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You would have thought him a prosecutor knee-deep rooting out corruption. The man detested the very possibility of anyone scheming under his nose. But Jean-Claude Trichet wasn’t some overtly aggressive DA targeting mafiosos, he was the ECB’s boss determined to impeach businesses even local governments throughout Europe before any of them let Brent get into their heads.

Brent, of course, the benchmark oil price for Europe. In the middle of 2008, when the first part of our story took place, crude was surging in a way it hadn’t since the seventies. This immediately brought fears of another not-so-great inflation wiping out much prosperity for a second generation.

The key development, at least so far as policymakers were concerned, was these schemes. As J-C explained on June 8, 2008:

“TRICHET. Broadly based second-round effects stemming from the impact of higher energy and food prices on price and wage-setting behaviour must be avoided. In this context, the Governing Council is concerned about the existence of schemes in which nominal wages are indexed to consumer prices.”

This would risk the dreaded “wage-price spiral”, where automatic CPI-linked raises cause second order effects like those when other workers demand the same. Unless the ECB nipped the trend in the bud, the situation risked becoming a self-reinforcing spiral of higher consumer prices/costs leading to more wage gains forcing companies to raise prices and so on.

To interrupt that cycle, mainstream theory posits a committed course of “tightening”, whatever that means. While the concept may seem straightforward, and should be, it is not. In this post-modern method of central banking, tightening is deemed to be whatever the tighteners say it is. Could be rate hikes, might be some other policy change, even just using the word in the right way at the right time is thought to be enough (moral suasion).

Thus, no one ever demands a complete answer to the only question which matters: is there too much money? Policymakers can’t say. This does not prevent them from replying in part on occasion. June 2008 just so happened to be one of them.

“TRICHET. The monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons. Annual M3 growth remained very vigorous in April, supported by the continued strong growth of MFI loans to the private sector.”

M3 was and remains the official broadest definition of money supply for Europe. According to the ECB’s numbers, growth in this aggregate was reaching double-digits despite all the fuss surrounding European banks somehow caught up in what everyone “knew” was US subprime mortgage problems.

But there was a snag beyond the money figures. First off, it was widely known (in policy circles, anyway) these were anything but precise; guesstimates so as not to be left totally in the shadows as in the case of the Federal Reserve which just two years prior had simply given up on its M3 for its lack of sufficient coverage to real effective money use globally.

In more immediate terms, Trichet’s specific June 2008 M3 reference also came with a caveat: “While the impact of the flat yield curve and other temporary factors suggest that annual M3 growth continues to overstate the underlying pace of monetary expansion…” [emphasis added]

Germany and other major European bond curves had indeed flattened substantially from mid-March 2008 (Bear Stearns). The spread between the German 5-year bobl and 10-year bund had narrowed from +57 bps to just +23 bps the day prior to Trichet’s press conference.

By the time he had finished complaining, that same 5s10s spread had dropped another 16 bps to +7 bps. The following Monday, June 9, 2008, it was fully inverted and then some at -6 bps; an enormous 29-bps compression in a matter of days.

The only time this spread had ever been close to something like this was on two prior occasions. One, the year before, on June 4, 2007, when the 5s and 10s matched yields (a zero or perfectly flat curve segment). Prior to then, September 7, 2000, also no worse than a zero spread.

Germany suffered a “technical recession” beginning in that third quarter of 2000 before getting wiped – along with much of the rest of the world – by the dot-com recession the year after. Obviously, 2007 and 2008 were not truly inflationary in Europe or anywhere, rather what today everyone calls the Great “Recession.” Each preceded and foretold by the slightest smidge of a bund-bobl upturn.

While the curves including Germany’s would un-invert and steepen over the intervening month between Governing Council meetings in mid-2008, by the time the ECB got together in early July to vote on the first of what everyone thought would be a steady series of “tightening” rate hikes, that inversion albeit brief was a topic of both public as well as private market conversation for obvious reasons.

European officials as their American counterparts rely on economic rather than any monetary aggregates to guide their policies which are grounded, for lack of any better term, in psychology not money. So, while flat and inverted curves denoted serious deflationary potential traded inside this crucial piece of the planetary financial architecture, Trichet was far more concerned about those dastardly wage schemes being influenced by Brent.

This is why on July 3, 2008, the ECB went forward announcing its rate hike (+25 bps) regardless of such overwhelming and historic contrary market guidance. As Jean-Claude flat-out stated, “It proves that we take seriously the anchoring of inflation expectations and our responsibility vis-à-vis our fellow citizens. It also proves that they can trust us when we say that we will maintain price stability in the medium term.”

But what would truly be a greater and more immediate threat to price stability (and also employment), some wishy-washy nonsense about wage schemes and inflation expectations, or what was more directly implied by the curve inversion? At the July affair, one journalist dared to offer a question on that score:

“QUESTION. And finally, last month [June 2008] I wonder whether you were surprised by the sharp yield curve inversion that followed your press conference, and whether or not you see potential losses from banks on the basis of that yield curve as yet another risk to financial stability and in line with further bank write-downs and ongoing money market tensions?”

Perhaps this particular journalist (who wasn’t named; they never are in the transcripts) should have switched places with poor Jean-Claude, if not least because this correspondent actually demonstrated useful knowledge. Flat, inverted curves, “ongoing money market tensions”, these are the factors and correlations that actually mean something to the financial and economic systems, and should mean everything to supposedly monetary authorities.

You know how this chapter of the story ends, and how committing such a major, massive mistake wouldn’t be the end of Trichet’s career. No, on the contrary, the guy was left in place to repeat the exact same gross error (twice) a mere three years later. In that instance, Germany’s 5s10s spread was again flattening, but starting from an exceptionally steep level never got closer than +67 bps.

It wouldn’t matter because Trichet was ignoring all market signals, including those yet again demonstrating clear and “ongoing money market tensions” most notably “Club Med” sovereign bonds disrupting collateral chains all throughout the world, not just in Europe or euros.

This, too, a repeating phenomenon. Back in ’08, rather than weaker sovereigns, there had been way too many low-quality private credits allowed to poison euro-denominated collateral streams just as both subprime and prime mortgage bonds had in collateralized US$ money markets.

As each broke down into crisis, demand for higher quality collateral climbs through the roof, raising their prices depressing yields and upturning what should have been upward sloping curves had wage schemes and oil prices meant what policymakers thought they had. Beyond direct buying pressures, the markets also translated such ugly potential and deflationary probabilities into lower growth and inflation expectations, further reducing yields particularly at the longer end of many markets.

The German 30-year bund had been introduced in August 2000 but never really took part in the next month’s curve mishap. The spread between the 10-year and 30-year did flatten dramatically in line with the 5s10s in 2007 and again 2008, but not nearly as much or as obviously as that other segment.

In fact, the 10s30s in Germany had never really come all that close to outright inversion – until last week.

For the first time ever, more than two decades of trading, the 10s30s dropped as far below zero as the 5s10s had for that one day in June 2008. Worse, the former remained inverted for several more days. And while it has un-inverted this week, now the 5s10s are as close to a zero spread as they had been since those trenchant days in the late spring of 2008.

Yes, these markets are a complete and utter mess, an unprecedented one in this key aspect. The situations, you’ve no doubt noticed, are eerily similar: oil prices, official focus on wages and the psychology of expectations, not any real attention paid to “ongoing money market tensions” that have, once again, embroiled crucial components of global collateral chains (in this case, as 2011, primarily Italy).

And there’s much more. The start toward collapse in German yield spreads coincided with the same in their US Treasury counterparts (the latter already inverted, becoming much deeper) during the month of July. The European government’s statistical agency, Eurostat, tells us that Industrial Production across all of Europe crashed by 2.3% June to July.

While that might suggest local problems especially in Germany related to energy, Russia, etc., the more sobering data also for July comes from that export-heavy country’s trade figures. Compared to July 2021, exports from it in US dollar terms were down sharply, falling 4.6% year-over-year, the worst since July 2020.

But those estimates include the higher prices of today’s “inflation.” By volume, German exports plummeted 20.3% when compared to the year prior. While not quite unprecedented, this one is uncomfortably close: only twice have exports fallen (by volume) on annual basis by that much or slightly more, May of 2020, when near everything was government-closed, and January 2009 when it had become all-too-clear “ongoing money market disruptions” really were the primary problem.

The reason anyone in and outside of trading sovereign bond curves should be so interested in Germany’s export results is clear enough. This country’s mighty industrial sector produces and ships goods in large quantities to every corner of the globe. Or, had before July.

You can’t blame Shanghai lockdowns, nor COVID of any variety, wave, or variant. Global demand just may have hit a wall when market curves did. And we see it, too, in a bunch of other global data including too many here in America.

Yet, the rate hikers are going to rate hike. Why? They cannot allow themselves to be perceived as being behind the curve. Which curve? The inflation curve. In fact, Mr. Trichet was asked about this all the way back in June 2008, and he looked as if he was about to leap right over the press conference table to confront the questioner who dared doubt the ECB’s bonafides.  

“TRICHET: First of all we are not behind the curve! We are, in the view of the Governing Council, at the appropriate position. We are very keen on being correctly positioned as regards our primary mandate and I am very strong on that. It does not seem to me that our reputation is that we are behind the curve, at least when I read various articles.”

This, not any better reason, is why the ECB would screw up so badly in 2008. Not just in its absurd rate hike, but more so rate hiking smack in the middle of a global monetary disaster; one it was repeatedly warned about in advance.

Behind the curve, yes, as always. But which one? The question shouldn’t be this difficult to correctly answer. 

Jeff Snider is Chief Strategist for Atlas Financial and co-host of the popular Eurodollar University podcast. 

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