“Not all the Germans believe in God, but all the Germans believe in the Bundesbank”, (Jacques Delors, the famous former head of the European Commission)

The Euro lost minimal ground this past week. However, a significant event took place last Tuesday, which was overlooked by the markets. We elaborate on that today because we believe that the decision by Germany’s Constitutional Court signifies a watershed moment for the future of the EU and the Euro. However, before we proceed with our thoughts on this topic, we believe that a few words are warranted in the major disconnect that is being observed between the real economy and the financial markets. The recent rally cannot be justified based on the unemployment numbers, declining corporate revenues, depressed earnings, and lost output.

How then could we explain the recent rally? We are of the opinion that a combination of three factors could be used to explain (but not justify) this irrational behavior, namely:

1. The belief that a swift recovery is in the works. Our humble opinion is that such a belief is misguided and dangerous. The recovery in our opinion will take at least 3-4 years.
2. The liquidity infused by the Fed and other central banks. The central banks have imparted the markets with liquidity, so we live in the era of moral hazard trading. “Don’t fight the Fed” might be the motto, but let’s not forget that central banks allowed the music to go on that created the havoc and “parties” in the 1920s, the 1960s, and the 2000s. None of those “parties” ended well.
3. A few stocks, the famous FAANGM (Facebook, Amazon, Apple, Netflix, Google, Microsoft) make up more than 22% of the market’s capitalization. However, the FAANGM is neither the economy nor the market. It would be wrong to follow such biased tendency and focus on the headlines rather than dig deeper into the underlying factors that could cause seismic shifts. We cannot be fascinated by symptoms, ignoring the underlying causes.   

As long as this irrational view dominates, then the much-needed market capitulation cannot happen and a healthy equilibrium cannot be restored into the markets. We are of the opinion that some form of reality will eventually be imparted into the markets (contemplation of negative rates in the US this past week might have been the start), and the markets will experience another correction between 15-20%. 

Now, here are our thoughts on the major development that took place in Europe last week. The Eurozone is headed for a deep recession which in turn may produce unprecedented structural damage to its foundations. The future of the Euro is tied to the Eurozone’s recovery and whether Germany and a couple of its allies (such as the Netherlands) will play along or will take a hard line. If the Eurozone recovers quickly, the Euro will strengthen. If it doesn’t recover quickly, it will fall. Our opinion is that the recovery will be slow for both the EU and the US. The decision by Germany’s Constitutional Court last Tuesday shouldn’t be taken lightly.

The recent decision by Germany’s Constitutional Court has been interpreted as an endorsement of the ECB’s recent bond purchases. We choose to defer. We are of the opinion that this could prove to be a game-changer for the fate of the Eurozone and of the Euro. Last Tuesday’s ruling by Germany’s Constitutional Court on the legitimacy of asset purchases by the European Central Bank (ECB) hits at the heart of the Euro’s existence. The ECB can exert monopoly power over sovereign states that have not mutualized their liabilities. This by itself is absurd. It’s like having the Fed in the US, without the Treasury Department!

The citizens have given up their monetary sovereignty in order to enjoy some protections. This resembles a situation where citizens give up some of their liberties and accept the monopoly power of the state in order to have police, a social safety net, courts, etc., all financed by taxation (which by itself represents a limitation on freedom ).

However, in such an arrangement a vital question arises: How do we protect the citizens from the protector when the latter goes rogue? In the US we have separation of powers and the constitution as the ultimate compass. Sovereignty under any constitution means that no other laws could be applied but for those propagated and accepted by the local authorities.

When sovereignty is abandoned to a foreign entity, the act by itself could be considered treasonous. When the Euro was created, the states gave up their monetary sovereignty to a third party (ECB). Since the 19th century whenever Europeans have allowed Germany to unify, significant problems keep coming up (WWI, WWII, the European financial crisis). The reality is that Germans after their last reunification in 1990 have pushed Europe into a series of significant turmoil (sterling crashed in 1992, EU recession in the 1990s, imbalances in the 2000s due to the Euros structure, etc.). Germany has been the main beneficiary of the Euro and the reality is that they dominate the ECB. 

When the Bundesbank’s powers were transferred to the ECB, certain important exceptions were inserted for the purpose of limiting the supranational body’s scope of authority.

1. Article 125 (no bailout provision) of the Treaty on the Functioning of the European Union clearly states that no member state would be liable for commitments made by authorities in another member state.
2. Article 123 of the same Treaty prohibits the ECB from financing a member state by buying bonds issued directly by that state.
3. Germany’s constitution explicitly states that German taxpayers cannot be burdened with liabilities tied to other countries.

Therefore, EU debt mutualization is unconstitutional in Germany and is further prohibited by the EU’s operating Treaty. The transfer of monetary sovereignty from the Bundesbank to the ECB is still governed by the German Constitution and the Treaty.

If the ECB has exercised authority that the German constitution and/or the treaty do not allow, then eventually we may be facing a situation where the German Constitutional Court will have to reclaim for Germany the monetary powers delegated to the ECB, otherwise the German constitution will have to change (good luck with that!)

Italian, Greek, Spanish, French, Belgian, and others’ debt levels are expected to rise substantially. Any limits to the ECB’s ability to buy bonds of member states will bring turmoil to the surface, and will make the EU’s recession deeper which in turn will inflict structural damages (it would be like when the foundations of a house suffer from structural damage). The rising spreads e.g. between Italian and German bonds signify the rising tremors.

The EU may soon be facing a watershed moment. We believe that unless structural changes take place, the Euro will face an existential crisis within the next 2-3 years  and therefore, we consider it as the most dysfunctional fiat major currency that was ever invented with a downward trajectory. In case that the existential threats to the Eurozone materialize, significant turmoil and uncertainty is expected, however following that we may see a resurgence of real asset purchases/investments taking place within Europe which could turn out to be the starting point of a much-needed economic renaissance.