Like the Fed, the ECB is resisting interest rate increases despite producer and consumer prices soaring. Consumer price inflation across the Eurozone was most recently recorded at 4.9%, making the real yield on Germany’s 5-year bond minus 5.5%. But Germany’s producer prices for October rose 19.2% compared with a year ago. There can be no doubt that producer prices have yet to feed fully into consumer prices, and that rising consumer prices have much further to go, reflecting the acceleration of the ECB’s currency debasement in recent years.
Therefore, in real terms, not only are negative rates already increasing, but they will go even further into record negative territory due to rising producer and consumer prices. Unless it abandons the euro to its fate on the foreign exchanges altogether, the ECB will be forced to permit its deposit rate to rise from its current —0.5% to offset the euro’s depreciation. And given the sheer scale of recent monetary expansion, euro interest rates will have to rise considerably to have any stabilising effect.
The euro shares this problem with the dollar. But even if interest rates increased only into modestly positive territory, the ECB would have to quicken the pace of its monetary creation just to keep highly indebted Eurozone member governments afloat. The foreign exchanges are bound to recognize the developing situation, punishing the euro if the ECB fails to raise rates and punishing it if it does. The euro’s fall won’t be limited to exchange rates against other currencies, which to varying degrees face similar dilemmas, but it will be particularly acute measured against prices for commodities and essential products. Arguably, the euro’s derating on the foreign exchanges has already commenced.
But there is an additional factor not generally appreciated, and that is the sheer size of the euro’s repo market and the danger to it that rising interest rates presents. Demand for collateral against which to obtain liquidity has led to significant monetary expansion, with the repo market acting not as a marginal liquidity management tool as is the case in other banking systems, but as an accumulating source of credit. This is illustrated in Figure 4, which is of an ICMA survey of 58 leading institutions in the euro system.
The total for this form of short-term financing grew to €8.31 trillion in outstanding contracts by December 2019. The collateral includes everything from government bonds and bills to pre-packaged commercial bank debt. According to the ICMA survey, double counting, whereby repos are offset by reverse repos, is minimal. This is important when one considers that a reverse repo is the other side of a repo, so that with repos being additional to the reverse repos recorded, the sum of the two is a valid measure of the size of the repo market. The value of repos transacted with central banks as part of official monetary policy operations were not included in the survey and continue to be “very substantial”. But repos with central banks in the ordinary course of financing are included.
Today, even excluding central bank repos connected with monetary policy operations, this figure almost certainly exceeds €10 trillion by a significant margin, given the accelerated monetary expansion since the ICMA survey, and when one allows for participants beyond the 58 dealers recorded. An important element of this market is interest rates, which with the ECB’s deposit rate sitting at minus 0.5% means Eurozone cash can be freely obtained by the banks at no cost.
The zero cost of repo cash raises the question of the consequences if the ECB’s deposit rate is forced back into positive territory. The repo market will likely contract in size, which is tantamount to a decrease in outstanding bank credit. Banks would then be forced to liquidate balance sheet assets, which would drive all negative bond yields into positive territory, and higher, accelerating the contraction of bank credit even further as collateral values collapse. Moreover, the contraction of bank credit implied by the withdrawal of repo finance will almost certainly have the knock-on effect of rapidly triggering a liquidity crisis in a banking cohort with exceptionally high balance sheet gearing.
There is a further issue to consider over collateral quality. While the US Fed only accepts very high-quality securities as repo collateral, with the Eurozone’s national banks and the ECB almost anything is accepted — it had to be when Greece and the other PIGS were bailed out. And the hidden bailouts of Italian banks by bundling dodgy loans into repo collateral was the way they were removed from national bank balance sheets and hidden in the TARGET2 system
The result is that the first repos not to be renewed by commercial counterparties are those whose collateral is bad or doubtful. We have no knowledge how much is involved. But given the incentive for national regulators in the PIGS to have deemed non-performing loans to be creditworthy so that they could act as repo collateral, the amounts will be considerable. Having accepted this bad collateral, national central banks will be unable to reject them for fear of triggering a banking crisis in their own jurisdictions. Furthermore, they are likely to be forced to accept additional repo collateral if it is rejected by commercial counterparties and bank failures are to be prevented.
The numbers involved are larger than the ECB and national central banks’ combined balance sheets.
The crisis from rising interest rates in the Eurozone will be different from that facing US dollar markets. With the Eurozone’s global systemically important banks (the G-SIBs) geared up to thirty times measured by assets to balance sheet equity, rising bond yields of little more than a few per cent will likely collapse the entire euro system, spreading systemic risk to Japan, where its G-SIBs are similarly geared, the UK and Switzerland and then the US and China which have the least operationally geared banking systems.
It will require the major central banks to mount the largest banking system rescue ever seen, dwarfing the Lehman crisis. The required expansion of currency and credit by the central bank network is unimaginable and comes in addition to the massive monetary expansion of the last two years. The collapse in purchasing power of the entire fiat currency system is therefore in prospect, along with the values of everything that depends upon it.