POLITICO Pro Morning Central Banker: Energy price relief — Zero-day options — The long arriverderci

June 1, 2023 Times Europe

By GEOFFREY SMITH

  — Broad inflationary relief across Europe and a continuing energy sell-off points to a more dovish ECB.

  — ECB flags zero-day options risk as it eyes new sources of instability.

  — As Visco’s long arrivederci begins, we ask what will happen to Italy’s ECB board seat if Panetta goes?

ECB 3.75% ⇡ — BOE 4.5% ⇡ — FED 5.35% ⇡— SNB 1.5% ⇡— BOJ -0.10% ⇣— RBA 3.85% ⇡— PBOC 3.65%⇣— CBR 7.5% ⇣ — SARB 8.25% ⇡

Good morning! June is here, it’s the European Central Bank’s 25th birthday and hopes of an end to its tightening cycle are, as the poet said, bustin’ out all over. It seems a big drop in headline inflation in May in Germany and France, which account for roughly half of eurozone gross national income, has convinced at least some (including Berenberg’s Holger Schmieding) that the ECB should be done hiking by July at the latest.

But fear not if you disagree. Others who have crunched the numbers do too and say it will take at least another big drop in June — to below 5 percent — to generate a second-quarter number that can undershoot the ECB’s own forecasts and force them to take another look at their projections. No surprise, then, that there was a chorus of ‘meh’ from VP Luis de Guindos and others on Wednesday. Tough crowd.

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— ECB publishes its May meeting accounts.

— Eurostat releases Eurozone inflation and unemployment numbers.

— Sweden’s Riksbank publishes its Financial Stability Report.

EUROZONE PRICES IN FOCUS: Eurostat’s number for the eurozone, due at 11 a.m. CET, should now undershoot the consensus 7.0 percent forecast. Weak import prices in Germany and producer prices in France are also pointing to much more disinflation in the pipeline. Even so, to sustain yesterday’s excitement, we will probably need a good clear drop in core prices that relies on more than just the introduction of cheap rail tickets in Germany.

While Eurostat has the most important numbers, the day’s most interesting reading may come from elsewhere. The ECB will today publish the accounts* of its last meeting in early May, which should shed light on how easy, or hard, it will be to get a majority on the governing council to switch to ‘pause’ mode.

Stockholm syndrome? Even more interestingly, Sweden’s Riksbank is due to publish its semi-annual Financial Stability Report. Why are we so curious? Because if you’re expecting higher interest rates to cause trouble anywhere, then Europe’s frothiest real estate market is the obvious place to start looking, not least because property companies account for over 40 percent of local banks’ corporate loan books there.

*For those new to central banking, it is mandatory on pain of death to call them “accounts”, rather than “minutes” (which would give the entirely misleading impression that the ECB was just reluctantly mimicking the Fed, BoE and others).

ENERGY INPUT WATCH: The contribution of energy to the disinflation process may have further to run yet. Crude oil futures are back flirting with an 18-month low as China’s post-reopening rebound fizzles. China’s official purchasing managers index, which tracks large state-owned enterprises, now shows the manufacturing sector back in contraction in May. The latest leg down has been driven by expectations that the ‘OPEC+’ group won’t agree to support prices by cutting output at a key ministerial meeting this weekend.

Benchmark Brent futures were down 15 percent year-to-date and nearly 50 percent off their highs in the aftermath of Russia’s Ukraine invasion. Benchmark natural gas futures in the Netherlands, meanwhile, hit their lowest in over two years last Friday.

The great de-stocking? The sell-off is now so acute, say Goldman’s usually bullish energy team, that “it’s likely the largest commodity de-stocking the [commodities] complex has ever witnessed.” Markets, they added in a note this week, have rarely seen such a sharp rise in funding costs from such a low level, a fact that is making it ever costlier to fund and store commodities over the long term, thus the associated de-stocking. “The bottom line is markets have cashed in on their insurance policies in the form of physical and financial hedges,” the Goldman analysts noted. But be careful what you wish for. “On net, that leaves the entire complex exposed to upside should recessionary risks not materialize,” they also warned, highlighting this makes commodities an excellent inflation hedge (which, we’re sure, they’d be keen to broker).

ZERO DAYS TO VOLATILITY: In an unexpected turn, the ECB set its sights on disorderly market moves stemming from the growing use of 0DTE (zero-day-to-expiry) options in its latest Financial Stability Review (FSR) released on Wednesday. Never heard of them? You will soon. These are ultra-short-dated equity options contracts that have become something of a market craze across the pond. They expire, you guessed it, on the day, which means traders can use them to hedge (ok, gamble) exposure to big swings in equity markets from calendar events like interest rate decisions or U.S. employment reports.

The evolving bored ape risk: It may have begun with the “Reddit” crew of retail investors, but regulators are growing concerned the options are gaining traction with more sophisticated traders too. By the ECB’s measure trading in the S&P 500 flavor of the options recently reached an all-time high, and now accounts for between 40-45 percent of traded volumes. According to JPMorgan analysts (who have already warned about their use) the daily notional value of trading in 0DTE options may be as much as $1 trillion.

So what’s the issue? Because of their short duration, investors can use a lot of leverage on the options which can have a magnified effect on the underlying index. The ECB is concerned that in the current environment (you know, bank failures, inflation shocks), this could see negative surprises lead to wild swings in U.S. equity markets, which of course would have knock-on effects around the world. It would also mean market makers have to ensure their portfolios remain hedged by selling underlying securities, further exacerbating any price moves.

SAYONARA, MRS WATANABE: In other FSR news, the ECB added Bank of Japan policy normalization to the lengthening list of potential problems for eurozone markets. Growing expectations that the BoJ will use the current rise in inflation to relax its cap on JGB yields could be upsetting for the global bond market, Frankfurt reckons, because it could force home some of the liquidity that has been hunting for yield elsewhere for the last decade — including to the eurozone.

“Japanese investors withdrawing abruptly from the euro area bond market could have a material effect on prices, particularly in more concentrated market segments,” the ECB said. “Such dynamics could be amplified by the increased net supply of these bonds resulting from quantitative tightening by the ECB.”

GET WITH IT: ECB Vice-President Luis de Guindos meanwhile also called for liquidity rules to be adjusted “to the modern world” to combat digital bank runs — adding his voice to a growing chorus of regulators backing changes to cope with social media-assisted stampedes. The Spaniard said the speed of deposit outflows in the U.S., where $42 billion was pulled from Silicon Valley Bank in one day, showed “how rapidly a bank can be emptied” thanks to online banking. As cheap central bank funding dries up, banks will also have to compete for deposits, both among themselves and with money market funds, he warned — which, of course, is an ironic twist to multi-year institutional efforts to make banking more frictionless and open.

Captured bond markets: Similarly, the ECB hasn’t forgotten about liquidity risks at nonbanks. De Guindos called for investment funds to have to hold more liquid assets to deal with any outflows — as part of a framework to handle a mismatch between hard-to-sell assets and easy withdrawals at funds. He said those concerns were particularly pronounced for property funds amid a contraction in commercial real estate prices.

THE U.K’s ‘CORE’ PROBLEM: As inflation appears on the retreat on the Continent, things across the Channel look rather different. Underlying inflation in Britain is proving more persistent than in other countries, Bank of England Monetary Policy Committee member Catherine Mann told an event hosted by Pictet.

Getting sticky: In contrast to the drop in eurozone core inflation last month, core price inflation in Britain surged to a 31-year high of 6.8 percent. The core measure excludes items such as energy and food and is seen as more “sticky”, or harder to tackle. Economists polled by Reuters now think Threadneedle Street will be far more aggressive with its rate hikes, possibly peaking at 5.5 percent later this year.

Watch out for the Bank of England’s money and credit data for April at 10:30 a.m. CET.

THE LONG ARRIVEDERCI BEGINS: Ignazio Visco’s last annual press conference as Bank of Italy governor seemed almost hand-crafted to rattle the hard-right government of Giorgia Meloni. In a not-so-short speech, Visco — who leaves in November — said the expansion of globalization over the last 30 years has resulted in a “fundamental contribution” to human wellbeing and that Italy ought to pursue a dramatic increase in migration to recoup decades of lost productivity.

Not especially controversial ideas for your average liberal, but Visco — long prone to wading into Italian political debate — was touching on two issues that are sensitive for Meloni and her Brothers of Italy party. Since coming into office the government has pushed a protectionist, anti-globalization agenda and fought hard to promote an increase in domestic birth rates over mass migration — which one minister has described as “ethnic substitution.” Visco, however, noted that a baby boom would only improve the labor market in the “very long term.”

VISCOUS LIQUIDITY: The departing governor also reassured Italian savers that the country’s banks were in “good enough condition,” having survived successive interest rate hikes. He nevertheless warned of an ongoing drop in bank liquidity as savers shift their deposits to “more remunerative” asset classes. Since July last year, deposits have dropped by 6 percent — not catastrophic but “meriting prudence.”

BOARD SEAT GAMBLE: For those wondering how Visco’s departure could shake up the power balance over at the ECB, our money’s on Fabio Panetta, who currently represents Italy on the ECB board, being called in to take his place. The problem is, if Premier Giorgia Meloni does recall Panetta, Italy’s seat on the six-strong ECB board will be put at risk.

Wait, how does that work? The ECB still allocates four of those seats to the ‘big four’ economies of Germany, France, Italy and Spain, but that structure has been outgrown by the eurozone’s expansion over the years to 20 members. An early departure by Panetta would create a rare opportunity for its smaller, newer members to expand their representation at the top level. Click here for Johanna and Ben’s story.

FLOODING OUT: U.S. banks suffered their biggest quarterly deposit outflow on record in the three months through March, as the sharp rise in U.S. interest rates triggered the collapse of three mid-size lenders, according to a release from the Federal Deposit Insurance Corp. on Wednesday. That was the largest outflow since the FDIC started collecting such data in 1984.

Whose problem? Separately, the FDIC added another four banks to its ‘problem list’, taking the number to 43. These banks between them have less than $60 billion in assets. Given that Silicon Valley Bank alone was more than three times as large, you are entitled to carry on doubting that the FDIC’s definition of ‘problem’.

Elsewhere in the U.S., job openings surged back above 10 million in April, pushing back the long-prophesied labor-market cooling by another month, while Congress inched toward a deal that will avert the risk of a default in the near term, and shave no more than 0.3 percent off GDP growth this year and 0.1 percent in 2024 (according to Oxford Economics’ Nancy Vanden Houten).

“A decision to hold our policy rate constant at a coming meeting should not be interpreted to mean that we have reached the peak rate for this cycle,” Federal Reserve Governor Philip Jefferson told a conference in Washington on Wednesday.

“Looking at how fast inflation is right now, I think it’s very likely that we’re in for more than one more 0.25 percent interest rate hike… It also seems to me that it’s probably too optimistic to expect interest rates to drop already at the beginning of next year,” said Bank of Estonia Governor Madis Müller, Bank of Estonia Governor.

“The transition path that we are on to R* or R** has an awful lot of volatility associated with it. Volatility in exchange rates, volatility in prices, a lot of volatility in assets. And some of that volatility is going to be reflected in things breaking… Often the water is calmest before the falls,” noted BoE MPC member Catherine Mann at a Pictet event on Wednesday.

(Editor’s note: R* is the interest rate appropriate for the real economy, R** is the interest rate where financial stability starts to crumble.)

— RBA governor Philip Lowe’s big blunder down under (Daily Mail)

— A day in the life of the 18th-century Bank of England (History Today)

THANKS TO: Izabella Kaminska, Ben Munster, Johanna Treeck, Anjuli Davies and Hannah Brenton.

(Editor’s note: this is intended as a selective list, giving precedence to European events)

THURSDAY, 1 June

— China Caixin PMI, 3.45 a.m.

— Germany April retail sales, 8 a.m.

— Riksbank Financial Stability Report, 9:30 a.m.

— ECB’s Knot speaks at European Banking Federation conference, 9.55 a.m.

— U.K. April money and credit data. 10:30 a.m.

— Eurozone May CPI, 11 a.m.