Category Archives: Central Banks

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.

What the hell just happened? Part 1

Part 1

Most of the year, the S&P 500 Index traded sideways in a narrow range (+- 3% from end of 2014). Then, suddenly, this:

SPX 2015-09-02

The German DAX-Index had been up 26% by April, but had to give up all of its gains:

DAX 2015-09-02

A measurement of expected volatility, the VIX-Index, surged to the highest level since 2009:

VIX 2015-09-02

Seemingly out of the blue, something has rattled markets. But what happened? There was no major bankruptcy, or disappointing company results, or nasty surprises on the macro front. The Fed keeps pushing out its first rate hike further and further; the IMF is actually begging the Fed to delay any rate hikes until 2016.

I have three theories to offer:

  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 and SDR
  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.

If #1, then the market should recover quickly. If #2 or #3, then more trouble lies ahead. Let’s look at the details. This write-up got a bit long, so I will deal with #2 and 3 in a separate post.

The Flash Crash of August 24


In the three days leading to the flash crash on Monday, August 24, US equity markets begin losing ground:

SPX 20days 2015-09-02

After many months of being subdued, observed and implied volatility of options suddenly spikes from 12 to over 50 in the matter of hours. That made options, both calls and puts, suddenly much more expensive:

VIX 20days 2015-09-02


Small Excursion into Volatility

(You may skip this paragraph)

What does implied volatility mean? It’s not a concept that is easily understood by casual investors. Let me try to explain.

Let’s say there are two stocks, Boring Inc and Exciting Inc., both trading at $100. You believe their stock prices will go up. You buy call options giving you the right to buy each at a strike price of $103.

Boring Exciting Inc

Despite the fact that both stocks start trading at $100 and end at $102, the call options on “Exciting Inc” will most likely be more expensive than those of “Boring Inc”. Why? The share price of “Exciting Inc” is simply more volatile; it has larger swings. That increases the likelihood of the share price moving above the strike price ($103) during the lifetime of the option. For the owner of options in “Boring Inc” it never made sense to exercise his option (buy at $103) since the share price never exceeded that level. It doesn’t matter that both stocks ended at the same price ($102). Everything else equal, options on volatile stocks are worth more than options on boring stocks.

At an implied volatility of 16 you would be paying a fair price for an option if the stock price had moves larger than 1% (16 divided by square root of 256 trading days) on one third of trading days (33.3% = one sigma). Ergo, the stock price should move less than 1% on the remaining two thirds of days.

It is impossible to know in advance on how much a stock will move in the future. But the price of an option today has an imbedded assumption on its future swings, hence the name implied volatility. You can then make a wild guess and say “this stock is never going to move more than 3% on at least 10 days in September” and not buy (and rather sell) that option.

Looking back, you can measure volatility. It’s nothing else than the standard deviation. It’s then called historic, or observed volatility (as opposed to implied, or expected volatility embedded in option prices).

Increased levels of volatility make both calls and puts more expensive. Hence those who wish to protect their portfolio from losses (by purchasing puts) suddenly are facing higher costs.

Back to the main story:

August 24, 2015

On Monday morning, Chinese equities are selling off. The Shanghai Composite Index loses 8.5%. US equity futures are limit down (-5%) even before Wall Street opens. For the first time in history, trading in all four major US stock market futures (S&P 500, Dow Jones, Nasdaq-100 and Russell 2000) is being halted. That means stock prices have to begin trading without knowing where the fair price relative to futures would be. Arbitrage or hedging via futures is impossible.

The New York Stock Exchange (NYSE) imposes “rule 48”, which allows stocks to open promptly without price indications. Still, many stocks and ETF’s listed on the NYSE open only after delays of up to 30 minutes (see red line below; compare to blue line on a ‘normal’ day):

Delayed opening by number of symbols 2015-08-24

Nothing instills more panic among investors than not being able to sell. The CBOE (Chicago Board of Options Exchange) was unable to compute the VIX index for the first 30 minutes “since it was too volatile” (talk about irony):

VIX intraday 2015-08-24


Meanwhile, ETF’s (exchange-traded funds) on volatility were trading, without knowing where the underlying (VIX index) was. Over the first 30 minutes, more than 5 million shares of UVXY (ProShares Ultra VIX Short Term Futures ETF) and more than 30 million shares of VXX (iPath S&P 500 VIX Short-Term Futures ETN) were traded:

UVXY 2015-08-24


As you can see above, the UVXY ETF almost tripled in price in less than 5 days. You might not be aware of the “special features” of this ETF. Since inception in 2012 its price had fallen from (split-adjusted) $210,000 (yes, as in a fifth of a million) to $24:

UVXY since 2012

Or, if you prefer a logarithmic scale:

UVXY since 2012 log

So it is the perfect example of a “wasting asset”. Still, $300m of investor’s money sits in this ETF (and $1bn in its brother VXX). What do speculators do with such a loyal wasting asset? They short it. Or sell calls on it. Yes, you can trade options on a levered ETF on a future on the expected standard deviation of options on an index of stocks. It’s a derivative to the fifth power.

The volume in options traded on VXX and UVXY was larger on Friday, August 21st (the trade day before) than on the actual Flash Crash. Which is unusual. These charts show volume up to Friday, August 28th (so the Flash Crash is the fifth volume bar from the right):

UVXY option volume 2015-08-21 higher than on crash day

VXX option volume 2015-08-21 higher than on crash day

Also, the assets under management in a different, short-volatility ETF (XIV) doubled to more than $1bn in the week before the 24th:

Short vol ETF AuM increase

By shorting (or writing calls) on a wasting asset you can pick up small, but decent amounts of money every month. But when it goes wrong, you can lose a ton if you cannot cover your trade. The saying “picking up pennies in front of a steam roller” applies. Is this what caused the Flash Crash? Not by itself (the amounts involved are too small), but it probably aggravated the situation.

Blue Chips Can Flash-Crash, Too

Something else happened: dozens of blue chip stocks flash-crashed, too. And not too timid (many -20% to over -50%):

F to 10.44 - 2015-08-24 - was 15 on 8-19 - 50bn mkt cap - 150bn EV HCA flash crash 2015-08-24 KKR flash crash 2015-08-24 AAPL flash crash 2015-08-24 LVS flash crash 2015-08-24 GE flash crash 2015-08-24 PEP flash crash 2015-08-24

GE (General Electric) has a market capitalization of $250bn (and enterprise value of more than $500bn). Pepsi 135bn. Ford 50bn. Those companies’ share prices were ripped apart like ragdolls by a pitbull. And this is the largest and most sophisticated equity market in the world?

If you had stop-loss orders in the market, you were taken to the cleaners. And if you wanted to buy some stock, many online broker websites were unreachable.

Carnage in ETF World

You are a “passive” investor and only have ETF’s? If you thought those were safe from flash crashes, look at these charts:

SYLD Cambria Shareholder Yield ETF 2015-08-24 PKW Buyback achievers ETF 2015-08-24 USMV 2015-08-24 SPLV 2015-08-24 RSP flash crash 2015-08-24 DIA flash crash 2015-08-24 SPY flash crash 2015-08-24 QQQ flash crash 2015-08-24


Among those ETF’s are the largest in the world (SPY). Those are not some speculative niche ETF’s. The Guggenheim S&P 500 Equal-Weight (RSP) was almost cut in half! You can see how its price kept falling despite multiple trading halts (a trading halt gives traders an opportunity to rethink their orders). And there was volume.

Volume speaks volumes

August 24th was a special day in many ways. First, the volume in stock market futures was simply off-the-chart:

Number of trades SPX futures new record 2015-08-24

Two million S&P 500 futures changed hands. Each contract equals 250 times index value, which adds up to [2m x 250 x 1,900 =] $950bn. Insane.

It gets better.

You’d think that with record volume there would be record liquidity. Wrong. Liquidity in the e-mini S&P 500 futures (1/5th of the size of its big brother) during the critical opening minutes of Wall Street was the lowest since at least 2009 (black line):

E-mini liquidity 2015-08-24


The lines represent the depth of book in number of contracts (y-axis) at any given time during the trading day (x-axis), color-coded by date (blue = oldest). The lower, the less liquidity.

What does this mean? A lot of the “liquidity” you see on “normal” days is bogus. The large majority of orders is posted by machines (or high-frequency traders, HFT), only to be withdrawn at the slightest sign of turmoil (when you needed them most).

Another interesting observation is the number of trades within the first ten seconds of trading:

Trades within first 10 seconds of trading 2015-08-24

However, the average trade size (number of shares traded per trade, here in the S&P 500 ETF), reached a historic low:

SPY average trade size 2015-08-25

Are small investors throwing in the towel (200 shares of SPY equal less than $40,000)? No, it’s again the machines, shredding large orders into thousands of small pieces to avoid detection by other machines. How do we know?

Odd lots less than USD 250 more than 50pct - 2015-08-24

More than half of all odd-lot trades (trades with less than 100 shares) executed within the first ten seconds had a value of less than $250. If those were retail (= small investor) orders, they would get killed by trading commissions (usually $5-10 per trade even at discount brokers).

Large volume and small trades leads to a huge number of price changes. The largest ETF in the world (SPDR S&P 500 ETF, SPY) had over 500,000 price changes during regular trading on August 24 (or more than 20 per second).

But wait, there’s more.

Among 220 ETF’s crashing 10% or more, a few crashed every minute on the minute (that’s when the dots fall down like rain):

ETFs flash crashed every minute on the minute 2015-08-24b




Clearly non-human activity, and probably programmed by humans to behave exactly as shown.

If stocks and ETF’s are fair game for HFT (high-frequency traders), so are options. The three-day period from August 24th set new records for option volume: over 50 billion quotes:

50bn option quotes over 3 days 2015-08-26

A new record of 9 million option quotes in a single second has been reached. Why the insanity, what is to be gained?

The aim is to overwhelm trading systems run by competitors or end-investors. Of all order in large ETF’s, 43% are cancelled within 100 milliseconds:

43 pct of orders in ETF are cancelled within 100ms - Nanex 2015-06018


Same applies to stocks. Given the speed of light, almost one third of all orders have already expired before they reach a computer screen on the West Coast or in Europe:

30pct of stock quotes expired once reach Europe


And we haven’t even touched the issue of “direct access” for HFT’s (while everybody else sees data slowed-down by the “Securities Information Processor”, or SIP).

Conclusions of Part 1

  • Speculative positions in volatility-related products might have aggravated, but not triggered, the Flash Crash
  • The structure of the largest equity market in the world is highly unstable
  • Stock exchanges, enjoying immunity from lawsuits, are supposed to be “self-regulating”. Which is akin to making the fox guard the hen house.
  • The SEC (Securities Exchange Commission) is either complicit or incapable of reigning into high-frequency trading
  • Phantom liquidity vanishes the moment you need it
  • Flash crashes can happen any time, in any security
  • Retail investors get creamed trying to sell or buy during a flash crash
  • Stop-loss orders turn into loss-guaranteed-orders
  • If futures are being halted and blue chip stocks crash 20-50% on no news, what will the “market” look like when actually something significant happens?
  • Do you want to trust your life savings to this casino?

A link to part 2 and 3 will be found here in the coming days.

Special thanks to Eric Hunsader of Nanex for posting many charts used in this post. He can (and should) be followed on Twitter under @nanexllc.

Gold: Religion or Salvation?

What can you do if your investment thesis is not working? Look at the arguments of the opposing camp, see if they are convincing or if your train of thought is holding up.

Whom should we hear for the case against gold? You can’t take so-called “research” from investment banks. They are (best case) clueless, as their only objective is to generate client activity (trust me, I worked in this business for 14 years). Given the recent crash in gold prices, what do you think is more likely to propel an investor into action – a call to “catch a falling knife” (“Buy gold now”) or a call to “cut your losses and get rid of that nasty investment”? Fear of losses is greater than fear of missed opportunities.

Let’s take Jason Zweig’s recent Wall Street Journal article “Let’s Be Honest About Gold – It’s a Pet Rock”.

He opens with a valid question:

“Gold is supposed to be a haven amid hard times and soft money. So why, even as Greece has defaulted, the euro has sunk against the dollar, and the Chinese stock market has stumbled, has gold been sitting there like a pet rock?”

Yes, Greece recently defaulted on a (relatively small) payment to the IMF. Yes, the Euro has declined against the Dollar. But that is also a function of a strong Dollar. Strong Dollar usually means weak gold. If all major currencies (except the pegged Yuan) fall against the Dollar, would you rather say all three are weak or the Dollar is strong?

Major currencies 2015-07-24

Gold, despite its recent crash, has beaten the Euro and the Yen since May 2014.

Over the past 20 years, the correlation between gold and the US Dollar has always been negative:Gold USD correlation 20 years

I don’t see why a falling Euro should have boosted the gold price.

Zweig continues:

“Many people may have bought gold for the wrong reasons: because of its glittering 18.7% average annual return between 2002 and 2011, because of its purportedly magical inflation-fighting properties, because it is supposed to shine in the darkest of days. But gold’s long-term returns are muted, it isn’t a panacea for inflation, and it does well in response to unexpected crises—but not long-simmering troubles like the Greek situation.”

It’s probably fair to say many investors were attracted to gold by its stellar performance. But doesn’t that apply to most investments? And if past positive performance is not a good indicator for future performance, wouldn’t the same apply to recent negative performance?

“Purportedly magical inflation-fighting properties”: That statement implies gold was not offering protection from inflation. Let’s look at the facts:

Gold vs inflation since 1965

During the one period of elevated inflation (1974, 1980), gold offered perfect protection. Even smaller spikes of inflation (2005, 2008, 2011) seem to reflect on the gold price.

The correlation coefficient (r-squared) between gold price and US consumer price index since 2001 is remarkably high (0.85):

Gold price vs CPI

More from Zweig:

“It is time to call owning gold what it is: an act of faith.”

That is a pretty bold statement considering our current (fiat) monetary system is less than 50 years old, following 5,000 years of gold- and silver-based systems.

From Wikipedia:

Fiat money is currency which derives its value from government regulation or law. The term derives from the Latin fiat (“let it be done”, “it shall be”).

Our current monetary system is backed by – nothing. A dollar note is a non-interest bearing debt without maturity issued by a privately-owned bank (Federal Reserve Bank System levered 70 times (July 2015: $4.5 trillion assets, $64 billion capital). You have no assurance the issuer won’t print a lot more of those notes, thereby devaluing yours.

As soon as you deposit that note in your account at a bank you become a creditor of that bank. Your money may continue to exist as pixels on a screen, or bytes on a hard disk. Your deposits may be “bailed-in”, as depositors in Cyprus had to learn. Or access to your funds may be limited to a few Euros per day, as savers in Greece recently experienced.

How is that not based on faith?


“Own gold if you feel you must, but admit honestly that you are relying on hope and imagination.” 


“Recognize, too, that gold bugs—the people who believe in owning the yellow metal no matter what—often resemble the subjects of a laboratory experiment on the psychology of cognitive dissonance.”

Why wouldn’t it be the other way ’round – fiat money believers are the actual lab rats?

“When you are in the grip of cognitive dissonance, anything that could be regarded as evidence that you might be wrong becomes proof that you must be right. If, for instance, massive money-printing by central banks hasn’t ignited apocalyptic inflation, that doesn’t mean it won’t. That means it is more likely than ever to happen—someday.”

What is money? Is the definition limited to cash (notes and coins, $1.3trn)? Would you include short-term ($1.1trn) or long-term deposits ($188bn)? If I can buy a car financed by a car loan, doesn’t that qualify as “money” for the car dealer, too? Does he care if he is paid in cash or credit? So isn’t total money therefore all of the above ($59trn)? Should we include derivatives? Globally?

The Fed’s balance sheet as increased from (roughly) $900bn in 2008 to $4.5trn, or $3.6trn. Excess reserves of US banks went up from practically zero to $2.45trn, meaning that two thirds of the money “printed” by the Fed came right back. Only one third, or $1.15trn, “made it out into the real economy”. Meanwhile, the amount of Commercial Paper outstanding fell from $2.2trn to $1trn. So that’s $1.2trn less in credit (= money) outstanding. Fed’s action neutralized.

Zweig might have countered that the total amount of credit outstanding in the US has, nevertheless, increased by 18% from $50trn to $59trn since 2008. So there is more money around.

The amount of goods and services produced / consumed has also increased, but less. Shouldn’t that lead to inflation?

Not so fast.

M * v = Y * p

Monetary aggregates (M) times velocity of money (v) equals real gross national product (GNP, or Y) times price (p).

You may ramp up M, and still get no inflation if the velocity of money declines. And that’s exactly what is happening. Velocity of money is partially psychological. If I earn $10 and put them in a bank account, those $10 have a velocity of 1. If, however, I feel optimistic about my future income I might not save the money, but hop in a taxi. The taxi driver spends the money at a restaurant. The same $10 now had a velocity of 3.

The problem with money created by central banks (“money printing”) or commercial banks (crediting a customer’s account as he takes a loan) is that this money has to be held by someone at any time. It doesn’t go away (unless central bank reduces liquidity by selling assets or commercial banks shrink their loan book in a credit crunch).

When the Fed launches QE4, the ECB keeps printing money, the BoJ, SNB, BoE, PBoC… in short, all the world’s central banks print money, at what point will you start wondering “wait a minute – this paper money is everywhere”. Stuff has value only if it is rare. Eliminate the rarity value and it becomes worthless. One day, the Federal Reserve and the Treasury might agree to “cancel” trillions of debt under the pretext that it was “simply one arm of the government owing money to another arm”. Or the Fed might be forced to buy Japanese government bonds in order to avoid a default of Japan as its currency collapses and Japanese citizens try to exchange their rapidly devaluing Yen into anything denominated in foreign currencies.

So what could make “v” (velocity) go up and lead to inflation?

  • demand-driven (not happening in low-growth economy). Possible if government were to increase demand by substantial deficit spending (e.g. war)
  • supply-driven (not enough production capacity; currently unlikely)
  • wage-driven (currently unlikely as labor organization is declining, high un- or underemployment)
  • tangible asset bubble (housing bubbles in US, UK, Canada, Australia could lead to increased rent)
  • financial asset bubble (stocks, bonds, alternative assets. Once bubble bursts, money looking for other places)
  • import-driven (currently not the case as dollar is strong)
  • commodity-driven (currently not the case as prices of oil, copper etc are falling)
  • loss of confidence in fiat currency (possible)

One word on Treasury Securities. There are (roughly) $18 trillion outstanding, of which $12 trillion are “marketable” (the remainder locked-up in intra-government debt). Of those $12 trillion, $2.5 are held by the Fed and $3 trillion by foreign central banks. Hence almost 50% of all marketable Treasury securities are held by central banks (and this doesn’t even include sovereign wealth funds). Central banks are price insensitive. They are political buyers and sellers. How comfortable would you be holding those securities knowing there is a huge, potentially irrational elephant in the same room?

The US has twin deficits (trade and fiscal) that need to be financed. Most of it externally. World currency reserves in US Dollar have increased dramatically in recent years (from $2 to $12 trillion):

World FX Res 2015-07

China’s appetite for recycling its trade surpluses into Treasury bonds seems to have ended; same for Japan. Those were the two largest foreign buyers.

You can let foreigners finance your deficits for a while, but you end up owing more and more debt to foreigners than they owe you. Your “International Investment Position” (IIP) deteriorates. The US used to have a positive IIP until the mid-1980’s. It then reversed and is on an accelerating decline since the financial crisis of 2008:


It will soon reach negative $6 trillion, or 1/3 of GDP. There is a limit up to which foreign creditors (central banks) are willing to continue to finance the US deficits. When that point is reached, a dollar crisis will emerge. The US will have to address its deficits. Imports can be reduced by a recession or dollar cheapening (or both). Both measures hurt the exports of other nations and lead to reduced economic activity.

So my best guess is that inflation will be triggered by a currency crisis.

There is another “excuse” / explanation why recent multi-year money printing has not led to inflation. Increasing debt is inflationary. But a high (and stable) level of debt is, paradoxically, deflationary. Debt needs to be serviced. Only productive assets can produce earnings / cash flow with which to service debt. According to the Bank for International Settlement (BIS), global public and private non-bank debt has reached 260% of GDP. “Persistently low interest rates are a symptom of a debt-fueled growth model”. Or, otherwise said, current levels of debt are extracting so much debt service from productive assets that any interest rate increase would lead to collapse. No wonder the Fed has left interest rates near zero for seven years now.

Back to Zweig:

“There is a case to be made for owning gold, but it speaks in a whisper, not in the shouts of doomsday so customary among gold bugs. Because gold, unlike stocks, bonds, real estate and other financial assets, generates no income, valuing it is all but impossible.” 

Why would gold generate income? It’s just a piece of metal. It has no risk of bankruptcy, no counterparty risk, no redemption risk. The only risk I can think of (apart from theft / fire) is that a large meteorite full of gold crashes on earth. Gold is not supposed to generate income. It’s just supposed to exist. Chemical inertia makes it durable for thousands of years. That is all it does.

The Euro-zone (and Switzerland) have played with negative interest rates. If you had a large deposit, the bank would not credit interest, but take something away. Doesn’t that make gold look favorable? Depositors in Cyprus or Greece would probably have been very happy owning some gold instead of having their Euros locked-up or confiscated in their banking systems (without any of their own fault).

I agree on the valuation part. It is not easy. There are some models (based on real interest rates), but I will skip them here.

Back to Zweig:

“Gold is two things, neither of which is easy to price: a commodity and a currency. First, the commodity: At recent prices, mining companies are losing money on more than an eighth of the gold they dig out of the ground, says Ms. Cooper of Barclays. That could lead to a decline in supply. And if demand—even from non-investment buyers like consumers in China or India—rises unexpectedly, there might not be enough gold to go around.”

According to a recent Bloomberg report, leading gold mining companies had the following all-in sustaining costs (AISC) per ounce in Q1 2015: Kinross $957, Barrick $927, Yamana $892, Goldcorp $885 and Newmont $849. Furthermore, gold mining companies sell part of production ahead of time via gold futures. So a depressed spot price takes time to work through their hedges. Anyway – why would an investor in physical gold care about the miners? And why would someone worry about ‘unexpected rise in demand’? The amount of gold ever mined is estimated to be between 160,000 and 185,000 tonnes. That gold still exists (it is never consumed). It is always there as potential supply. We will never run out of gold. It is just a question of price.

For investors in gold mining stocks, however, there is reason for concern. Based on credit default swap rates, the implied probability of default within a year for Barrick Gold is now 71%:

ABX default probability

The stock price (in Canadian Dollars, green line above) has declined by 80% since the peak. But the company is still worth US-$ 8.5bn. So before going bankrupt, the company would surely be able to raise money via a rights offering.

If gold remains around current levels, gold miners will have to write down the value of their resources (similar to oil companies) and possibly close some (high cost) mines, but those are mostly non-cash charges. Unless a company is forced to sell some mines or put itself up for sale, its shareholders will benefit once the gold price recovers. Owning a gold-mining ETF makes sure you own those companies able to acquire others on the cheap.

Back to Zweig:

“As a currency, gold has a latent and indeterminate value, Mr. Brodsky says. If the world goes to financial hell in a handbasket, you wouldn’t lug gold ingots to the supermarket so you could stock up on canned goods. But you might pay for those goods with dollars that are again backed with gold, as they were until 1971.”

Now Zweig has me confused. He cites Mr. Brodsky, describing a case where the dollar is again backed by gold. Why would that be the case? Because the current monetary system has collapsed! That is the whole point of gold – it’s the only way to regain the people’s confidence and introduce a new currency.

Zweig’s final paragraph:

“Laurens Swinkels, a senior researcher at Norges Bank Investment Management in Oslo, reckons that the total market value of the world’s financial assets at the end of 2014 was about $102.7 trillion. The World Gold Council estimates that the world’s total quantity of gold held for investment was about $1.4 trillion as of late 2014. So, if you held the same proportion of gold as the world’s investors as a whole, you would allocate 1.3% of your investment portfolio to it. Anything much above that is more than an act of faith; it is a leap in the dark. Not even gold’s glitter can change that.”

I have much more faith in the 1.3% allocated to gold than the 98.7% allocated to paper assets. To me, the current financial system is unsustainable and will probably need a reset within the next few years. Once a crisis hits, markets will move quickly. Possibly too quickly for many to act. As in Greece. One day, you were able to withdraw your entire savings. The next day, it was over.

I am absolutely convinced gold will again play a major role in the future. I know losses in gold- and silver mining companies have been steep, but you will be rewarded nicely for sitting tight. Nobody forces you to sell. Do not realize those losses by selling. On the contrary – I would recommend adding physical precious metals as well as mining companies at current prices.

Back one last time to Zweig. Here he is four years ago, writing on the same subject:

Jason Zweig 2011 - no basis for that opinion



Gold Crash July 20

In early Asian trade (9:29am Australian time) Gold futures suddenly tanked 5% within seconds. There was no news, no movement in the EUR/USD or other currency pairs. Silver followed, as usual:

Gold crash 2015-07-20

Gold crash 2015-07-20 double halt

The selling was so sudden and so violent trading was halted twice (see above).

Who would sell thousands of gold futures at once into a quiet (and not very liquid) market? It looks as if triggering trading halts was intended.

If you sell futures in this way, you are all but guaranteed to make losses. You are not price-sensitive. Which market participants are not price sensitive? I only know one group: central banks (they intervene based on policy objectives – never on rational thought).

Gold 2015-07-20

True, gold had just breached previous lows (November 2014, March 2015). This might have triggered some stop-loss orders.

Here are the last 4 seconds of trading before the first trading halt (courtesy of Nanex LLC):

Gold crash 2015-07-20 first halt

The hit came in the minute before the Australian open (21:30 Central Time). What a coincidence.

It was not a single move down. You see little upward bumps. That means it was not a “fat finger” (false order entry). To me this looks like an algorithm programmed to drown all buy orders.

If you were gutsy enough to buy some gold futures after the first drop you immediately regretted your decision by the time you were liquidated in the second drop (futures traders use leverage, and hence need to use tight stop loss orders to avoid getting wiped out).

If this happened to you a few times, you will refrain from trying to “buy the dip” next time. The seller seems to have unlimited resources and is not acting rationally. As fewer traders dare to stand up to the seller, the latter has an easy game, as potential buyers are running away scared.

The culprit is obvious. The question is “why”? Central banks are the largest holders of investable physical gold. Why would they depress the price of a good they own?

On Friday afternoon, the People’s Bank of China (PBoC) revealed it had increased its gold holdings from 1,054 to 1,658 tonnes. This was the first update since 2009 (!). Jim Rickards (author of Currency Wars) expected the update to happen in 2015, so it was no surprise.

What might have been a surprise (to some) was the increase of 600 tonnes. While a lot, it was less than many market participants expected. According to Rickards, China would need at least 4,500 tonnes to be at par with the United States (gold in relation to GDP). In a recent interview (with Koos Jansen) he stated:

“I know for a fact that SAFE, which is a Sovereign Wealth Fund that manages the foreign exchanges reserves of the People’s Bank Of China, bought 600 tons of physical gold through June and July 2013. I know this from the Perth Mint and Chinese dealers. At this moment the gold is on the balance sheet of SAFE but this can be flipped to the PBOC’s sheet like it happened in 2009.”

So we should not take the PBoC number for granted. It is a highly political number. The Chinese have much more gold than they admit. But it would be unwise for them to reveal all their cards at this time. The Chinese do not want to upset the dollar standard; they simply want to secure a spot at the table for the moment when a new currency system needs to be discussed.

According to Swiss Customs Administration we know China has imported no less than 342 tonnes of gold from Switzerland over the last 17 months (January 2014 – May 2015):

Swiss Gold Exports 2015-05

You can probably add Hong Kong (571 tonnes) and Singapore (193 tonnes) to that number. That would make a total of 1,107 tonnes just from Switzerland, just over the past 1 1/2 years.

Koos Jansen believes that based on his calculations total Chinese gold reserves amount to around 15,000 tonnes:

Estimated Chinese gold reserves above 15000t

So is the gold price crash and the Chinese revelation of increased reserves a coincidence?

China is under immense pressure after its stock market almost had to close down due to selling pressure:

SSEC 2015-07-20

Revealing an increased amount of gold was probably intended to bolster confidence in the Chinese currency and, possibly, convey a message of solvency.

China wants the Yuan to join the IMF’s Special Drawing Rights (SDR), possibly before the end of the year. The last thing they could use is economic turmoil caused by a stock market crash. The IMF would only consider including the Yuan if it can be traded freely (free from central bank intervention, as was necessary over many years to keep it from strengthening towards the US dollar due to large current account surpluses).

The US would most likely lose its veto power in the IMF (15% of votes) if China was included. The US might hence work behind the scenes to avoid such a scenario. The least one could do to embarrass China was to make the PBoC look bad by making the gold price crash just after the PBoC announced a large increase in holdings. Yes, that is childish, but that’s how politics work.

But there is collateral damage: Gold mining stocks. Take American Barrick, for example. It fell no less than 25% within a week, hitting a 25-year low (my chart provider goes back for 20 years only):

ABX 2015-07-20

The ECB might also have a hand in this. I assume more than a few Greek investors have bought physical gold in the past weeks and months (in order to protect wealth in case of an exit from the Euro). A sharp price drop would make them regret their decision and deter others from doing so in similar situations.

Finally another observation on Greece. Syriza’s failure to obtain any concessions, even after winning a popular referendum, had a terrible effect on the newly formed far-left party Podemos in Spain:


The predicted number of seats in Spain’s upcoming national elections more than halved compared to the beginning of the year. Maybe Greece was simply a sacrifice in order to keep Podemos from becoming the strongest party in Spain. Spain’s debt (EUR 1trn, 98% debt-to-GDP) is probably too large to be bailed out by the Euro-zone’s various rescue mechanisms.


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