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. Tomorrow's 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 instructive.
First, the ECB reported that its balance sheet shrank last week. With the ECB set to takeanother 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 ifisn'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 primafacie 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; the 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.