economy in contraction during the third quarter of the
year.

I think that they must have asked the inflation questions before the latest surge in energy costs.

That said, rates of inflation
at businesses slowed again over the month. Input costs
increased at the softest pace in close to a year, while
output charge inflation was the weakest in the year-to-date

I am no great fan of the PMI series but we know that central bankers are.

Bond Market Problems

This is a threefold issue for the ECB. Firstly bond yields have risen with even the ten-year yield of Germany at 1.3%. Now that is not very much but as ECB policy was keeping it negative for so long it is a change and if its bond market catches a cold well there is Italy with a ten-year yield of 3.65%. Secondly the ECB is manipulating reinvestments of its large sovereign bond portfolio to flatter the Italian position but the “spread” to Germany is over 2.3%. Thirdly there is a point that happens whenever QE is enacted on a large scale.

Poor liquidity has fuelled greater volatility, with bond prices swinging on ostensibly small developments and news. “[There’s] large pricing moves on not a lot and you also get a bit of dislocation,” said Lyn Graham-Taylor, senior rates strategist at Rabobank. ( Financial Times)

It is a point that I have made many times. If you dominate a market in the way that central banks have you create a false market, which would be illegal if anyone else did it. But then you have the issue that the market is affected once you withdraw which means they will come under pressure to restart QE.

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