Problèmes de plomberie

We assume most of our readers ordinarily don’t spend much time thinking about their house plumbing, but we also know from experience that when a plumbing issue emerges it becomes difficult to think about anything else until it is resolved. The European financial system may well be facing one of those “plumbing issues”. While this week’s ECB Governing Council meeting is ostensibly about delivering another hike – we expect 75 basis points, in line with consensus – they may also address their nagging excess reserves problem. As obscurely technical as it may seem, this is major, since remunerating those reserves at a growing deposit rate entails a significant cost to the central bank…and ultimately the governments’ coffers, at a time when the fiscal space is narrowing.

The ramifications for liquidity are not straightforward: while “encouraging” the early unwinding of TLTROs – one of the available levers to diminish excess reserves - would set free a significant amount of bonds at a time of collateral scarcity, moving too fast on Quantitative Tightening would add to already challenging conditions on the bond market. We expect the ECB to choose prudence on the latter and postpone decisions. Yet, we continue to be concerned with the speed at which monetary policy is tightening everywhere, which mechanically raises the risk of financial stability accidents.

The UK has been a source of global stress lately. The market reaction last Friday upon news that a significant number of MPs were ready to back a return of former PM Boris Johnson signalled a preference by investors for a fiscally prudent brand of conservatism which Johnson would have had difficulty embodying, even if he would probably have kept Jeremy Hunt as Chancellor had he won. With Johnson out of the race on Sunday night, the new fiscally prudent stance is solidified, whoever from the two remaining candidates – Rishi Sunak, now the clear favourite, or Penny Mordaunt – wins. They both supported Brexit, but we maintain the view we held last week: with a diminished capacity to steer a lone macroeconomic course, some gradual improvement in the relationship with the EU is now the only workable option.