Category Archives: Bond Market

Two Versions of the US Fiscal Deficit

The US (federal) fiscal deficit has been deteriorating recently. This is an odd thing during the late stages of an economic recovery. The budget for 2016/17 (September 30) has been missed by around 10%, and the current fiscal year target (440bn) looks far off.

While spending continues to increase, receipts (government income) have leveled off since the beginning of 2016:

Individual income taxes have peaked at $ 1.6 trillion:

Meanwhile, corporate income taxes peaked in early 2015 and are now flat at $ 300 billion:

The deteriorating fiscal deficit, combined with a persistent trade deficit, would be bad enough. However, adding up the ‘official’ fiscal deficits since 2007, and comparing that number with the increase in federal government debt, something does not add up:

The fiscal deficit was actually 41% higher than stated. The difference stems from shifting certain expenses into “investments”.

With significant increases in spending on military, Veterans’ Affairs and Homeland Security the fiscal situation is likely to get only worse. Once foreign investors (private and central banks / sovereign wealth funds) stop financing the US twin deficits a current account crisis will occur. As the Federal Reserve is likely to keep a lid on bond yields the foreign exchange market will be the only available valve for adjustment. A significant devaluation of the US dollar is likely.

What the hell just happened – Part 2

Part 2

(for part 1, please look here)

At the beginning of part 1, I offered three theories to explain what happened on global stocks markets, culminating in the flash crash of August 24, 2015:

  1. Flash-crash induced by high-frequency traders and panic-covering of short positions in volatility products
  2. US and China mutually crashing each other’s stock markets in an escalating financial war over AIIB (Asian Infrastructure Investment Bank, a competitor to the IMF) and SDR (Special Drawing Rights, the IMF’s virtual currency)
  3.  The appreciation of the Chinese Yuan versus other Asian currencies hurt Chinese exports and forced the PBoC to devalue the Yuan. This has caused the end of the largest carry-trade in history.

Chinese Stock Market Crash

I initially thought I could brush aside theory #2 pretty quickly. But then I read the following:

Citadel suspended - Hunsader

Citadel, based in Chicago, is one of the largest hedge funds in the world. It masquerades as a market maker, executing 13% of all US stock market and 20% of all US option trading volume. It can safely be called a high-frequency trading firm.

Furthermore, China curbed trading in futures of the country’s prominent market indices, the CSI 300 and CSI 500. Trading volume in CSI 300 futures declined by 99% (!):

CSI 300 futures


Earlier in July, many stocks listed in China were suspended from trading (peaking at 71% on July 8th):

Chinese stocks halted

There were reports of short sellers being imprisoned, portfolio managers being carted away for “re-education” and journalists being forced to apologize for reporting on the Chinese stock market.

Take a look at a 20-year chart of the Shanghai Stock Exchange Composite Index:

SSEC 2015-09-08

Was the Chinese stock market in a bubble? Clearly. Has short-selling and high-frequency trading “helped” making the crash worse? Probably.

As an aside, consider the growth in Chinese GDP over the same period (in USD):

China GDP 1995-2015It went approximately 10-fold. Stocks didn’t do much, except for two bubbles (which quickly deflated). Most investors didn’t make any money in a country with one of the strongest growth rates over the past two decades.

Chinese Economy: Serious Slowdown

On August 8, Chinese July export data missed expectations by declining 8.3% (-1% expected). The weakness persisted in August (-5.5%). What happened?

  1. Chinese wages have risen substantially. Over the past 7 years, monthly minimum wages in Shanghai increased from CNY 690 to 2,020 (+16% per annum). Over the same period, average yearly wages in manufacturing have increased from CNY 15,750 to 51,500 (+22% per annum). Some US companies have moved labor-intensive production back to home (“reshoring”).
  2. The Chinese Yuan, due to a soft peg, has not moved much against the US Dollar. However, most other currencies fell against the Dollar. This meant the Yuan appreciated against currencies of competing export countries in Asia (and customer countries in Europe):

Asian FX 2015-09-10

  • A strong Yuan makes Chinese products less competitive abroad. No wonder exports began to stutter. Additionally, Chinese company margins are getting squeezed from rising labor costs.
  • China was coerced into letting its currency appreciate in exchange for its entry into WTO (World Trade Organization):

History of Yuan

  •  Foreign Direct Investment (FDI), capital inflows and a large positive trade balance led to a growing positive current account balance:

China current account to GDP

  • This enabled China to become the largest foreign holder of US Treasury securities:

Foreign holders of US Treasury securities

  • However, capital flows recently reversed:

China capital flows

Two reasons:

  1. Wealthy Chinese trying to bring some of their legally or illegally (bribery, crime) acquired wealth abroad. Australian house prices have doubled over the past decade driven by Chinese buying.
  2. Speculators and hedge funds used to bet on continued appreciation of the Yuan versus the Dollar. It is said to be the largest “carry trade” in history, estimated to have reached up to $3 trillion. In a carry trade, an investor borrows money in a low-yielding currency (USD, Euro or Yen) and investing the proceeds into a higher-yielding one (Yuan, with interest rates between 5.25% and 7.5% over much of the past decade). Usually, interest rate differentials between currencies are being “lost” once you try to lock in your gain by selling forward contracts. However, forward rates in the Chinese Yuan were higher than spot prices as investors expected further appreciation. Carry traders not only benefitted from interest rate differential, but also from currency appreciation on top. You could borrow, for example, Dollars at 1%, buy Yuan, invest at 5%, and get some price appreciation on top. Leveraged a modest 10 times and you could show your investors annual returns of 40-50% without much volatility or draw-down. Every hedge-fund managers’ dream.

All dreams end at some point, and so did this one.

On August 11, the (more freely traded) offshore Yuan began dropping against the USD after the PBoC (People’s Bank of China, China’s central bank) allowed its price to fall (upwards move in chart means weaker Yuan):

CNY offshore 2015-08-12

  • The Yuan devaluation came as a shock to most market participants.
  • Equities and currencies began moving, initially contained, then culminating in a waterfall-like movement on Monday, August 24:

SPX 2015-08-24 month

  • The Shanghai Stock Exchange Composite Index (SSEC) fell 4% on Friday before the flash crash, 8% on Monday and another 8% on Tuesday for a three-day loss of 19%.
  • The Japanese Yen strengthened from 124 JPY/USD to 116.
  • Remarkably, the Euro also rallied, from 1.10 to 1.17.
  • This is an indication of large carry trades being unwound. Yen and Euro had been borrowed (thanks to low interest rates) and sold short. Unwinding those trade meant to buy back Yen and Euros.


Chinese Yuan: Ambushed Ambitions

A five percent devaluation does not seem significant – unless this was just the beginning. Back in 1994, China devalued the Yuan by roughly one third. This put pressure on other Asian currencies, eventually leading to the Asian crisis 1997/98:

CNY since 1980

All signs point towards a repeat of a larger devaluation. Not because the PBoC wants to devalue, but rather because it cannot prevent the Yuan from falling. Take a look at foreign currency reserves (mostly USD) at the PBoC:

Chinese FX reserves 2015-08

Reserves peaked at a little over $4 trillion in June 2014. Since then, reserves declined by over $450bn. August alone saw a decline of $94bn. So with a slightly positive trade balance, capital outflows must be even larger. The PCoC is intervening to support the Yuan (buying Yuan, selling Dollars). This causes Dollar reserves to fall.

The PBoC will not watch its reserves flying out of the door for too long. Eventually, the pressure will become too high. So how do you devalue? Trying a pro-rated withdrawal just invites speculators to bet on further weakness. You have to do it overnight. Go large or go home. Carry traders will lose their shirt.

The PBoC is at the other end of the carry trade. It is long the (low-yielding) Dollar, and short (higher-yielding) Yuan. A negative interest spread on $4trn of reserves is costing the PBoC $200bn a year. By devaluing its currency by, say, 25%, the central bank “makes” roughly $1trn (as its remaining Dollar reserves appreciate in Yuan).

Chinese Prime Minister Li recently complained that the decline in commodity prices lowered China’s income from tariffs, putting its finances under pressure. He also stated that the Yuan devaluation was prompted by weakness in other currencies.

In July, China switched towards reporting FX reserves (and gold, by the way) on a monthly basis (previously: quarterly). The PBoC has adopted the IMF’s “Special Data Dissemination Standard” (SDDS), a step likely done in good faith.

The Chinese have refrained from competitive devaluation for more than 20 years, motivated by WTO accession and potential inclusion of the Yuan in the SDR (Special Drawing Rights) currency basket. This was expected to happen the end of 2015. However, on August 4th, the IMF announced the Yuan would not be included at this time (allegedly since SDR users have requested more time to prepare for such a move – a bogus excuse in my view). With the IMF removing the SDR “carrot” at the last moment, China does no longer feel obligated to adhere to fairplay. A new round of competitive devaluations in Asia and Latin America seems unavoidable.

Possible ramifications for Emerging Markets:

  • Emerging Market (EM) central banks try to defend their currencies by selling dollars and rising interest rates, thereby throwing their economies into recession
  • A drop in EM currency leads to bankruptcy of companies with unhedged debt in foreign currency (usually US Dollar)
  • Drop in EM currency leads to imported inflation, cutting into domestic demand, possibly leading to social unrest
  • EM borrowers lose access to bond markets. Even otherwise
  • Exports from Developed Markets (DM) into EM suffer. DM Companies close loss-making foreign subsidiaries, take write-downs
  • DM banks have to write-down EM loans
  • A global recession ensues


Privilege of Reserve Currency

  • China is not alone in losing FX reserves; Russia has lost about half (from roughly $600bn to 300bn):

Russian FX Res 2015-07

  • Foreign exchange reserves are falling everywhere; even Algeria is down to $159bn at the end of June from 179bn at the end of 2014.
  • Some of the decline, at least for oil-exporting countries, seems to be linked to the decline in oil prices. Less Dollars coming in while same amount of Dollars going out for essential imports.
  • One theory goes as far as saying that the US is not interested in low, but rather high oil prices, as this would boost foreign demand for US Dollars. This in turn would enable the US to run a large current account deficit without negative repercussions on its exchange rate.
  • The game would be over once oil-exporting countries stop pricing oil exports in US Dollars. China plans to introduce a Yuan-based oil price benchmark, which will compete with Brent and West Texas Intermediate (WTI).

It is no secret China (and many others) are not happy with the US Dollar (and therefore the US) dominating our monetary system. Almost all commodities are exclusively priced in US Dollars. What at first sight seems like a convenience turns out to be one of the keys to world dominance. Advantages of the US Dollar being the world’s reserve currency:

  • The US will always be able to buy commodities, as it can print the currency to be delivered in exchange
  • Countries not using the US Dollar will have to acquire US Dollars first before being able to pay for, say, crude oil. This creates a demand for Dollars of around four billion dollars per day alone from oil consumption (assumed consumption in non-USD countries of 80m barrels per day x $50 per barrel).
  • Central banks of oil-exporting countries are forced to absorb those Dollars and become captive investors in US Treasury securities.
  • Countries pegging their currencies to the US Dollar are forced to buy Dollars if the US runs an expansive monetary policy and floods markets with Dollars. Buying Dollars means selling its own currency. This expands monetary supply, which can lead to inflation. The US thereby can export inflation. Detrimental effects of US monetary policy pop up abroad.
  • Algeria, for example, is not able to sell its oil in its own currency. Where would, say, Italy get those Dinars from? The market in Algerian Dinar is not big enough. Hence Algeria prices its oil in Dollars, and accumulates them at the central bank. Why not in Euros? Most countries that tried to price their oil in anything other than the Dollar have experienced sudden appearance of F-16’s in their skies.
  • US goods make up only six percent of Turkish imports. However, 60% of its imports are priced in US Dollars. Since the end of 2012, the Turkish Lira dropped 35% against the Dollar. From the perspective of a Turkish importer, the Dollar rose from 1.78 to 3.03, or 70%. If 60% of your imports go up by 70% will get you inflation (around 7% for now). Turkey’s consumer price index went from 200 in 2012 to 260 (+30%). This (normally) forces the central bank to raise interest rates, just at a time when the economy slows down. If the central bank tries to support the exchange rate by purchasing Turkish Lira (and selling Dollars) it make matters worse by shrinking the monetary base. Should it run out of Dollars to sell, the country may become unable to pay for imports or service any Dollar-denominated debt. Turkish companies with (unhedged) foreign currency debt positions will see their credit rating downgraded and might default on their debt. In short: total mayhem.

Emerging Markets in Turmoil

  • Look at Emerging Markets currencies:

EM FX 2015-09-09

  • This is a full-blown Emerging Market crisis. Strangely enough, the crisis has not yet reached those nations’ foreign currency government bonds.
  • Meanwhile, sovereign ratings are under pressure:

EM ratings 2015-09

  • USD-denominated Brazil government bond yields jumped from 5.5% to 6% after the country’s rating was reduced to ‘junk’ by S&P on September 9th.
  • How low can the Turkish Lira fall? There is no limit. The Turkish Lira, as all other currencies, are not backed by anything but trust (in the country’s central bank, political and social stability, demographics, foreign debt, overall debt, current account, capital flows, etc).
  • Russia, the US’s old foe, is not only forced to accumulate Dollars. Those Dollars remain on an account as a US bank (in the name of the Russian Central Bank). In order to earn a tiny bit on those Dollars, Russia invests in US Treasury securities, thereby helping to finance the US budget deficit (and the most expensive military in the world).
  • Russia is selling oil and gas in exchange for IOU’s (“I owe you”) from its greatest enemy. It can’t even sell its Treasury securities all at once. The Federal Reserve could simply refuse to execute their sell order.
  • Compare this to the effect of a strong or weak Dollar on the US: only 16% of US GDP are imports. It pays to be large. Avocados sold from California to New York do not constitute external trade.
  • Since the last crisis (1998) EM borrowing in USD has grown exponentially from $2 trillion to almost $10 trillion:

USD credit to non-US non-banks

  • EM bulls point towards large foreign exchange reserves as reason why this crisis will not be a repeat of 1997/98. However, those reserves are melting away fast. The build-up in debt eclipses central bank FX reserves by far.
  • In the past, elevated debt levels in EM were able to be “cured” by strong GDP growth. With population growth and productivity growth slowing down, there is no such hope.

Future Monetary System

  • Many non-US countries are fed up with the dominance of the US Dollar (and, as a consequence, the USA).
  • The past has seen many world reserve currency come and go, like empires:

Reserve Currency status does not last forever

  • According to one theory, a reserve currency eventually destroys itself as large current account deficits are required to supply the world with currency.
  • Once the US Dollar loses its role as reserve currency, who could take over? The Euro?
  • The Euro-zone counts 333 million citizens and a GDP of $13 trillion (US: 321m / $17trn). The EU has grown towards 508 million citizens and more than $18 trillion in GDP. It has eclipsed the US in potential economic power (but lacks military power).
  • US Dollar and Euro make up 85% of all world reserve currencies. There is no other currency left large enough to assume that function:

World FX Res IMF 2015-Q1

  • I initially assumed the Euro could assume the role of reserve currency. However, the Euro area has a current account surplus, meaning more money is coming in then going out (at least at current exchange rates). That would make it difficult to provide enough Euros to the rest of the world. There would be a constant shortage of Euros. Unless the ECB started buying foreign assets in exchange for Euros (which I doubt).
  • The future of our international monetary system is unclear. According to a plan by the IMF, all domestic currencies would be abolished and replaced by its currency, the SDR. Control of the monetary system would be completely out of reach of any democratically elected governments.
  • China seems to expect significant changes in the near future. It encourages its citizens to buy gold. According to Peter Hambro, Petropavlovsk Chairman and co-founder, 1,700 tonnes of gold worth USD 65 billion have been physically withdrawn from the Shanghai Gold Exchange in the twelve months leading to August 2015. The amount is more than half of the world’s annual gold mine supply. According to one theory, this is to protect its citizens from a large devaluation of the Yuan (gold price would rise in Yuan).


Can the Federal Reserve Raise Rates?

  • The Federal Open Market Committee (FOMC, the body that decides over monetary policy) will meet September 16-17. Fed watchers are divided over what will be the outcome.
  • After years of zero-interest-rate policy the Federal Reserve urgently wants to raise interest rates. Why? If and when the next recession hits, the Fed cannot lower rates if rates are already at zero percent.
  • Can the Fed raise rates? Of course it can. But would it matter? Only if some banks were actually borrowing from the Fed, right? Look at the latest balance sheet:

Fed assets 2015-07

(The * indicates amounts of less than 500 million; 241m to be exact)

  • Nobody is borrowing from the Fed. So how does it want to influence interest rates?
  • The Fed determines an upper and lower limit for the Fed Funds Rate (currently 0% and 0.25%). Banks trade reserve balances at the Fed among each other. They negotiate the rate at which one bank with excess reserves lends some of its balance to a bank in need of reserves. The weighted average across all transactions is the so-called “Federal Funds Effective Rate” (currently at 0.14%).
  • Before US banks borrow from the Fed they will use their excess reserves parked at the Fed. Look at the Fed’s liabilities (and its meagre capital of 58bn or 1.3% of total assets, resulting in leverage of 76 times):

Fed liabilities 2015-07

  • Banks have deposited $2.6 trillion with the Fed. Of those, $2.5 trillion are in excess of reserve requirements. The Fed does not pay any interest on those reserves (and earns a huge spread by investing those funds into Treasury securities).
  • Given that much excess supply, why would the Effective Fed Funds Rate go up?
  • The Fed is aware of this problem. It created a few new tools (reverse repo; would take too much time to explain).
  • As the Fed has over-supplied the market with liquidity it might find itself now unable to control short-term interest rates via a lending rate. It might have to try to do so via a deposit rate. However, offering interest on deposits at the Fed would compete with other institutions (like Money Market Mutual Funds). It could lead to unwanted side-effects.

Should the Fed Raise Rates?

  • IMF and World bank publicly urge the Fed to postpone rate hikes. That is remarkable. They would have had the option to do so privately. But they chose to go public. This makes it more difficult for the Fed to postpone, because it could be seen as giving in to political pressure. On the other hand, the situation in Emerging Markets must be really dire for IMF and World Bank to resort to public pressure.
  • There are two fears: 1 – raising rates would make the Dollar even stronger and escalate weakness of EM currencies (unless their central banks raise rates, too), and 2 – global debt has reached a level where higher interest rates cannot be extracted from productive assets without bankrupting the system.
  • However, a lot of Dollar strength has already been anticipated, as seen in this chart of the Dollar Index (a mix of major currencies):

USD Index 2015-09-11


  • My personal view is the Fed should not hike rates as the US economy seems to be slowing down. If the Fed raised rates now it might be forced to back down a few months later and reverse course, hurting credibility.
  • The ECB infamously raised rates just before the financial crisis 2008. The rate hikes in 2011 had to be corrected shortly thereafter, too:

ECB refinancing rate

What Will the Fed Do?

  • Probably some combination of a limited increase in short-term rates combined with another round of “Quantitative Easing” (bond purchases).
  • The Fed might also give guidance on what it plans to do with maturing bonds in its portfolio. Reinvesting those assets or letting the portfolio “run off”? At a minimum, I would expect reinvestment.
  • More extreme versions would include the declaration of a yield cap on Treasury bonds (“we will buy any bonds with yields of 2% or higher). Treasury bond yields would immediately drop below 2%, probably without much buying needed by the Fed. But the Fed wants to buy a lot of assets (in order to pump money into the economy), so this might not be the best approach.
  • The Fed could begin buying foreign assets, although this would be considered a hostile act by other central banks and constitute an escalation of currency wars.
  • The federal government could announce another fiscal stimulus plan (just in time for the 2016 presidential election). Believe it or not, the federal fiscal primary deficit has shrunk to 0.3% of GDP:

US fiscal and primary deficit 2015-06


How will markets react?

  • It might not even matter what the Fed announces next week, as long as market participants believe that the Fed has their back and will prevent the economy from falling apart (despite the fact the Fed wasn’t able to do so in 2008/9).
  • According to rumors, the Fed helped create a certain “Plunge Protection Team” (PPT), a non-recourse credit line given to a stealth buyer of stocks at the lows of the market in 2009. The PPT could have been selling stocks ahead of FOMC meetings, leading to a drop, then buying back after the news release.
  • Market participants, seeing rising stock and bond prices, assume that what the Fed does was “good” for stocks / bonds (even if it might do nothing for the real economy). It’s all about perception.

Longer-term Outlook

  • Once the dust settles, problems in Emerging Markets, currency devaluations and downgrades of sovereign and corporate credits will take the upper hand again.
  • Volatility and market crashes are like earthquakes – very hard to predict. Long periods of calm suddenly erupt into mayhem. It almost seems as if during long periods of calm stress builds up, almost silently. People get used to the calm, and erect fragile buildings. ZIRP (zero-interest-rate policy) by central banks has suppressed volatility over the past years. Handing out cheap loans to almost anyone with a pulse is all but a guarantee for things blowing up once conditions turn less favorable.

VIX 20 years

  • Was the spike in volatility (to 53, highest in past 20 years with exception of 2008/9) already this year’s earthquake, or simply a tremor ahead of the “big one”? Impossible to tell. Given the state of Emerging Markets I believe the “big one” is yet to come. If the Fed hikes, a crisis will follow. If it doesn’t, the inevitable will only be delayed.

US June Retail Sales

US June retail sales (-0.3% m/m) came in below expectations (+0.3%). Excluding car and gasoline sales, sales declined 0.2% (consensus +0.6%). On top of that, May sales were revised downwards by $1.7bn:

US Retail sales 2015-06

Retail sales growth has slowed down into a range normally associated with recessions (see chart below). However, low inflation is partially to blame for this development (sales = price x volume):

US Retail sales 2015-06 chart

Real retail sales therefore do not look as bad:

US Real retail sales 2015-06

US Real retail sales 2015-06 chart

Retail sales are boosted by population growth. In order to normalize, we have to look at per-capita real retail sales:

US real per capital retail sales 2015-06

Real per-capita retail sales are below a level seen in October 2004 (!):

US real per capital retail sales 2015-06 chart

Auto sales, driven by low-interest and subprime loans, are a significant part of retail sales. Without them, retail sales are stagnating:

US Retail Sales xA 2015-06 table

Retail sales growth excluding autos has dipped deep into recessionary territory:

US Retail Sales xA 2015-06



Retail sales growth is being held back by lack of real income growth. Luckily for consumers, inflation is low. Durable consumer goods are benefitting from cheap and easily available financing. Should those benign conditions change, the consumer will have to cut back on spending. It is hard to see the Fed increasing interest rates under these circumstances. If it did raise rates nevertheless (as it is trying to telegraph to markets), it would be seen as a policy mistake. Therefore, the dollar might not strengthen, but weaken (counter-intuitively), as market participants would assume a swift reversal of any rate hikes. The US economy might even be pushed into another recession.

June NFP

US June non-farm payrolls (+223,000) came in roughly in line with expectations (+230,000). However, revisions over the past five months add up to -154,000. Each of the past five months has been revised downwards (something last seen during the 2008/09 financial crisis).

NFP 2015-06

No reason to sound the alarm, but definitely worth watching. Year-over-year, employment growth is still healthy at 2.1%.

The (more volatile) household survey even registered a decline in employment, especially in the private sector:

NFP 2015-06 HH

Visual inspection in historic contest does not (yet) reveal a change in trend:

NFP 2015-06 chart

However, revisions can be up to 300,000, so it is theoretically possible (though unlikely) the workforce shrunk in June.

The labor-force-participation-rate (employed population relative to working-age population) declined to the lowest level since 1977:

LFPR 2015-06


The downtrend in LFPR seems to have resumed, which is obviously negative for overall income, consumption and therefore GDP:

LFPR 2015-06 table


Hard to believe, but the US and Greece had the same change in employment since the year 2000:

employment Greece vs USA

Hourly earnings and hours worked were flat in June (see below). It has happened before during the current expansion. However, with a decline of 0.8% from its previous peak the “weekly hours” indicator is already half-way towards triggering a recession warning (from -1.5% on). So this, too, needs to be watched:

hours and earnings 2015-06

Finally, ISM and capital goods orders were quite soft:

ISM 2015-06


CONCLUSION: The Fed won’t be able to raise rates in this environment. This could weaken the US Dollar and strengthen the Euro (together with gold).

Tsipras announces referendum on bailout

From FT’s Peter Spiegel:

“Alexis Tsipras, the Greek prime minister, has announced a national referendum on whether his country should agree to creditors’ demands that would release desperately-needed bailout aid to avoid national bankruptcy.

In a televised address to the nation after a late-night meeting of his cabinet, Mr Tsipras announced that the plebiscite would be held on July 5, a week on Sunday.

Mr Tsipras was unenthusiastic about the referendum, saying the creditors’ proposal was “blackmail” and an “indecent proposal”. But he said he would abide by the will of the Greek people as to whether to accept the agreement, presented at a meeting of eurozone finance ministers on Thursday.

In a sign of how tendentious the vote will be, Panagiotis Lafazanis, the leader of the hard-left group in Mr Tsipras’ governing Syriza party, announced he and his faction would not support a “yes” vote.”

This is the logical outcome of the situation Tsipras is in: if he accepts the Troika’s austerity measures he would break election promises (and would likely be blamed by his people for continued economic malaise). If he does not accept, Greece would likely face bankruptcy, a collapse of the banking system with subsequent loss of most (remaining) savings deposits.

So the “easy” way out is to ask the people. This way, nobody can blame Tsipras for the outcome. A smart move. And he waited until the very last minute, so he can claim to have gotten the “best and final” offer from Troika. It’s “take it or leave it”.

Here is the full text of Tsipras’ speech:

My fellow Greeks,

For the past six months the Greek government has been giving battle in conditions of unprecedented economic asphyxiation, to implement your mandate, of Jan. 25. It was a mandate to negotiate with our partners to end austerity and to restore prosperity and social justice to our country.

(It was) for a viable agreement which would respect both democracy, common European rules and would lead to a definitive exit from the crisis.

Throughout this negotiation period, we were asked to adopt bailout agreements which were agreed with previous governments, even though these were categorically condemned by the Greek people in the recent elections.

But we did not, even for a moment, contemplate yielding. That is, to effectively betray your own trust.

After five months of tough negotiations our partners, unfortunately, concluded at the Eurogroup the day before last with a proposal, an ultimatum, to the Hellenic Republic and the Greek people.

An ultimatum which contravenes the founding principles and values of Europe. The value of our common European structure.

The Greek government was asked to accept a proposal which accumulates unbearable new burdens on the Greek people and undermines the recovery of Greek society and its economy, not only maintaining uncertainty, but by amplifying social imbalances even further.

The proposals of the institutions include measures which lead to a further detribalization of the labor market, pension cutbacks, new reductions in public sector salaries and an increase in VAT on food, eateries and tourism, with an elimination of tax breaks on the islands.

These proposals clearly violate European social rules and fundamental rights to work, equality and to dignity, proving that the aim of some partners and institutions was not a viable and beneficial agreement for all sides, but the humiliation of the entire Greek people.

These proposals prove the fixation, primarily of the International Monetary Fund, to tough and punitive austerity.

It makes it more imperative than ever that leading European forces rise to the occasion and take initiatives which will draw a line under Greek debt, a crisis which also affects other European countries, threatening the future of European unification.

My fellow Greeks, we are now burdened with the historic responsibility, (in homage to) to the struggles of the Hellenic people, to enshrine democracy and our national sovereignty.

It is a responsibility to the future of our country. And that responsibility compels us to answer to this ultimatum based on the will of the Greek people.

A while ago I convened the cabinet, where I suggested a referendum for the Greek people to decide in sovereignty.

The suggestion was unanimously accepted.

Tomorrow the plenary of the Greek parliament will convene to ratify the proposal of the cabinet for a referendum next Sunday, July 5, posing the question of the acceptance or rejection of the proposal by the institutions.

I have already communicated my decision to the President of France and the German Chancellor, the President of the ECB, while tomorrow in correspondence to the EU leaders and institutions I will formally request a few days extension of the (bailout) program so the Greek people can decide, free of pressure or coercion, as is dictated by the Constitution of our country and the democratic tradition of Europe.

My fellow Greeks,

To this blackmail-ultimatum, for the acceptance on our part of a strict and humiliating austerity (proposal), and with no end to it in sight nor with the prospect of allowing us to ever stand on our feet economically or socially, I call upon you to decide sovereignly and proudly, as the history of Greeks dictates.

To this autocratic and harsh austerity, we should respond with democracy, with composure and decisiveness.

Greece, the cradle of democracy, should send a strong democratic answer to Europe and the world community.

I am personally committed to respect the result of your democratic choices, whatever those may be.

I am absolutely certain your choice will honor the history of our country, and send a message of dignity to the whole world.

In these crucial hours, we must all remember Europe is the common home of its people. There are no owners or guests in Europe.

Greece is, and will remain an indispensable part of Europe and Europe an indispensable part of Greece. But Greece without democracy is a Europe without identity or a compass.

I call upon you all to take the decisions worthy of us.

For us, future generations, for the history of Greeks.

For the sovereignty and dignity of our people.

Tsipras does not mention the consequences of a “no” vote. Instead, he speaks a lot about “sending a strong answer” to “autocratic and harsh austerity”, humiliation, dignity and sovereignty. He refrains from making any recommendation, but I think it is clear which outcome of the vote he favors.

The outcome of the referendum is uncertain. Most likely, it depends on which faction is more successful in motivating its supporters to show up at the ballot boxes. Is the fear of losing the Euro stronger than the indignity of accepting more austerity? Usually, when people suffer, those who are against something are more motivated than those in favor.

What about the EUR 1.5bn due to the IMF on June 30th? Greece is unlikely to pay, and Tsipras has asked the Troika for a few extra days of leniency (which they have little reason to refuse).

There is some discussion if this constitutes a “fiscal matter” and hence would not be eligible for referendum according to article 44 (so we could end up in high court if a legal battle breaks out):

Article 44

There are reports on long lines at ATM’s (automated teller machines) in Greece to withdraw cash. Lines began to build shortly after midnight, immediately after the announcement of referendum. This will put more strain on the Greek banking system. The ECB will be forced to increase ELA (Emergency Liquidity Assistance) on Monday (unless it wants to be blamed to have pulled to trigger). The ECB has announced a conference call for Sunday (to assess the amount of cash outflows I assume). So far, Greek banks are planning to open on Monday, without any capital controls.

The ECB could, however, demand daily withdrawal limits in exchange for increasing the the ELA limit. But what if Greece refuses to enact those limits?

The last time Greece intended to hold a referendum (2011) it was killed by the EU within a week:

2011 referendum killed

While still a possibility, I don’t think the Greek people would take such a development lightly at this stage.

Could the referendum be cancelled by Tsipras? Only if the Troika agrees to a significant cut in Greek debt. This was a main request by Greece. It is a sensible request, since Greek debt-to-GDP is at 174%:


Even with a (proposed) budget surplus of 3.5% per annum it would take until the year 2047 for Greece to meet the Maastricht criterion of 60% debt-to-GDP. You simply cannot tell an entire generation their working life will be “lost” in order to pay back other countries’ taxpayers.

You cannot even blame Greece for not having cut government spending. It cut, by far, the most out of all European countries:

Greek spending cuts

Compare to Italy, whose debt-to-GDP ratio is now (132%) already above the point where Greece was when the crisis began (127%):

Italy spending cuts

The problem in Greece is that it lost around one quarter of GDP since the peak:

GDP various


That is a depression. Adding severe austerity onto a depression is plain stupid.

For a detailed account on what went wrong in recent debt negotiations you may want to read The Greeks deserved better than this by Nick Malkoutzis at MacroPolis.

For financial markets, this development will come as a surprise. The VIX (volatility index) is near the bottom of its range over the past 6 years. It won’t be on Monday:

VIX 2015-06-26

Demand for portfolio insurance will increase, making options (both puts and calls) more expensive. Rising volatility usually goes in hand with falling stock prices (chicken and egg question applies).

The Troika might have taken comfort in the fact that, so far, no contagion to other PIIGS (for example Spain, Italy and Portugal) was visible. This might change now.

It will be interesting to see what kind of scare tactics EU politicians will resort to in order to convince Greek people not to vote (or vote in favor of Troika’s proposal). Let’s hope that violence does not feature among those tactics.

Choices faced in referendum, as seen by Greek newspaper Kathimerini:

Greek referendum choices


Bank Jog

The Wall Street Journal called recent deposit outflows from Greek banks a “bank jog” (as opposed to “bank run”). A bank run usually leads to affected banks running out of cash quickly (within days or hours). The Greek banking system has been bleeding deposits since years. But the movement has been accelerating last week:

Greek deposit outflows week of 2015-06-15-19

If those numbers (from “sources” in Greek banking industry) are correct, almost EUR 5bn left during last week. At this pace, 20bn could leave within a month, the most ever:

Private sector deposits and monthly change - VERY GOOD

What are the chances of avoiding a default and exit from the Euro?

Germany has had no problem sending EUR 100bn a year for 20 years to former East-German states to pay for reunification. Among German states, a “Laenderfinanzausgleich” regulates transfer payments from rich states to poorer states. Fortunes change, as Bavaria once was a recipient of payments. It has now turned into a net payer.  In the US, some states are net payers, others are net receivers of federal funds. A union of any kind can only survive if the stronger are ready to support the weak.

German tabloid BILD is constantly trying to pitch public opinion against Greece. Recent examples:

Ihr Pleite-Griechen - BILD

(“Why don’t you sell your islands, you bankrupt Greeks … and the Acropolis, too!”

Nein - keine weiteren Milliarden fuer die gierigen Griechen - BILD 2015-02-26b

(BILD readers are encouraged to take selfies with the headline “No! No more billions for those grabby Greeks!” and email / send it online)

BILD is trying to convey that Germans are required to pay for lavish Greek early retirement.

So I searched for evidence for those claims. If a lot of Greek workers retired early, there should be an elevated level of retirees compared to overall population. The facts:

Pensioners per population

Germany has a much higher proportion of pensioners than Greece (average population age, while omitted here,  even works to the detriment of Greeks).

So are Greek pension payments more generous than others? Here are “social protection expenses” from Eurostat:

Social protection expenses per inhabitant

Again, Greece scores below average and way below Germany. If elevated social costs per inhabitant were detrimental, Switzerland should be in a bad shape.

Affordability is, of course, a completely different question. If your real GDP declines by 25% and your unemployment rate goes above 25% (leading to less taxes paid and higher expenses) any government budget would become unhinged.



Yes, Greek pension payments may not be sustainable on the basis of current government revenue, but this is not a function of too generous pension payments. It is a function of a severely shrinking economy, sucked dry by extreme austerity.

Why would some media love to see Greece (and the Euro) fail? A successful Euro would marginalize the British Pound further. Today, the European Union of 28 countries counts 506 million inhabitants – 57% more than the United States (321 million). Combined with cheap Russian gas the resulting economic powerhouse could threaten the dominance of the US.

ECB and IMF had hoped that a run on Greek banks would turn violent, possibly lead to military deployment and fall of the current government. But, so far, the plan has not worked.

The situation is on the knife’s edge. I don’t think the Greek government will blink. So unless the EU, ECB & IMF blink, Greece will limp along, and simply not pay the EUR 1.6bn due to the IMF on June 30. There is nothing the creditors could do (unless they want to begin confiscating Greek assets abroad). I will be the first rebellion of a Euro-zone member against Troika-prescribed austerity. This will lead to envy in other countries. Given mismanagement of the debt crisis from the very beginning, European institutions have only themselves to blame.



Count-down to Grexit?

The ECB has painted itself into a corner. The table below is quite good. In the left column you see that customers have withdrawn around EUR 40bn from Greek banks since October 2014 (almost a quarter of all deposits). Capital flight is in full bloom. The ECB is keeping the Greek banking system alive by increasing Emergency Liquidity Assistance (ELA) every week. The increases correspond to the decline in deposits. Effectively, the ECB is enabling and financing capital flight.

Meanwhile ELA has reached more than 50% (!) of all Greek deposits. If depositors needed to be “bailed-in” (as in Cyprus) there won’t be much left:

Greek deposit flows and ELA caps


A Grexit now would not come handy for the ECB, as EUR 7bn were scheduled to be repaid by Greece over July and August:

Greek debt maturities by creditor 2015

But is that really what matters? Or could it be that a Grexit now is finally ‘allowed’, after most Greek debt has been moved from the banking sector onto public creditors (= taxpayers)?

Sozialisierung Schulden Griechenlands

(red = private sector share, grey = public sector share of Greek debt)

A Greek default would be embarrassing for ECB, Euro-zone and the IMF, but is this how those institutions think? A default doesn’t mean they have to find additional funds to send to Greece; on the contrary – default means doing nothing. Nobody would have to fear any votes in national parliament or court challenges. So maybe it is the path of least resistance.

Let’s assume there is no agreement by Friday. Greece defaults, the ECB cuts off ELA, and Greece refuses to enact capital controls. Could the ECB cut off Greece from TARGET2 (the inter-Euro-zone payment system)?

Article 63 TFEU (Treaty of the Functioning of the European Union) states that any restrictions on capital movement are not allowed:

Art 64 TFEU

However I am sure politicians will find ways how to break the rules, once again.

Meanwhile, contagion is in full force. The yield on Spanish 30yr government bonds surged from 1.87% to 3.57%:

Spain 30yr 2015-06-16b

The 20-year Portuguese bond does not look better:

Portugal 20yr 2015-06-16

Volatility is going to increase further ahead of the weekend. Since nobody knows what is going to happen it is rational to bid up the prices for both calls and puts (so you are positioned for either outcome). This increases implied volatility, which makes insuring your portfolio against losses more expensive. Usually equity markets fall in times of increasing volatility (unclear which one is chicken and which one is the egg).

Fasten seatbelts

Someone would like to see Greece burn

After the close of European equity markets the Sueddeutsche Zeitung ran the following story:

SZ - Notfallplan

Without naming sources, the newspaper claims Euro-Group had decided on an emergency plan for Greece, which would include capital controls.

Which is nonsense, since only Greece can decide on capital controls. Greece, of course, denied having such plans:

Reuters - denial

By refusing to deny the report, the German government actively encouraged speculation.

Such reports, placed in the media by Euro-Group people without doubt, serve only one aim: incite capital flight from Greece, and thereby increasing the pressure on the current Greek government to agree to more austerity measures.

Any Greek saver still leaving his money in the Greek banking system after these reports must be asleep.

The ECB will have to further increase ELA (emergency liquidity assistance) on Wednesday unless it wants to see the collapse of the Greek banking system. Since EuroGroup only meets on Thursday, this seems unlikely. However, ECB has always said that ELA is conditional on Greek banks remaining solvent, and further financial aid flowing to Greece. Should EuroGroup decide on Friday that Greece does not offer enough reforms in order for further financial help, the ECB should, consequently, declare an end to ELA. This would lead to a complete collapse of the Greek banking system, with the remaining savers losing most of their deposits as they are being bailed-in (as seen in Cyprus). This would be quite unpopular and come to haunt the current government.

ECB and EuroGroup seem to bet on the idea that the Greek government would not opt for political suicide; however, agreeing to more austerity measures might also make it impossible for Syriza to survive politically.

It seems we have reached the end of the road, and the can cannot be kicked down the road any further. There is a non-trivial chance Greece will not budge, and the ECB will pull the plug. In order to avoid a collapse of the banking system, Greece would need to switch to a new currency immediately.

Contagion is already visible in government bond spreads of Portugal, Italy and Spain:

10yr spreads 2015-06-15

It is dangerous to assume a “Grexit” is priced-in and would not lead to serious repercussions in financial markets.

EU-Greek talks end without deal

  • After the IMF left negotiations with Greece, the EU also declared Sunday’s talks to have failed after a brief 45-minute meeting
  • According to the EU Commission, a gap on fiscal measures was around EUR 2bn (1.1% of GDP) annually remains. That’s not huge, and probably not worth leaving the Euro-zone for, but who knows if that is the full story
  • “Further Greece discussion will now move to EuroGroup” (next meeting of finance ministers from the Euro-zone is on Thursday, June 18)
  • Greek side claims it was Juncker who walked out after saying he didn’t have authority to make any concessions regarding fiscal gap
  • With IMF and EU/EuroGroup potentially at the end of their patience, the only thing keeping Greece afloat is the ECB. When the ECB loses patience it will look like this (Cyprus):

ECB put deadline on Cyprus

  • ECB could easily put an end to the drama by issuing a similar deadline. As long as it doesn’t, there is still hope.
  • On Wednesday (June 17) the ECB will decide on ELA (emergency liquidity assistance) and haircuts for sovereign bonds
  • Peter Spiegel (FT) was able to get the following classy comment:


  • According to Der Spiegel, quoting FAS, Greece proposed cutting 2% of GDP in military spending (instead of cutting same amount from pension payments). Apparently, this caused “grave differences” between the IMF and the EU Commission.

Greece - schwere Differenzen


  • Germany benefits most from Greek military orders; it is not clear to me why the IMF would oppose such proposals. Greece has always been spending a lot of money on defense (in relation to GDP). This can be explained by the need to be able to defend more than 6,000 islands, many of which are located directly in front of its main adversary, Turkey.

greece turkey map2

  • Greece could, theoretically, block all maritime traffic through the Bosphorus.
  • Look at the Greek island of Kastellorizo (Meis), 2 km away from Turkey mainland, but 570 km away from Athens:


  • The Turkish invasion of Cyprus (1974) after a Greek military coup didn’t help either.

Greece defense spending pct GDP

  • Defense spending in both countries is about twice the level in the EU and seems to be correlated:

Greece defense spending pct GDP chart

  • The US has openly asked European members of NATO to increase military spending to 2% of GDP as a “response to Russian aggression in Eastern Europe”. The IMF, as a US-influenced organization, might have orders not to touch military spending. Being forced to cut pensions in order to be able to continue weapons purchases might be the straw that breaks the camel’s back.

CONCLUSION: In the end, the ECB decides over life and death of the Greek banking system. Wednesday’s ELA decision, together with FOMC meeting, might make for a volatile week in financial markets.