European Canaries Sighing

Fri 26 Nov 2021

As the new German government is being installed, European risk indicators are on the rise. Are markets preparing to challenge the Euro’s new status quo?

The newsflow from Europe has focused on renewed lockdowns in Austria and dire Covid warnings from Germany. However, a closer look at the continent suggests growing signs of distress for the common currency. For one, inflation in Germany is very high, prompting attacks by popular German newspapers on the ECB. While ECB Chair Christine Lagarde maintains a dovish stance, outgoing Bundesbank President Jens Weidman clashed with her over the Bank’s accommodative policy, laying bare the divisions in the body that holds the Euro together. Meanwhile, as Olaf Scholtz government prepares to be sworn in, a hawkish German finance minister is about to sit at the Eurogroup table. CDS spreads in the periphery, the proverbial canary in the coal mine, have been rising for the past month. As have yield spreads over German bonds, the Eurozone’s risk-free asset.

At the same time, the Euro has been losing strength. 

After a decade of Merkelian peace, do we find ourselves approaching the next European crisis? 

Always a risk

Edward Gibbon’s The History of the Decline and Fall of the Roman Empire is one of the most interesting and important pieces of historical work in existence. Published during the Enlightenment and shortly before the French Revolution, in the 18th century, it focused on how the Roman Empire, ostensibly at its apex and controlling both sides of the Mediterranean by 180 CE, fell to ruin within just a few generations. Gibbon, a faithful representative of the Age of Reason, challenged the traditional view that Commodus, the corrupt and inept heir of Marcus Aurelius, was solely to blame for the decline. While his polemic against the insidious impact of religion and civic elitism may have been criticised, he drew praise from such contemporaries as David Hume and Adam Smith, as well as from Sir Winston Churchill, who tried to model his own works after him. The most important takeaway of his magnum opus is that the more immeasurable the success, the more invisible the seeds of its eventual failure. Everything is constantly in flux. The fact that a structure has been resilient for centuries does not necessarily ensure its survival, even for the shortest term.  

The European Union is far from a perfect and unassailable construct. It nearly dissolved in the wake of the Global Financial Crisis in 2009, when the subsequent Euro crisis (2010-2012) exposed the flaws of the currency union. It would only be a few years before one of its founding members and key pillars, the United Kingdom, left the Union altogether. During the height of its crisis, in July 2012, the Eurozone was saved by a momentous and impromptu speech by the Chair of the ECB, current Italian Prime Minister Mario Draghi. “Within our mandate, we will do whatever it takes, and trust me, it will be enough”. Without consent from his political masters, he implicitly threatened to interpret his mandate more broadly than ever before and that he would emulate the US central bank and begin Eurozone bond purchases, strictly speaking, forbidden by the Maastricht Treaty. 

Bond markets, who had previously witnessed the awesome power of the Federal Reserve and its asset purchases, paused for thought but were not immediately convinced. They turned their eye to Angela Merkel, the German Chancellor and Europe’s de facto leader. Ms Merkel, never one to willingly step into the limelight, was probably happy that someone else dealt with the hottest political subject of the time; the mutualisation of European debt. Her silence was interpreted as acquiescence. Mr. Draghi lost no time, and by September he unveiled his outright monetary transactions programme. Although fully-fledged Quantitative Easing would not take place until 2015, bond traders were convinced that fighting the ECB would be as bad as fighting the Fed. This was especially true for the European bond market, which was much shallower than its US counterpart and one that the European Central Bank could more easily dominate. 

The underlying problem was never solved

“Never let a good crisis go to waste”, is often said, but European leaders did just that. Following Ms Merkel’s lead, they avoided tackling the issue of debt mutualisation directly and let the ECB do the work for them. Quantitative Easing was a step in the right direction, but the currency union remains poorly structured. Last September, French central banker Francois Villeroy pointed out that the banking union remains incomplete and that the project has lost all momentum. While there’s now a single bank supervisory and dissolution mechanism, as well as various emergency lending schemes, the thorny issue of an EU-wide deposit protection remains elusive. Local central banks may guarantee deposits, but this means little in the context of the ECB. 

It is also important to remember that “European QE” rules suggest that local central banks, which have no money issuance power, are responsible for 80% of their national bonds purchased by the ECB. This was a safety mechanism, ensuring that national agencies would foot the bill if the Eurozone was to dissolve. 

This brings us to the root of all problems: chronic distrust. The Eurozone is struggling to move forward and commonly deal with issues. The 3% deficit rule may have been waived during the Covid Crisis, but it remains a straightjacket for European growth. The Eurozone is lacking a central supra-national fiscal ministry. As long as countries are unwilling to cede power to such an institution, they rely on alliances in the so-called Eurogroup, an informal gathering of all finance ministers. Rules there are fluid and subject to whichever faction has the most sway, no matter how small it is in terms of electoral power. Take, for example, the incoming German Finance Minister, Christian Lindner. With 5.3 million votes, Mr. Lindner’s party represents 11% of all German voters and less than 1.5% of the Eurozone population. Yet he will be able to fully wield the power of the German economy in the council, threatening to break the coalition government in Germany if the principles he sets forth are violated. And these principles are hawkish and adverse in terms of further steps towards a more congruent banking union. His outsized influence is the perfect example of why a central fiscal instrument is needed. 

But to cede fiscal authority means to cede the core of political power, the ability to spend money. To do that, insurance would be needed, like an elected government, and with it a Eurozone constitution. With it, national ability to dictate foreign policy and be in charge of the military would dissolve. The move, necessary to cement the currency union, is still considered unthinkable by European governments, as no one is willing to part with power within its own domain in favour of a US-style Federal Government. And without such an authority, the Euro will remain a weaker currency than the US Dollar and the ECB will always rely on the Fed’s policy to feel empowered.

Are markets priming for another crisis?

Financial markets know and acknowledge the structural weakness of the common currency. Years of quiet acquiescence aren’t the same as years of leadership and their outcomes should not be the same. The power structure behind the Euro is still fickle and subject to changing conditions and people in charge. Mr. Draghi left office some time ago. As Ms. Merkel, the quintessence of European stability, follows him to the exit, it is a growing probability that investors might want to test its resilience under a new regime. Power, for now, wrests in French hands, both politically and in terms of monetary policy. But it is difficult to believe that the issuers of the Eurozone’s risk free asset, the German Bund, and the largest stakeholders in the ECB won’t challenge for primacy soon enough. 

The ability to speedily capitalise on any visible chink in the armour may be hindered simply due to lack of bond traders. The ECB has long dominated the shallow European asset pool, crowding out even institutional bond investors. However, as long as borrowing remains cheap, gathering assets to mount a challenge is not too difficult a feat. The prevalence of algorithmic trading may even ensure a quicker resolution either way. 

Rising peripheral Credit Default Swaps and yield spreads versus Germany are certainly a worrying factor. As is rising yield spreads between peripheral countries and Germany, where the money tends to go in times that are considered unsafe. Most importantly, the Euro has been in freefall for a few months. These are certainly signs to raise an eyebrow. 

We are fully aware of possible confirmation bias and at this point, acknowledge that the evidence is circumstantial. The moves could be random or related to other factors, such as worsening Covid-19 conditions for the continent. We simply don’t have enough evidence to ascertain either way. But

1. We think the risk needle has moved slightly upwards
2. We believe the fact that Europe has managed to maintain a shaky status quo for a decade must create a false sense of security. Free and efficient markets thrive on inconsistencies, and it is only a matter of time before the Euro is tested again.

Investors would be well advised to keep a close eye on rising pressures in the region, and may prefer geographies where banking and fiscal union is not a complicating factor.