Draghi Doesn’t See "Bubbles" — Let Me Show You Some

06/24/2017Daniel Lacalle

Mario Draghi has again missed an exceptional opportunity to adjust monetary policy. By ignoring the huge risks that are being created from the brutal inflation of financial assets, saying that “there are no signs of a bubble,” the European Central Bank (ECB) remains adamantly focused on creating inflation by decree, denying the effects of technology, demography, and overcapacity.

“No signs of bubble”? I’ll show you some of them myself.

  • The percentage of debt of major countries “bought” by the ECB: Germany, 17%, France 14%, Italy 12%, and Spain 16%. In all cases, in 2016 and 2015 the ECB was the largest buyer of said countries’ net emissions.

Ask yourself a question: On the day the ECB stops buying, which of you would buy peripheral or European bonds at these prices? Clearly, the first sign of a bubble is the absence of demand in the secondary that offsets the impact of the ECB. It indicates that the current price is simply unacceptable in an open market, even if the recovery is confirmed, especially because rates do not even reflect a minimum real return, being below inflation.

  • European Union high-yield bonds are trading at record-low yields despite the fact that cash generation and debt repayment capacity, according to Moody’s and Fitch, have not improved significantly.
  • European largest stocks (Eurostoxx 50) trade at 20x PE and 8.3x EV/EBITDA despite eight years of flat earnings and downgrades, which have only just recently reversed.
  • Infrastructure deals’ multiples have increased five-fold in three years to an astonishing average of 16-19x EBITDA.
  • Excess liquidity in the euro zone already reaches 1.2 trillion euros. It has multiplied by almost seven since the “stimulus” program was launched.

Anything for Inflation

There is a problem in the huge amount of assets bought by the ECB, whose balance sheet already exceeds 25% of the European Union’s GDP. At the beginning of the repurchase program, it could be argued that risky assets, especially sovereign bonds, could have been cheap or under-valued because of the risk of break-up of the euro and overall negative sentiment. However, that statement cannot be made today, with bond yields at historic lows and debt levels at historic highs. Monetary policy is a perverse incentive to spend more and add more debt.

Of course, what the ECB expects is the arrival of the inflation mantra, that mirage that deficit states yearn for and no consumer has ever wanted.

But the search for inflation by decree meets the pitfall of reality. The positive disinflation that technological advances generate adds to the logical change of consumption patterns due to aging of the population and the elephant in the room: The European Union has never had a problem of lack of investment, but of excess spending on dozens of industrial and infrastructure plans that have left behind some positive effects, but — due to excess — greater debt and overcapacity .

Now that prices are moderating again with the dilution of the base effect, the opportunity to moderate this unnecessary monetary stimulus is lost. As I explained at CNBC on May 29, the supposed positive effects of the buyback program cannot make us ignore the accumulation of risk in sovereign and corporate bonds and the dangerous impact on the financial sector.

Draghi, at Least, Warns

The president of the ECB does not stop alerting governments about the importance of reforms to drive growth, lower taxes and reduced imbalances, but no one hears. When Draghi warns banks of their weaknesses, they don’t listen either. When he reminds deficit spending governments that monetary policy has an expiration date, they look the other way. It’s party time .

Monetary policy is “like Coca-Cola,” said Jens Weidmann , president of the Bundesbank. A drink that stimulates, but has too much sugar and no real healing qualities.

The problem of losing this opportunity to moderate monetary policy is that it is highly unlikely that the necessary measures will be taken to correct excesses when they are no longer a debate of economic analyst, but evident to all citizens. Because then, the central bank will be afraid of a financial market correction, after a bubble inflated by its policies.

European governments make a huge mistake thinking that prosperity is going to be generated from debt and not from savings. But they make an even bigger mistake if they think that by perpetuating the imbalances, they will prevent a crisis.

At the press conference, Draghi said that “nobody knows when or where the next crisis will come: the only sure thing is that it will come.”

What Draghi did not explain is that the artificial creation of money without support, well above real economic growth, is always behind those crises. But that is another problem, that will be dealt with by the next president of the Central Bank, who will offer the “new” solution … Yes, you have guessed it: Cut rates and increase liquidity.

Reprinted with permission of the author. Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank Trap, Life In The Financial Markets, and The Energy World Is Flat (Wiley).

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Draghi Wants More Inflation

06/08/2017C.Jay Engel

The ECB's regular policy statement was announced today by President Mario Draghi and it was the typical central banking balance beam act of self-congratulation for the strong economy coupled with the conditional warning that was inflation was too low. This way, everyone should be thrilled that the economy is strong and yet the central planners don't have to cut back on the monetary addiction. 

It is assumed, of course, that unless the economy is experiencing 2% inflation rates (as calculated by their own statistical reference points), there's still lots of printing work to be done. Deflation is to them the Great Enemy to be slaughtered. 

But since it's been nearly a decade of loose monetary policy in one way or another, and progress needs to be shown to justify their careers, they emphasize that the economy doesn't per se need more stimulus. To satisfy both the need for more money creation and the bank's trustworthiness, the ECB's statement dropped reference to future interest rate cuts while at the same time refusing to slow the current pace of stimulus.

These miniscule changes in their posturing is supposed to be of great importance, a sign that the Planners really know what they are doing; they are fine tuning and perfecting the European economy. 

But it's all hogwash. They don't know how to run an economy. They only know how to put on a great performance and create money with which to prop up assets and governments around the Eurozone. The game, as it always seems to do, goes on.

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Dimon and Kashkari Clash on the Health of Banks

04/13/2017C.Jay Engel

JP Morgan CEO Jamie Dimon and Minneapolis Fed's Neel Kashkari recently had a bit of a clash over the health of US banks, with Kashkari rebutting Dimon's claim that there's no longer a risk of taxpayers having to bailout banks in a financial crisis. Bloomberg summarizes:

In an essay published on Medium and republished on the Minneapolis Fed website, [Kashkari] challenged Dimon’s assertion in his annual letter to shareholders that 1) there’s no longer a risk that taxpayers will be stuck with the bill if a big bank fails, and 2) banks have too much capital (meaning an unnecessarily thick safety cushion).  

Kashkari responded to this with: “Both of these assertions are demonstrably false.”

As Bloomberg explains, the conflict is over the acronym TLAC, which stands for total loss-absorbing capacity. That is, in the case of a sudden swarm of losses, how much capital does a bank have to have to absorb all these losses? The more capital, the safer the bank. Kashkari believes that banks are not as safe as Dimon says they are. Their disagreement is over who would absorb the losses (that is, where the capital to absorb the losses would come from). Here is the difference:

  • Dimon operates on the assumption that the unsecured bondholders of the bank will simply be forced to take a loss and they no will longer receive their interest payments. Thus, unsecured bondholders will aid in the loss absorption rather than, say, taxpayers.
  • Kashkari does not include these bondholders because if one bank announced a default on its debts, bondholders across the financial system who own the debt of other banks would panic. Financial contagion would ensue. Thus, the regulators (i.e., Kashkari) need to protect the bondholders.

Kashkari, then, is emphatic that the TLAC should not be thought of as including bonds. Because according to him, the financial regulators, at the end of the day, are going to do everything they can to prevent financial contagion. Bloomberg:

[W]hen push comes to shove, bondholders will absorb few if any losses. Taxpayers will be forced to step up and make sure they keep getting paid.

In a free market, taxpayers wouldn't even be part of the equation. Bondholders take risks and earn the profits or suffer the losses accordingly. But the much bigger point is that if our system wasn't predicated on the crony assumption that the taxpayers and the Fed (lender of last resort) would be there to save investors, these banks wouldn't be nearly as concerned about their health in the first place. The Federal Reserve system and its explicit rejection of sound money has spawned the very challenges it seeks to overcome.

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