Category Archives: Bond Market

Mental contortions of a printing machine operator

“We never pre-commit” is the standard answer the ECB (European Central Bank) has for anyone asking about future interest rates (journalists regularly waste one of their two permitted questions at ECB press conferences).

Why should central bankers not indicate future interest rates decisions? Because market participants will price that information accordingly, so the announcement would have no or even a counter-intuitive effect on markets. This could potentially undermine the central bank’s credibility.

If central bankers want to keep their ability to influence asset prices, they need to keep markets guessing about future actions.

What on earth then is the Federal Reserve (“Fed”) doing?

The FOMC (Federal Open Market Committee) published where every member sees interest rates for the next three years and when they expected the first interest rate increase (see below):

What the heck?

This not only takes any element of surprise away; it also puts “outliers” under the spotlight and enhances groupthink (who wants to be the one that leaned out of the window and was  completely wrong?).

Forget all the official statements. Forget anything you read in the “financial press”.

The Fed is printing money (“quantitative easing”) in order to achieve two goals:

1. Finance the government deficit

2. Cheapen the dollar (to help exports).

But how can you justify printing money when inflation is running at 3%, especially when you adopt an inflation target of 2%?

The Fed came up with a great plan: forecasting inflation of 1.6-2.0% for 2014 (at or below its new target) enables it to claim there is “danger of missing the target”. Hence printing more money is “required”.

In order to paint a picture of a weakening economy, the Fed starts out with elevated estimates for GDP growth, only to be able to reduce them at an opportune time.

The Fed now sees 2012 growth at 2.2-2.7%, down from 2.5-2.9% in its November forecast.

How Bernanke & Co. are able to predict inflation in 2014 when they couldn’t see a bursting housing bubble six months ahead is anybody’s guess.

The other benefit of forecasting (close to) zero percent interest rates into 2014 is the following: the Fed “sits” on the yield curve, depressing it as far out as possible by making markets price in available information. Euro Dollar futures have reacted and are now pricing in rates of less than 0.15% until the end of 2014:

This translates further into longer-dated bonds, depressing their yields. The Fed makes it easier for the government to pay its debt. If you pay zero interest on your debt (and assuming you can roll it over indefinitely) it has absolutely no effect on your budget. It is as if the debt didn’t exist (see How Dr. Ben Copperfield makes trillions disappear ).

All the pseudo-scientific yada-yada on economic theory are just hollow bones thrown to journalists and pundits to have something to “chew” on and write about.

The only thing that matters is the monetization of more and more government debt, and how to sell it to the public.

Paul Krugman would argue that despite all the “quantitative easing” inflation has not really picked up. At zero percent interest rates, money has no preference – there is no opportunity cost of just “lying around” without interest. Investing money for 4 years for 0.15% return is not “riskless return” – it’s “return-less risk”. Perversely, the Fed has created a situation where raising interest rates would probably lead to inflation. It is boxed into ZIRP (zero interest rate policy) for infinity.

Things will get serious once the Fed adopts a policy called N-GDP targeting. Instead of inflation, the Fed will try to “target” nominal GDP. If real GDP growth is zero, the nominal GDP growth will be made up entirely of inflation. Debt is a nominal unit, and it is supported by nominal GDP. In order to keep the ratio between GDP and debt halfway bearable, GDP must be inflated. It is a tax on everybody holding dollars, since the value of those will decline.

Meanwhile, the Japanese are resorting to stealth interventions to break the Yen’s strength.    Currency wars have gone from “cold” to “hot”. The Fed’s printing of dollars is forcing other central banks to purchase them and selling their own currency in the hope of stemming their own currency’s rise. This makes them involuntary buyers of Treasury bills and bonds, making it easier for the US government to finance its deficit.

This, of course, will end badly. When the public loses confidence in paper currencies, barter trade and new, gold-backed currencies will be the only solution. “There is not enough gold” will the skeptics say, but it is only a question of price.

“Nobody understands debt (but me)”

Luckily they are easy to spot: the demagogues, the manipulators and the hired claqueurs. Unfortunately, there is no lack of media willing to provide a platform to perform their insidious game.

Take Nobel-prize wielding economist Paul Krugman. In an article for the New York Times (“Nobody understands debt”) from January 1, 2012, he writes:

“Through most of 2011, as in 2012, almost all of the conversation in Washington was about the allegedly urgent issue of reducing the budget deficit.”

His opening gambit: a reduction of the budget deficit is not an urgent issue. Really? The US has reached 100% debt-to-GDP, and each year another 10%-points get added to the pile. Those $15 trillion exclude a vast array of debt from quasi-governmental organizations (FannieMae, FreddieMac, etc) and unfunded liabilities (Medicare, Social Security, Veterans’ benefits) resulting in a total debt of $61.6 trillion, as per the Heritage Foundation. This explains Krugman’s disdain for the institution, as we will see below. He continues:

“This misplaced focus said a lot about our political culture, in particular about how disconnected Congress is from the suffering of ordinary Americans.”

Krugman tries to portray those who are trying to save the country by reducing spending as heartless and mean-spirited people, when those attributes should apply to those who applauded spending future generations’ taxes to the point of collapsing the financial system. To add insult to injury:

“When people in [Washington] D.C. talk about deficits and debt, by and large they have no idea what they’re talking about.”

He brings out the “I know better – I have a Nobel prize” argument. And the reasoning:

“Perhaps most obviously, the economic ‘experts’ on whom much of Congress relies have been repeatedly, utterly wrong about the short-run effects of budget deficits. People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now! And while they’ve been waiting, those rates have dropped to historical lows.”

This is right in line with those people who, back at the height of the housing boom, ridiculed anyone warning about dangers of a possible fall in housing prices. Only because riding your bike with your hands up in the air went smoothly for 10 seconds doesn’t mean you will make it in one piece over the pothole. Krugman’s rhetoric matches that of a mayfly rejecting the possibility she might die at the end of the day because so far the sun has never set during its life.

Could the international financial crisis have led to a flight to safety into US Treasury bonds? Could the trillions of Fed buying have helped? Could the largest non-official buyer of Treasuries (Cayman Islands) be hedge funds looking for a cheap way to “hedge” stock market risk, because, in a twisted way, they rely on negative correlation between stocks and bonds (if one goes up, the other one goes down) to continue ad infinitum? Where else are the Chinese going to put their trillions of foreign exchange assets accumulated by holding the Yuan down? In the crumbling Euro? Back to mayfly Krugman:

“For while debt can be a problem, the way our politicians and pundits think about debt is all wrong, and exaggerates the problem’s size.”

If anything, the size of the debt problem is underestimated. It is amazing to see how the problem (too much spending leading to too much debt) is being turned around 180 degrees into “the problem is too little spending”.

“Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing.”

Paying back debt doesn’t impoverish; spending money you don’t have does. But Mayfly doesn’t relent and tries to spell it out in simple terms for the average American:

“They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments. This is, however, a really bad analogy in at least two ways. First, families have to pay back their debt. Governments don’t – all they need to do is ensure that debt grows more slowly than their tax base.”

Exactly. Let’s look at how US GDP and debt have developed over the last 46 years:

Debt caught up with GDP, reaching 100% in Q4 2011. Debt (taking only the “on-the-books” part) is growing faster than GDP.

Over the last three years, US debt has grown by roughly $4 trillion , while GDP has grown only by $1 trillion. One additional dollar of debt has led only to 25 cents additional GDP. This is the “marginal utility of debt” (how much you get out of an additional dollar of government spending). At elevated debt levels, debt service (interest and redemptions) carves out an increasingly high share of tax revenue, leaving less for productive uses.

The lower chart shows rolling 3-year periods for growth in GDP and debt as well as the resulting ratio (marginal debt utility). It has almost reached zero. Granted, the increase in government debt has partially been “diluted” by a deleveraging of the private sector. Still, 2012 will be the fourth year in a row with a budget deficit exceeding $1 trillion. Continuing this pace, combined with a marginal debt utility of 0.25 would get the US to a Greece-like 143% debt-to-GDP ratio within 9 years. But Mayfly tells us we don’t understand.

“We need more, not less, government spending to get us out of our unemployment trap. And the wrong-headed, ill-informed obsession with debt is standing in its way.”

How can a Nobel-prize carrying economist, who is presumably smart, write such nonsense? “He knows better”, says Jim Rickards (author of “Currency Wars”). And that makes Krugman so dangerous. Decision makers will reference his “debt does not matter” mantra over and over again – until it’s over. Thank you, Mayfly. You really understand debt – and how to make others believe it doesn’t matter.





The ghost of the Bundesbank haunting the halls of Brussels

In his book “More money than God”, Sebastian Mallaby describes how George Soros received a signal from Helmut Schlesinger (president of Bundesbank at that time), to go ahead and speculate on a devaluation of the Italian Lira and the British Pound.

Germany had enjoyed a boost from the integration of Eastern Germany, which, partially due to a generous 1:1 exchange offer for the Eastern German Mark, led to unacceptably high inflation. Despite numerous warnings from the Bundesbank, fiscal policies did nothing to reign into the growing threat to price stability. Seeing its advice ignored, the Bundesbank fought back and raised its discount rate all the way to 8.75%.

This caused problems for other European countries, who were forced to follow the Bundesbank unless they wanted to risk a weakening of their currencies. They had to apply a restrictive monetary policy despite their own economies just recovering from the recession of the early 90’s.

According to Mallaby, British finance minister Lamont had insulted Schlesinger at a meeting, trying to extract a promise to cut German interest rates. Despite Schlesinger’s refusal, Lamont led the press to believe Schlesinger had made concessions.

The “payback” didn’t wait for long; Schlesinger publicly denied any intention of cutting rates. He also expressed low confidence in the fixed relationships among European currencies, particularly the “unsoundness” of the Italian Lira.

This was the go-ahead for George Soros to attack the European Exchange Rate Mechanism. Mallaby:

“Schlesinger’s answer was as clear as Soros could have wished for. The Bundesbank was open to the idea of monetary union, but not at any price. It’s first priority was to preserve the proud tradition of the inflation-proof Deutsche Mark, and if other economies could not stomach the austerity this implied, well, then they should devalue.”

“Soros suspected that Schlesinger would be perfectly content to see his hard line on inflation sabotage the plans for European monetary union, since that union would involve the creation of a European central bank, which would supplant the Bundesbank.”

“All bureaucracies are motivated by self-preservation, Soros reflected, and Schlesinger, a career Bundesbank official, was surely the personification of this tendency.” 

Ironically, 20 years later, a similar setup emerges, albeit with (so far) fixed exchange rates. While Germany enjoys the lowest unemployment rate of the last two decades, its European trading partners are re-entering into recession.

In the run-up to the umpteenth Euro-summit last week, most market participants expected the ECB to “reward” politicians with the long-awaited “all-in” action of purchasing increasing amounts of PIIGS government debt.

If you haven’t done so, I recommend listening to the ECB press conference Q&A session (16 minutes into the webcast). Draghi expresses surprise about market expectations the ECB would step up bond purchases after the summit. Draghi subsequently repels any attempt at extracting any concessions whatsoever.

Minute 36: “Why is it so impossible for the ECB to act like the other central banks? –” We have a treaty: price stability and no monetary financing”

Minute 59: “Why wouldn’t it be okay for Euro-zone central banks to lend to the IMF?” – “I think each central bank has its institutional set-up. The primary mandate of the ECB is price stability. In the US the primary mandate of the Fed is completely different from us. Same is for the Bank of England”.

Draghi left no room for ambiguity or interpretation. Every single attempt to extract some hope of monetary creation was cut up, diced and discarded. It couldn’t have been clearer. Draghi mentioned the “principles of the Bundesbank”. The spirit clearly lives on. Those that claim the Bundesbank intentionally encouraged speculators to attack the British Pound in order to expel it from the European Exchange Rate Mechanism in 1992 might find another example of “creative destruction” in front of their disbelieving eyes.

How this could be good for equities (Friday’s rally) is a mystery to me. But then again, the S&P 500 celebrated a new all-time high in October 2007, mere four weeks before the official start of the “great recession”.

The answer to the question “why would the Bundesbank intentionally crash the Euro” lies in the TARGET2 system of intra-Euro central bank payments. Izabella Kaminska of FT Alphaville describes how the Bundesbank has run out of assets to sell in order to fund other Euro-zone central banks. This in itself is quite amazing. The Bundesbank and the Dutch Central Bank seem to be financing the entire Euro-zone central bank system. As the music stops, the Bundesbank is taking away all chairs at the same time.

Merkozy are still trying to save the Euro by severe austerity at the last minute, but it is too late. Financial markets have already revolted and put countries in various buckets via yield curve “triage”:

The ghost of the Bundesbank has reappeared, this time under the disguise of an Italian. Ignore its powers at your own peril.






The (Euro) answer, my friend, is showing in the bond market

Politicians and non-elected maquinistas are still trying to figure out how to make the still-borne EFSF (European Financial Stability Facility) walk, or better, fly. A month after the “miracle of Cannes”, the trumpets of victory over the debt crisis have fallen silent. Instead, the first EFSF bond issue after the G20 summit ended up in disaster (reduced, postponed, not fully placed).

If you thought this experience was a lesson on how not to fight a debt crisis you were wrong: more debt, leveraged via a complicated structure, insured by itself, completely unfunded. Peter Tchir made the effort to go through the “EFSF guidelines”; his verdict: “beyond comical”. I am getting tired of hearing about new “miracle cures” every other day. It is such a waste of time. Like a pal, who, every other weekend, wants to introduce his “new” girlfriend and you wonder if it is worth to be nice and strike up a conversation.

The house is on fire, but politicians are discussing if buying a second dog would make the property safer, and what kind of collar it could possibly wear.

Should we believe ECB’s Noyer when he says (11/28) “The economic situation in Italy is not that bad”? Why then, may one ask, did Italy prefer not to release its Q3 GDP data (was scheduled for 11/16)? Is the third-largest government bond market on earth wrong in yielding 7-8% across the curve?

No, it is “not that bad”. It is horrible.

Take the rumor about EUR 400-600bn IMF help for Italy (strategically leaked on a Sunday). What does it say about Europe if the IMF has to bend over backwards to bail out one country for 12-18 months?

It says: “Europe is bankrupt and cannot save itself”.

Remember the latest product innovation from the IMF, announced not even a week ago? “Credit lines” of 500% of a country’s quota. Spain and Italy would be able to receive $30-60bn – a joke in the big scheme of things.

The program was already obsolete a few days after its inception. This is how fast the fire is burning through the attic – and the owners are still sleeping.

If the EUR 600bn for Italy materialized, Spain would feel entitled to some help, too. But Italy has first-mover advantage. Hence the ominous warning from the incoming Spanish government to “mull financial options without ruling out an application for international aid” (11/22).

Once Italy and Spain fed at the trough, it will be empty. The poor Portuguese will be left behind, as it will be every man for himself.

Greece has been reduced to a mere side-show. The only question being if the next tranche (EUR 8bn) will be paid out before Greece declares a “temporarily suspended debt service” on December 16 as EUR 12bn of debt matures. Even assuming the EU/IMF help flows, the cash drain, together with a monthly fiscal deficit of 1bn+, would be 5bn.

As usual, the bond market has already an idea on how this will pan out. Looking at various yield curves we get the following picture:

  • Greece is “off the chart” (in the “toast” zone)
  • Portugal will not make it as debt and interest is not sustainable and the EFSF struggles to raise bailout funds.
  • The “soft Euro-zone” could survive by aggressive monetization of debt by the ECB – once the German hardliners quit. Inflation would probably follow in a few years, but that is another question.
  • The “hard Euro-zone” would consist of Germany and the Netherlands. They unilaterally quit the Euro-zone and introduce a pegged currency pair.
  • France is really the only unsolved question in this puzzle. Bond yields have peeled away from Germany a bit too far. Historically, France was a “soft” currency country with frequent realignments of exchange rate under the European ERM (Exchange Rate Mechanism). Given the strong political ties France will probably be forced to stay married to Germany, but it will be an unhappy marriage, with an eventual break-up at a later date.
  • I have included Hungary just out of curiosity, since their love-hate relationship with the IMF is slightly entertaining.

Sometimes I get the impression Germany’s insistence on austerity is in fact an attempt to escalate the crisis. The Euro-summit on December 9 will bring treaty changes that allow countries to exit the Euro. Everybody assumes this is to “punish” deficit offenders, when, in fact, it is Germany’s carefully crafted exit from the Euro-zone.

The remaining countries will be free to print their way out of looming insolvency, albeit at the price of having to figure out who will pay for the substantial losses on PIIGS bonds parked at the ECB.

Germany will see its currency gradually strengthen, and temporarily suffer from declining exports, but Germany has lived well with a strong currency before. The alternative, a complete melt-down of the Euro-zone, is definitely less appealing.

The Euro Fiasco Suicide Formula (EFSF)

There is one simple rule for investors: avoid all things beginning with “Euro-“. Eurotunnel ended in bankruptcy. Eurodisney was a disaster for public shareholders. And so the Euro itself is following the same path.

“Euro” birds

European politicians are faced with one problem: none of their plans to end Europe’s debt crisis has worked. Absolutely nothing. Which is not that surprising – since when does adding debt solve a debt problem?

Fishing in Lake Acronym yielded only meager catches like SGP (“Stability and Growth Programme”, a paradox), SMP (“Securities Market Programme”, which has less to do with market than with manipulation), and, finally, the bazooka: the EFSF (European Financial Stability Facility).

“Stability” sounds good, and “Facility” leaves the uninitiated in the dark as to whether this is another debt pyramid and who will ultimately foot the bill.

The idea behind the EFSF must be so good the agency wants to keep it to itself and prefers not to shed light on the mechanism behind it. Based on leaked drafts and comments in the press it could look like this:


  1. Since Germany successfully repelled French demands for an EFSF banking license creative minds found ways of leveraging the (non-existent) funds.
  2. The original EFSF capacity was EUR 440bn; 150bn already went to Greece, Ireland and Portugal. After 40bn inexplicably vanished, 250bn are left.
  3. EUR 250bn is nothing compared to the funding requirements of Italy and Spain; hence it needs to be “leveraged”.
  4. The EFSF would invest those 250bn in the “equity” (or high risk) tranche of a “Special Purpose Vehicle”. Governments, the IMF and Sovereign Wealth Funds (SWF) are supposed to gobble up the 500bn “mezzanine” (or medium risk) tranche. Together with a 250bn “low risk” tranche the SPV would have EUR 1 trillion in firepower.
  5. This firepower is then used for purchasing “PIIGS” government bonds in primary and secondary markets. Some small change (EUR 106bn) would even be left over to recapitalize the entire European banking system.
  6. To entice investors formerly burnt in PIIGS bonds to repeat their mistake, the SPV would issue “partial protection certificates” (PPC). Those PPC’s are in fact credit default swaps, but since politicians have blamed the latter for the consequences of their own actions they had to come up with a different name.
  7. Credit default swaps (unless the gods at ISDA decide otherwise) at least pay out the difference between par (100%) and the recovery value. PPC’s would cover only a limited amount (20%, for example). Because, you know, a sovereign default wouldn’t be that bad. Greece, of course, is unique and an exception. Right; so unique that RBS wrote down its Greek holdings to 37 cents on the Euro.
  8. For the “unlikely” event of a default (a 1 in 3 chance for Italy and Spain over the next five years according to implied default probabilities) the PPC will pay out a small token (in appreciation of your stupidity) of consolation. Not in cash, however, but in EFSF bonds. This is usually referred to as “captive insurance”. It is akin to the agent selling life insurance policies on the already listing Titanic.
  9. Not only is the insurance circular, but so are the guarantees. Keep in mind that all the EFSF has raised to far is EUR 14bn (and that money is already spoken for). Initial “guarantees” of EUr 780bn have melted down to 726bn as Greece, Ireland and Portugal have “stepped out” (they can’t participate in their own rescue). In case of “step-outs”, the maximum guarantee is reduced and remaining countries have their share of guarantees increased. It’s a game of inverse musical chairs where the last one standing loses, not wins.
  10. The only AAA-rated countries left are Germany, France, the Netherlands, Austria, Finland and Luxembourg. The last three do not matter due to size. With the German-French 10-year government bond spread at 1.5% the market believes France is about to lose its AAA. That leaves Germany and the Netherlands, or 33% of the original guarantors. In case Italy and Spain need money, 30% of the guarantors would “step out”, at which point the self-insurance scheme collapses:
  11. Condolences go out to the poor souls who bought the first three issues of EFSF debt at minuscule spreads to swap rates. Official lenders like the IMF (and, until the “comprehensive plan to save the Euro-zone”, the EFSF) are not supposed to take haircuts as this could cause abdominal pains with innocent taxpayers in other regions of the world. Hence the “AAA” rating for the EFSF. But during the night of October 26/27, the beautiful EFSF butterfly went into reverse metamorphosis and emerged as an ugly larvae. “Last loss” became “first loss” participation. The risk profile had been changed by the stroke of genius. And it showed in the yield spreads to German government bonds:
  12. It therefore does not come as a surprise the EFSF had to first scale down, then postpone, then buy part of their own bonds during the recently failed auction. According to an investor presentation in August, the plan was to have 7 bond issues by the end of 2011 (3 for Ireland, 4 for Portugal). It looks like the recent (4th) might have been the final one.
  13. In a desperate move, Klaus Regling (CEO of EFSF) announced plans to raise money via short-term bills with maturities of less than a year instead. Lend long, borrow short – even bankers understand this is a recipe for disaster.
  14. There was an odd statement by Chancellor Merkel at the recent G20 meeting in Cannes: “Hardly any countries in the G20 have said to participate in the EFSF”. This struck me as odd, since it was the truth, and politicians are not known to tell the truth. Did Merkel suffer from the effects of an extended stay at the bar with Putin? Unlikely. This just does not fit the usual “we will do everything to save the Euro”-line. She could have said something like “I am convinced the EFSF bond issue will be fully subscribed; the demand is so high we decided keep the books open for a little bit longer”. But no, she chose to tell the truth. Maybe it had dawned on her that the EFSF was actually a formula for mass (financial) suicide and that Germany would be the one footing the bill in the end? The only way to “escape” being burdened with other countries’ debt is to “step out” of the circle of guarantors. This could actually hasten the financial crisis.
CONCLUSION: Italy and Spain are too big to be saved by Germany and the Netherlands. Merkels statement reveals a sudden “buyers remorse” by Germany. The EFSF is dead before any org-chart has seen the light of the day. All what is left to do for Germany is to play on time and to prepare for the exit from the Euro.

Mystery solved: ECB can’t afford the Greek barber shop

Whenever you come across a mystery in finance there always is an explanation. Like the question why the ECB would so ferociously resist any “haircuts” on Greek debt. Despite all the evidence that current debt, now expected to peak at levels exceeding most calculators’ capacity, is unsustainable.

Why would the ECB, the largest single holder of Greek debt, not set an example by accepting the 21% haircut orchestrated by the banking lobby in July? (In order to still reach the 90% acceptance rate, the ECB was simply to be excluded from the calculation). Instead, the ECB promised Sodom and Gomorrah in case of a haircut (“Greek restructuring would be a disaster” – ECB’s Bini Smaghi, July 20th).

According to this chart, the ECB holds (nominal) EUR 55bn out of a total of roughly EUR 350bn of Greek debt:

Now they didn’t buy it at par (100%), but, let’s say, at 70% or EUR 38.5bn. A 50% haircut would reduce the value to 50%, at a cost of EUR 7.7bn. And this is only Greece (the ECB has other fine bonds on its books; EUR 165bn in total). Marked-to-market, losses would be much higher.

Problem is, the ECB has only EUR 5.3bn in equity. Here’s the balance sheet at the end of 2010:

Source: ECB 2010 annual report

(By the way, 5.3bn equity supporting 163bn in assets makes for 30x leverage).

By the end of 2010, the situation (due to unrealized losses on PIIGS bonds) was so dire the ECB had to ask national central banks (NCBs) to double its equity to 10.7bn effective 12/29/2010. However, not all NCBs could or would afford their share, and so the payment was stretched over three years (as seen in those “three easy low payments” commercials). Only 1.1bn was paid in a first installment, the remainder due at the end of 2011 and 2012 respectively.

To make matters worse, the non-Euro NCB’s (among them the Bank of England) are not liable for any losses the ECB incurs (since they are not entitled to share any profits, for example from seigniorage, either). That would explain why some NCB’s were not too keen on coughing up the big dough at once.

The ECB is basically bankrupt and would need to ask NCB’s (and those in turn their governments) again for more capital. This would create lots of cheer as governments are already struggling to protect their ratings from falling.

Governments could try to extract concessions from the ECB in return for recapitalizing, endangering the little independence and credibility that is left at this stage.

Hence the ostrich strategy: pretend the Greek bonds are worth what they were purchased for (and the ECB’s equity is still there). And this explains the ridiculous fight against allowing Greece a fresh start.

Maybe it’s time to pull a “Jordan” and claim that negative equity doesn’t really matter for a central bank (“Does the Swiss National Bank need equity” – Thomas Jordan, Vice Chairman of the Governing Board of the Swiss National Bank, speech in Basel 9/28/2011:

Somehow, accounting tricks are not explained in the ECB’s educational material for students:

Portugal: fiddler paid, music stops

While Greece is pretty forthcoming with its apocalyptic fiscal data, the same cannot be said of Portugal.

When it comes to inquiring about monthly fiscal deficits you bite on granite. Banco de Portugal has limited quarterly figures. The “Instituto Nacional de Estatistica” has conducted a study about population growth in Angola. It supplies data series on important topics as the “self-sufficiency ratio of wine”, the “movement of passengers on inland waterways”, and, not to be missed, the “crude divorce rate”.

Impossible to find a simple table about the general government fiscal deficit, preferably by month. Maybe I was looking for something that does not exist. Maybe I am too impatient; after all, the numbers for 2009 and 2010 seem to be only “half-finalized”:

Souce: EDP (Excessive Debt Procedure) tables, Eurostat, October 2011

Let’s work with what we have: quarterly GDP numbers and the governments forecast of -2.2% GDP growth in 2011 as well as -1.8% in 2012:

Now on towards the fiscal deficit. 2010 numbers got bumped up a bit from the “Madeira”-effect (discovery of formerly undisclosed debt, a.k.a. the “Greek” maneuver). The deficit is supposed to decline from roughly EUR 17bn (2009 and 2010) to 10bn (2011e) and 7bn (2012e).

In May, shortly before receiving a EUR 78bn bailout, the Portuguese government trumpeted encouraging snippets regarding the state of the economy. “Fiscal revenues up 16.8% y/y in April” (May 20th). “January-through-April central government deficit EUR 1.55bn, 2.28bn less than a year ago” (5/20). The new government announced “to set an example of cutting spending in administration” and intended “to surprise, go beyond bailout terms” (Coelho 6/6).

The good news continued: “Central government deficit for the first five months of 2011 cut to 1.03bn”; “State spending fell 7.2%, revenues rose 6.9% in the period January through May” (June 20th).

With all those feel-good reports it was only fair for the EU’s Troika report on Portugal to be “very positive” (Baroso, June 23rd). The EFSF disbursed its funds to Portugal on June 29th.

However, as anybody who has ever visited a Hungarian coffee house can confirm, as soon as you pay the fiddler, the music stops.

After six months, “there was a shortfall of 1.1% of GDP in budget” (Finance Minister, August 12th). Wait a minute. According to the INE (Instituto Nacional de Estatistica) the budget deficit for H1 2011 amounted to 8.4% of GDP or roughly EUR 6.7bn. So we went from 1bn at the end of May to 6.7bn mere four weeks later?

Of course, the new government found a “colossal” EUR 2bn hole in the public accounts “left by the outgoing Socialists” (Telegraph, July 18th). From then on, it was only downhill. “The country’s situation is grave” warned the Finance Minister (September 6th). He added “We are facing a serious financial crisis” (September 14th).

With factory orders declining by 16.8% in August and ECB financing for Portuguese banks rising to EUR 46bn (from 39bn in March) there is really not much to cheer about. How realistic are the governments projections then? How is it possible for debt-to-GDP to peak at 106.8% in 2013 (government, August 31st) when, taking the governments own numbers, one arrives at 115% by 2012?

In view of a rapidly deteriorating situation, is it really necessary to produce (government on 8/31st) wildly unrealistic forecasts such as budget deficits of 1.8% (2014) and 0.5% (2015)?

To evaluate past forecasting skills one look at the “SGP” (Stability- and Growth Programme) should suffice:

A case could be made for countries with excess savings to support those who enable those savings via trade deficits. However, a certain accountability and realistic assessment of the situation would be desirable. The “very positive” Troika report seems to have been co-authored by copious amounts of Madeira wine.


The Greek (Ministry) Mystery of Finance

  • The Greek January – September budget deficit was EUR 19.16bn versus 16.65bn same period last year (+15%). This only includes the central government.
  • The initial deficit target for 2011 was EUR 17bn. We blew past that after only 8 months. The revised target (July) is now 22bn (9.5% of GDP).
  • Latest estimate from the Greek government: 8.5% deficit (19.5bn) for 2011 (instead of 7.6% or 17bn).
  • Here’s a chart of the budget deficit (cumulative):


  • You can see that 2011 pans out to be worse than 2010 (dashed line).
  • Revenues are negatively impacted by the severe recession. Okay, but what about expenses?

  • While 2011 revenues are trending below 2010, expenses are trending higher.
  • Despite all the austerity measures, Greece is still spending 150% of its revenues:

  • Of course, the Ministry of Finance sees a reduction of the deficit to a miniscule 2.6% of GDP by 2014 as revenues rise and expenses come down:

  • How is that possible? Somehow, after spending four consecutive years in recession (2009-2012), the economy will rise like a phoenix and grow by 5.8% in 2014.
  • I leave it up to you to decide if this is credible.
  • One more thing: interest expenses were 14bn after 9 months = 18.7bn annualized.
  • As of June 30, Greek government debt stood at EUR 353.7bn.
  • You do the math – Greece is paying an average interest rate on its debt of 5.28% (less than Italian 10-year bond yield).
  • If Greece were to pay market rates (let’s be generous and take 10-year yields of 24%), it would spend EUR 84bn on interest.
  • This would exceed government revenues.

The Fed, ZIRP and the French boomerang

Ben Bernanke promised to sit, like an elephant, on short-term interest rates for another two years  – at least.

What were US Money Market Funds (MMF) going to do? US Treasury yields are 0.09% for 12 months, 0.02% for 6 and negative 0.01% for 3 months:


Source: Bloomberg 9/23/2011

You can’t deliver negative yields to investors (that would empty the fund pretty quickly) and you still want to charge some management fees.

Enter funding-hungry European banks.

You might be surprised to learn the following: the world’s largest bank (by assets) is – French:

Source: Global Finance, 9/7/2011

These huge collections of assets (compare to French GDP of ca. $2.1 trillion) have a bad habit: they want to be financed.

According to FitchRatings, French banks were the single largest recipient of funds from US MMF:

Source: FitchRatings, US Money Funds and European Banks, 9/23/2011

So far so good. A match made in heaven.

Then the European debt crisis intensified. Once Spanish and Italian bond yields started to peel off, a nagging thought crept onto the scene: Germany and France might have to carry the load of (yet unborn) EFSF (European Financial Stability Facility).

Credit default swaps on French government debt started to rise. This, in turn, would make French bank bailouts more difficult. French bank stocks tanked, and talk of possible nationalization added to further stress on the sovereign. A vicious cycle.

US MMF, of course, smelled the rat and began to withdraw their funding (by more than a third since the end of May):

Adding to funding worries, loans left in place are getting more and more short-term (a week or shorter):

 And this is where ZIRP (zero interest rate policy) goes full circle back to US institutions:

Source: Morgan Stanley 10-k

I am not sure what possessed MS to increase their exposure to French banks by 300% within a year (I suspect same dearth of lending opportunities given trillions of excess reserves parked at the Fed). The French engagement ($39bn) exceeds MS’s market capitalization ($26bn) by far.

Morgan Stanley’s share price has been cut in half since the beginning of the year and is now trading at less than 50% of book value. In other words: the market does not trust it’s books, or believes MS will destroy value going forward (or both).

I am not suggesting ZIRP is the only reason for problems; however, it is likely to have been an important trigger for a USD funding crisis at French banks.


Bundesbank ready to pull the Euro’s ripcord

Something odd is happening. Germans are leaving the ECB. First Weber, then Stark. Why would senior German officials withdraw from the ECB just at a time when they should seek greater influence?

One explanation: to avoid having a conflict of interest once Germany re-instates the Bundesbank as the leading central bank of Europe.

Currently, Germany and Greece are engaged in a game of chicken; the Germans do not want the first “domino” of the Euro zone to fall, and the Greeks know that.

Each time Greece nears default, Germany agrees to a last-minute stick save without offering a far-reaching solution. Their aim is to limit the funds actually flowing to Greece.

This, of course, guarantees the crisis to simmer on indefinitely, preventing a recovery in Southern Europe. But, as with every game, this one will have to end one day. Especially as German and Dutch 5-year CDS approach 100 bps. France’s CDS rocket has long left the launch pad, reaching 190 bps recently.

 Source: CMA

Assuming the Euro zone will eventually disintegrate (as default without Euro exit does not make much sense) there are two scenarios:

1. Germany watches as one “PIIGS” after another is being forced out, leading to bank runs in those countries (as savers try to escape devaluation by transferring their deposits into countries remaining in the zone)

2. Germany (together with the Netherlands) decides to leave the Euro zone. Germans would be happy to get their Deutschmark back. Savers in PIIGS would probably not want to “speculate” in a new, unproven currency and keep deposits in their banks. The Euro would devalue, improving competitiveness for troubled countries. The Germans would have to live with the inconvenience of a strong currency. Something they are used to from the days of the ERM (European Exchange Rate Mechanism).

Scenario (2) would overall be less damaging for Europe.

This is when I remembered an article in DER SPIEGEL

During the cold war, billions worth of a new series of Deutschmark were kept in a secret bunker under a harmless-looking villa near Frankfurt. This was in case the Russians tried to destabilize the West-German economy by flooding it with counterfeit Deutschmarks. The Bundesbank could have replaced most notes in circulation over a short period of time.

Video grab from DER SPIEGEL movie on secret stash of series “BBK II” Deutschmark, showing the 5 Deutschmark note

The “original” 5-Deutschmark note

I would be surprised if Germany was not prepared for a scenario where the Euro disintegrates.

Finally, one odd detail: after meticulously hiding the secret stash for 25 years, Germany decided to send it to the shredder. In 1988. End of story.

Except: The Berlin Wall fell in 1989. Erich Honnecker was still in power in October of 1989. Who cannot remember the talk of Russian tanks possibly crushing those “Montags”-demonstrators. And the Bundesbank decided the risk of an escalation was so low they could dispose of the back-up currency for good?

DER SPIEGEL broke the story in 2010, 22 years after the back-up currency had allegedly been destroyed.

Either the gardener spilled the beans on his death bed, and the Germans needed to “prove” the back-up currency was gone (and not just moved behind “the door behind the door”) in order not to upset their Euro partners.

Or, someone “saw” new Deutschmarks being printed, and the Bundesbank had to come up with a good story on why that was the case.