Three Developments in Europe You may have Missed

The focus in Europe has been Catalonia’s push
for independence and the attempt by Madrid to prevent it. 
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

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;
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

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’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

In the same year that Draghi leaves, the terms
of the European Council President (Tusk) ends as does the European Commission
  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. 


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