By Tom Luongo - August 1, 2023

The ECB has a credibility problem. It didn’t last year. Last year it was the Fed with the credibility problem. Today, it’s Christine Lagarde not Jerome Powell that needs to justify her policy.

Powell needed nearly a year after he began raising rates to get a significant portion of the market to believe he was serious about raising rates. Today, they don’t believe him if he making the odd dovish coo.

I don’t blame the market for its previous skepticism, it was well earned. But as I’ve pointed out many times, Powell’s incentives line up with his intentions and that has translated directly into Fed policy.

Lagarde has done the same thing, except she forgot that whole ‘incentives’ part. She has clearly tried to force her intentions onto the market to effect her masters’ policy.

So, she tried to out wait Powell, hoping that domestic US politics would force his hand into the ‘pivot’ that hasn’t come and won’t until something breaks.

That something in my mind is still the ECB. And the race is on as to whether deteriorating credit and economic conditions in the US will force Powell’s hand rather than Lagarde’s. The keys are oil prices and the Bank of Japan.

At last year’s July meeting Powell raised rates another 75 basis points and Lagarde responded by announcing the Transmission Protection Instrument (TPI) or Toilet Paper Initiative, as I like to call it.

The TPI was put in place to manage German/Italian credit spreads, because last summer they were blowing out very wide and threatening to take down the entire Euro-zone bond market. Powell’s studious application of “Rate Hikes of Unusual Size” as Danielle Dimartino Booth put it to me in the podcast we did back in February, was the cause.

The TPI announcement was paired with statements about the end of the ECB’s current QE programs. But the TPI is just QE in another form, especially if coupled with the ECB and European-adjacent jurisdictions are deploying reserves to manage the US yield curve.

But the TPI alone clearly isn’t enough. Eventually, shuffling underwater bonds from one pocket to another to massage credit spreads runs into the basic problem that Powell hasn’t stopped raising rates.

Running Out Of OPM

Eventually, as I pointed out in a recent article, policy limits are reached when rates themselves are the problem, not spreads. As a reminder, here’s the German 10-year weekly chart and Lagarde’s defense of 2.5%

Oh, and inflation was “stickier” than Lagarde was fronting this time last year. She was still on the “transitory” talking point. For some reason, the markets believed her. Or, more specifically, wanted to believe her.

The euro-zone bond market is a cancer patient in Stage IV. Each time there is a major event, the rot within it metastasizes again and a new alphabet program has to be invented — OMT, TARGET2, ESPP, TPI, ZOMG.

At this point, there is no internal solution, save blowing up the entire fiction of individual central banks within the EU. Lagarde needs help from the outside to keep this patient alive.

She gets that regularly from both the Biden administration in general as well as Treasury Secretary Janet Yellen specifically.

In this month’s Gold Goats ‘n Guns newsletter I laid out why I thought Yellen went to China to beg them to stop selling/start buying US Treasuries to keep a lid of global debt yields and the geopolitical implications for thiis. This morning Zerohedge reports that Yellen has already issued more than $500 billion in new debt and will sell more than $1 trillion in Q3 and another $722 billion in Q4. From the Treasury Marketable Borrowing Estimates report:

- During the July – September 2023 quarter, Treasury expects to borrow $1.007 trillion in privately-held net marketable debt, assuming an end-of-September cash balance of $650 billion. The borrowing estimate is $274 billion higher than announced in May 2023, primarily due to the lower beginning-of-quarter cash balance ($148 billion) and higher end-of-quarter cash balance ($50 billion), as well as projections of lower receipts and higher outlays ($83 billion).

- During the October – December 2023 quarter, Treasury expects to borrow $852 billion in privately-held net marketable debt, assuming an end-of-December cash balance of $750 billion.

With this much borrowing I expect Yellen can and will support Lagarde by structuring Treasury sales to over-supply high-yielding short term debt and under-supply long-term debt. It’s a subtle form of yield curve control designed to keep the 2/10 inversion high and the bid under the long-end of the curve strong.

Clearly, if you can keep long US yields well bid you help the ECB hold the line on German debt. But will it be enough?

The problem for these two Marxists Keynesians is that Powell has them right where he wants them. Despite all of the whining, US economic data looks better than EU data by a wide margin and the summer is nearly over, meaning higher oil prices.

Powell raise by 25 basis points as expected. So too did the ECB, also expected. Powell’s post-statement comments were also abundantly clear, he doesn’t believe inflation has been whipped. He is rightly saying that commodity inflation has a second wave coming, confirming the analysis of myself and Francis Hunt in a banger interview on Palisades Gold Radio (as I outlined in a recent private blog post for Patrons).

In fact, Powell said explicitly . . .

[SNIP]