Last week, we outlined our thoughts on the evolution of the growth vs. inflation trade off in the eurozone - that inflation in the eurozone has been sufficient to warrant a normalisation of monetary policy, or at least the removal of emergency monetary settings (QE, negative deposit rate, favourable TLTRO borrowing). This week, the ECB (European Central Bank) removed the emergency monetary settings (outside of the stock of QE assets, which are likely to be a feature of the ECB balance sheet well beyond Lagarde et al.) in one go, with a move in the three ECB policy rates of 50bps, taking the deposit rate to 0.00%.

The front loading of rate normalisation from the ECB was in part due to the acceleration of the underlying inflation dynamic (as judged by the Governing Council) and facilitated therein by the release of the ECB’s newest acronym - the TPI: Transmission Protection Instrument - in providing a platform of stability in the peripheral bond space.

Using the fiscal sustainability guard rails of Resilience and Recovery Fund (RRF) and NGEU programmes, the TPI replaces OMT, enabling the removal of NIRP, and at the same time working towards reducing bank reliance on TLTRO. OK?

The TPI (or ‘Spread Manipulation Tool’ - as it was referred to in the Bloomberg press conference pre-amble yesterday), seeks to provide a credible backstop for the widening of peripheral spreads to the extent that they are not driven by deteriorating fundamentals, with an interventionist firepower that is “not restricted ex-ante”. The required criteria is (i) that the member state in question is in compliance with EU fiscal rules; (ii) there is an absence of severe macroeconomic imbalances, (iii) the member state retains fiscal sustainability and, (iv) has sound and stable macro policies, consistent with the pledges under the RRF - acknowledging that the ultimate decision is not formulaic, but at the sole discretion of the ECB.

However, despite the attempt to deliver a tool that in theory provides an all-encompassing, all powerful periphery monetary transmission backstop, it is not clear in practice that it can work in the way it is intended - such is the narrow boundary between what is needed and what is possible in an incomplete monetary union.

It is clear that some of the GC saw a strong need for the instrument to be seen as unlimited (or beyond doubt from a transactional point of view). However, the reality is likely to prove very different. In practice, if there is a significant deterioration in the fundamentals of a member state, then the new ECB tool would struggle to find justification to act as it currently stands. If there was no fundamental deterioration, then there could be unlimited firepower - but it is hard to see why it would be needed under such circumstances. The ECB have used (and often celebrated the use of) ‘constructive ambiguity’ in its monetary tools, in order to reach agreement among 18 (now 19, with the recent inclusion of Croatia) member states. I have seen this morning a commentator note that asks whether TPI is taking constructive ambiguity too far. Time will tell, but I have serious concerns that the TPI may indeed fuel the spread movement it was designed to prevent, precisely by highlighting its inadequacies - fundamental deterioration can be a function of wider spreads as well as the cause of wider spreads.

As initiation of the TPI will require a process of analysis and agreement at the GC level (not to mention the as yet unanswered question of whether the initiation of TPI would require a unanimous agreement at the GC, or if dissenters, even the biggest nominal contributors, could be dragged along against their will?), at least in the near term, the primary spread tool remains the flexibility of the PEPP reinvestments on an interregional and intertemporal basis.

In addition to the disappointments under the TPI, Lagarde also disappointed some expectations on the rate curve. Despite the bigger than expected lift-off increment, Lagarde was clear that the decision of the Governing Council was a ‘front loading’ of policy, an acceleration of hikes (even suggesting that the forward guidance was no longer necessary as the ECB had brought forward the guidance from September), but not a change to the terminal rate - a change of pace, not destination!

This week’s meeting was also the most explicit the ECB has been in emphasising the link between EURUSD, inflation and monetary policy. While it is officially not in the mandate of the ECB to target any currency level, the viewpoint of one of the members of the executive board of the ECB is quite clear - that the GC should be very careful about the weakness of a currency against the current backdrop, where imported goods inflation as a function of the currency channel were detrimental to real consumer incomes and therefor growth prospects. In my opinion, the more explicit reference to the EUR is the first layer of discord. Further declines may invoke more direct verbal interventions.

In short, this ECB meeting will likely be retrospectively viewed as an important meeting from a historic perspective, not only due to the fact that the EC drew a line under its negative interest rate policy (NIRP) after more than a decade; nor due to the fact that the GC announced unanimous support for its most interventionist but also most convoluted and ambiguous policy to date; nor due to the fact that it likely signalled a notable concern over the impact of the EUR weakness on consumer inflation; BUT also that it came alongside the reopening of the Nord Stream 1 gas pipeline. From my perspective, the gas flow from Russia is the most significant factor for European economic fundamentals for the remainder of the year.

Indeed, while much of this week the central debate has focussed on the ECB periphery backstop - in particular with reference to Italy, set against a more fractious political backdrop – what about the German backstop? In many respects, the entire eurozone project is built upon an implicit guarantee from Germany, less so to the remainder of the core, but certainly to the periphery. The implicit suggestion, that the strength and reliability of the German economic model and their foundation is at the centre of the euro project, gave credibility to the union - at the heart of which was an exchange of credit for competitiveness. The implicit German guarantee gave the rest of the region lower funding rates by association (most acute at the periphery), and the adjustment in relation to diluted economic strength was expressed through the currency - a lower, and thus more competitive rate for the German industrial model to sell its products across the globe, and a captive, stable, free trading European area to sell them at home.

Over the years, there has been much focus on the exit of a number of member states in times of trouble (Grexit?, Italexit?, … ), but always little focus on Germany. It is far too early to suggest that the German economic model is irreparably damaged, or that the question marks over the economic model of Germany without cheap Russian gas bring into doubt the implicit guarantee that unites the eurozone. But this is a tail risk none are talking about, and as I see things, this is the key question for EUR at such low historic and undervalued levels. European energy security is at the heart of this question.

Despite all this, I personally remain of the view that while there are clear risks to the eurozone and to the EUR, the most important and far reaching of which being the energy security paradox, especially in relation to Germany, outside of an acute economic event (a full gas curtailment), EUR can perform far better than market pricing (although that may not be saying too much, given the extent of the current bearishness).

Prior to the Russia crisis and subsequent global economic and energy ramifications, there were a wide swathe of top tier banks all calling for substantial EURUSD gains on the back of an end to NIRP in Europe. The argument was that the positive interest rates would reverse substantial capital outflows from the eurozone (at the very least at the margin), as the eurozone turned net liabilities into net credits on its balance sheet. Now, even with the addition of a TPI, this narrative is nowhere to be found. Perhaps the argument has been outmatched by the energy concerns and resultant growth downgrades - despite RRF funding. Perhaps the EUR vs. USD arguments have simply been lost in the acronyms from Miami to Ibiza?