Greece Needs Another Bailout; EU Needs a Bankruptcy Law

"If you borrow one million dollars, the bank owns you. If you borrow one hundred million dollars, you own the bank."

Greece and the Eurozone are squaring off again, in what has to be the most widely predicted, exactly on schedule, third round of a sovereign debt crisis in the history of finance.

Greece's newly elected, ultra-left wing Syriza-led government is gearing up to demand that the austerity measures they "agreed to" - while standing on the business end of the Eurozone plank - be scaled back, and the 2010-2012 bailout packages be "renegotiated." The very real threat is that they will default on their ~300 billion of debt and loans - which are ~80% owned by European official institutions, ergo the Eurozone taxpayers - unless that debt is significantly written down.

Some ECB and European officials, for their part, are threatening to drop Greece from the Eurozone if they default, roll back austerity measures, or continue to lag in implementing the structural reforms and privatization of government assets as agreed to in 2010 and 2012. The cohesion of the European Union and the stability of the euro are again going to be tested in the coming months.

There is a lot of blame to go around here, and it's been covered ad nauseum in the financial press since the crisis originally broke in 2009. There are many excellent sources where you can read about it in as much detail as you can tolerate. I'm not going to rehash it here.

What interests me is that this bailout merry-go-round has reignited fervor - primarily from the IMF and their economic and political agenda sympathizers - for the establishment of a global sovereign bankruptcy regime. I don't think we need (or want) a global bankruptcy authority, but the EU could sure use an EU-wide sovereign bankruptcy law. Despite the fact that the EU could not legislate such a law in the short-term, if the EU agrees with the purpose and goals of bankruptcy, then they could hopefully find their way towards taking a significant haircut on Greece's debt and perhaps help them reformulate some of the austerity measures.

Legal Issues

(1) There is no such thing as a sovereign bankruptcy. That is, currently there is no international law, court or organization that has been granted power and legal standing by the global community to resolve sovereign defaults, or determine and enforce terms of sovereign debt restructurings.

In the US, bankruptcy law is federal law, and individuals, partnerships, corporations and municipalities can file for bankruptcy protection under various chapters of the bankruptcy code.

A fundamental goal of the federal bankruptcy laws enacted by Congress is to give debtors a financial "fresh start" from burdensome debts. The Supreme Court made this point about the purpose of the bankruptcy law in a 1934 decision: "It gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt." 

This goal is accomplished through the bankruptcy discharge, which releases debtors from personal liability from specific debts and prohibits creditors from ever taking any action against the debtor to collect those debts. 

The are very specific rights and protections provided to debtors and to creditors under the US bankruptcy code. Generally speaking, the provisions of the bankruptcy code allow a debtor to renegotiate contracts, refinance or extend the terms of existing debt, reduce principal and interest payments, and be discharged of some debt obligations. Municipalities, in particular, have considerable leeway in bankruptcy to re-write collective bargaining agreements and renegotiate pension liabilities and other benefits packages.

Caveat: There is no chapter that permits a state to declare bankruptcy, primarily due to Constitutional issues of state sovereignty.The EU would no doubt have to navigate a similarly difficult path if it were to contemplate drafting such a law.

(2) Contract law - particularly bond contract law - is the de facto legal resolution mechanism or guide in the event of default, or when debt is restructured to avoid default. 

Since there is no sovereign bankruptcy law or enforceable process, historically sovereign defaults and debt restructurings have been worked out privately and "voluntarily" between debtors and creditors, subject to the provisions and protections spelled out in sovereign bond contracts, bank loan agreements, and terms and requirements embedded in government loans, e.g from the ECB and IMF.

This can increase the complexity and terms of a broad-based debt restructuring, because the contract law that prevails changes materially depending on where the debt originated. For example, in the case of Greece's first bailout, the Greek sovereign bonds issued in US dollars fall under New York bond contract law; those issued in London (and possibly in Europe in euros?) fall under English law; Greek domestic debt is governed under Greek constitutional and contract law.

The Greek restructuring of 2010-2012 was still accomplished, but it required some legal and economic creativity. Excerpts from The Greek Debt Restructuring: An Autopsy, by Zettlemeyer, Trebesch and Gulati (edited for brevity):

The Greek debt restructuring of 2012 stands out in the history of sovereign defaults. It achieved very large debt relief – over 50 per cent of 2012 GDP – with minimal financial disruption, using a combination of new legal techniques, exceptionally large cash incentives, and official sector pressure on key creditors. But it did so at a cost. The timing and design of the restructuring left money on the table from the perspective of Greece, created a large risk for European taxpayers, and set precedents – particularly in its very generous treatment of holdout creditors – that are likely to make future debt restructurings in Europe more difficult.

There are entire areas of bond contract law that seem to have become uniquely relevant to sovereign restructurings and defaults in general, and the Greece bailout in particular. These include collective action clauses (CACs), exit consents, and the rights of holdout creditors. I'm not going to belabor it (for now) but these are among the issues providing great motivation and some traction to the IMF, et al, who would like to usurp the jurisdiction of the New York and EU courts and become the global sovereign bankruptcy resolution authority.

Sovereign debt crises and defaults are commonplace. 

Sovereign debt crises and defaults have occurred with stunning regularity over the centuries, and have increased in frequency in the past 200 years. From Debt Defaults and Lessons from a Decade of Crises, by Sturzenegger and Zettelmeyer (excerpts from chapter 1, edited for brevity):

Debt crises and defaults by sovereigns—city-states, kingdoms, and empires—are as old as sovereign borrowing itself. The first recorded default goes back at least to the fourth century B.C., when ten out of thirteen Greek municipalities in the Attic Maritime Association defaulted on loans from the Delos Temple (Winkler 1933). Most fiscal crises of European antiquity, however, seem to have been resolved through ‘‘currency debasement’’—namely, inflations or devaluations— rather than debt restructurings. 

Editor's note: Historically, many sovereign defaults were also mediated by the creditor country, um, invading that of the debtor. Britain used to be particularly fond of such "resolution mechanisms".

Defaults cum debt restructurings picked up in the modern era, beginning with defaults in France, Spain, and Portugal in the mid-sixteenth centuries.

Only in the nineteenth century, however, did debt crises, defaults, and debt restructurings—defined as changes in the originally envisaged debt service payments, either after a default or under the threat of default—explode in terms of both numbers and geographical incidence.

There have been hundreds of defaults and debt restructurings involving privately held sovereign debt since the early nineteenth century. In some cases, these were a reflection of the tumultuous political history of the period: the by-product of wars, revolutions, or civil conflicts that made debtor governments unwilling or unable to pay. Some countries defaulted after losing wars; others defaulted after enduring major civil wars.

As it turns out, the majority of defaults and debt restructurings involving private debtors that have occurred since the early nineteenth century—including almost all that were experienced since the late 1970s—do not, in fact, belong to this category, but reflect more subtle interactions between domestic economic policies and shocks to the economy, including changes in the external environment and sometimes, though not always, political shocks.

Where does this leave Greece and the euro?

So, sovereign debt crises and defaults are increasingly common. There is a larger base of private investors whose influence can be contentious. Sovereign debt issuance is often in multiple currencies and across financial markets, expanding the legal regimes that need to be crossed. All of which was expertly and perhaps luckily navigated - tadaa! - in the case of Greece's original bailouts.

The Eurozone and the IMF have forced drastic austerity measures on Greece but the ECB did not participate in the haircuts on Greek debt in 2010-2012 along with the private creditors (there were good reasons for it at the time). Greece has plunged into recession, cannot deflate its currency to get out of it, and cannot enact expansionary fiscal policy in the midst of severe austerity. Yes, they ran up an insane amount of debt and they did this to themselves. But you have all come to the same crossroads. It's your money or your union.

Not Commenting on Income Inequality

After spending the better part of several days reading research papers, articles, excerpts of books and reviews / critiques of books devoted to income inequality, I've decided that I'm not wading into this topic on a finance blog. Even exhaustive data collection and analysis - e.g by Thomas Piketty and his collaborators in the first part of "Capital in the Twenty-First Century" - becomes hopelessly confounded by rather improbable leaps of economic theory and relentless political grandstanding.

I apologize for abandoning the topic after promising a summary, but frankly its too stomach churning to navigate the political agendas on both sides. If you want to move forward on your own, godspeed.

The Shifting Burden of Federal Taxes

Part I: Yesterday we drilled down through the Congressional Budget Office's data on household wealth across the income distribution, as presented in their November 2014 report, The Distribution on Household Income and Federal Taxes, 2011.

Part II: Today we look at the federal tax data from the same report. Again, when analyzing the data we are avoiding political chest thumping or partisan baiting around ideas of "income inequality", "paying their fair share" and so on.

Part III: There is actually a significant body of academic research dedicated to analyzing income disparities over time - though it is necessarily evaluates a somewhat short historical window, since the data on household wealth only goes back to the early 1960s, and data on income taxes in the US and some industrialized countries only goes back to the early 1910s. As it turns out, the growth in "income inequality" that the US has seen since the late 1970s has taken us back to a similar range seen in the 1920s. This phenomena has been mimicked to greater or lesser extent in other industrialized countries of western Europe. Next week we will recap some of the academic research with various theories on why the income disparity shrank from the post-depression era to the early 1970s, then rose dramatically again back to pre-WWII levels over the past 30 years.

Recap: Household Wealth and the Impact of the Top 1%

The reason so many policy analysts, political pundits and reality shows seem obsessed with those whose income or net wealth puts them in the "top 1%" is because, well, they really are accumulating vast amounts of wealth at a pace far above the (rest of us slobs) other 99%. The first chart below shows household income gains made by: 

• the middle quintile (40-60% of households on the income distribution), 
• fourth quintile (60-80%) and 
• the highest quintile (top 20%, or 80-100%) 

in the U.S. since 1979. The highest quintile is further broken down in the first graph to the 81st to 90th percentile, 91st to 95th percentile and 96th to 99th percentile to show finer detail of which strata of that top 20% of the income distribution has made the most gains. 

What is left out of the graph above is the growth in household income of the "top 1%". We repeat a graph from yesterday which shows the dominance - not of the "top 20%" - but actually of the sliver of the "top 1%". 

In the table below we summarize changes in the average before-tax household income across the distribution from 1979 to 2011. Comparatively, it is the increase in household income of the top 1% that is dramatically outpacing that of all other groups. However, it is the middle quintile - the U.S. middle class itself - whose average increase in household has been the lowest over the past 33 years, at just 24%. Compare this to the top 1% of households, who have seen a rise of 175% in their average before-tax household income over the same period. 

But there is some nuance here that's important to factor in, and that the political flame-throwers find it convenient to ignore. 

The Rise of the Two-Income Household

From Wikipedia and the US Census Bureau (edited for brevity, formatting added):

Household income changes over the course of time, with income gains being substantially larger for the upper percentiles than for the lower percentiles. All areas of the income strata have seen their incomes rise since the late 1960s, especially during the late 1990s.

The overall increase in household income is largely the result of an increase in the percentage of households with more than one income earner. While households with just one income earner, most commonly the male, were the norm in the middle of the 20th century, 42% of all households and the vast majority of married couple households now have two or more income earners. With so many present day households having two income earners, a substantial increase in household income is easy to explain.

Two income earner households are far more common among the top quintile of households than the general population. 2006 U.S. Census Bureau data indicates that over three quarters, 76%, of households in the top quintile, with annual incomes exceeding $91,200, had two or more income earners compared to just 42% among the general population and a small minority in the bottom three quintiles. As a result much of the rising income inequity between the upper and lower percentiles can be explained through the increasing percentage of households with two or more incomes

There is also evidence that we will review next week that the rich have increasingly married each other. That is, the trend of doctors, lawyers and finance executives to inter-marry, making the dual-income households that much wealthier, is a significant factor in the growth in income of the top 20% and indeed the top 1%. This seems not to be true for business owners - who actually by far make up the lions share of the top 1%. 

Tax Burdens: Increasing on the Top 20%, Almost Non-Existent on the Bottom 40%

The CBO compiles federal income taxes paid by households across four categories: 

• Individual income taxes - federal taxes paid net of earned income tax credits, benefits and refunds, which are essentially social programs conducted via tax policy instead of fiscal policy. 
• Payroll taxes - Taxes for Social Security and Medicare, paid by employees and employers. These were reduced by 2.0% from 7.65% to 5.65% of wages up to ~$107k in 2011 and 2012, then rest to their previous levels in 2013.
• Corporate income taxes - "Corporate taxes aren't paid by companies, but passed along to consumers." The CBO apportions some of these taxes to households. Don't ask me how. 
• Excise taxes - federal taxes on a good or service, such as gasoline, cigarettes and alcohol. 

The biggest portion of total federal taxes paid by most income groups is average (often called effective) individual income taxes, so we start there.

The chart above shows a history of the average (effective) individual income tax rates by income quintile from 1979 through 2011. Two trends worth noting: 

1. The average effective federal income tax rate for the bottom to quintiles has dropped from 0 to 4.0% in 1970 to -7.5% and -1.3% in 2011. That means ~40% of households are on a net basis receiving refunds and credits through the federal government that are larger than their income taxes paid from wages. This is what politicians and policy analysts are often referring to when they say "income redistribution". 
2. The highest quintile has had its effective federal income tax rate shrink modestly over the same period from 15.9% to 14.2%. The CBO notes in its report that tax law changes as of 2013 raised the effective income tax rate for the highest quintile by up to 4.3% - to an estimated 18.5% - though it does not yet appear in the data. 

Skipping to the total average federal income tax rates by group, we have the following graph:

So the total tax burden on each income quintile has decreased since 1979, but the drop for the bottom 80% has been significant while the drop for the top 20% has been smaller. 

Again - before anyone starts gnashing their teeth about the rich getting soaked - how has that impacted overall after-tax incomes, given the (enormous) rise in incomes for the top quintile compared to everyone else?

Well, well well. What do you know. On an after tax income basis everyone is doing better, but the rise in income for the top 1% is the highest: up 175% on a before-tax basis (shown in previous table) but up 200% on an after tax basis over the past 33 years. 

However, there is nothing magical about 1979 other than thats when the the CBO's household income data series starts, and we need to consider trends in taxes and income over a longer period and put it into a broader context. 

So until next week, don't leap to any conclusions. 

Household Income and Red Velvet Oreos

Part I: Today we are reviewing the most recent analysis of household income data from the trustworthy, non-partisan Congressional Budget Office, courtesy of the report, The Distribution of Household Income and Federal Taxes, 2011, published November 12, 2014.

Part II: Tomorrow we will summarize the distribution of federal taxes. If you can't wait until tomorrow, please see the CBO report. 

Politically agnostic: The CBO presents this data "mostly" free of political slant or editorial, and I attempt to do the same. Political pundits and policy analysts on both sides of the aisle tend to pick out the one or two statistics or charts that support their view, ignoring the larger context in favor of table pounding polemics. That's rubbish. These are the facts, with some caveats for interpretation provided as necessary. 

What's a household?

The CBO aggregates and analyzes income and tax data by household - meaning, people who share a household unit regardless of their relationship. By contrast, the Internal Revenue Service generally reports income by "taxpaying unit". A married couple filing jointly is a single taxpaying unit, whereas a married couple living with an adult child may be considered two taxpaying units but a single household. Total household income is adjusted for household size, then the normalized household income data is put on a distribution. 

The rationale for considering income and taxes on a household basis is that (a) most households make joint economic decisions; (b) a larger household generally needs more income to support a given standard of living; and (c) economies of scale do exist in some types of consumption - particularly housing. From the CBO report (edited for brevity):

CBO chose to adjust for household size by dividing household income by the square root of the number of people in the household, counting adults and children equally. Households were then ranked by adjusted income and grouped into quintiles (or fifths) of equal numbers of people. Because household sizes vary, different quintiles generally have slightly different numbers of households.

That adjustment implies that each additional person increases a household’s needs but does so at a decreasing rate. For example, a household consisting of a married couple with two children and an income of $80,000 would have an adjusted income of $40,000 ($80,000/√4) and would have the equivalent economic ranking of a single person with an income of $40,000 or of a childless married couple with an income of $56,600 ($56,600/√2 is almost $40,000).

In 2011 there were roughly 121 million households in the U.S., with about 24 million households per quintile. The table below shows the minimum threshold for total household income in 2011 for each category, based on household size. For example, a single person living alone that made at least $77,800 in 2011 was in the top 20% (highest quintile) in terms of standard of living. The CBO estimates that a family of four would need household income of $155,500 to maintain the same standard of living.  

YMMV: It is important to note that one of the things not accounted for are differences in geography that impact prices of goods and services, the cost of housing, wages, and how that impacts teh relative standard of living. A four-person household in New York City living on $90k probably does not feel as "middle class" as the same household in Topeka, Kansas. 

If you're thinking "yikes! I'm really broke!" then bear with me. Your situation is not as grim - nor most other people's as flush - as those numbers would suggest.

What is included in household income?

More than you think. In fact, probably a lot more than you see in your W-2, or as gross income on your tax statement. The CBO includes in household income:

• Labor income = cash wages and salaries, including amounts allocated to 401(k) plans; employer-paid health insurance premiums; the employer's share of Social Security, Medicare and federal unemployment insurance payroll taxes; and the share of corporate income taxes borne by workers. 
• Business income = net income from businesses, farms, partnerships and S corps.
• Capital gains = realized profits from the sale of assets.
• Capital income excluding capital gains = Interest, dividends, rental income, and the share of corporate income taxes borne by owners of capital. 
• Other income =  primarily retirement income from pensions, annuities, distributions from 401(k)s and the like. 
• Government transfers = includes payments from Social Security, unemployment insurance, Supplementary Security Income, Temporary Assistance for Needy Families, veteran's programs, workers' compensation, other state and local government assistance programs. 
• In-kind benefits = includes the cost of Supplemental Nutrition Assistance Program vouchers, school lunches, housing assistance, Medicare, Medicaid and the Children's Health Insurance Program, among others. 

Why are the cost of employer-paid health insurance premiums, payroll taxes included as household income? Because there is economic consensus that employers pass along these costs by paying lower wages than they would otherwise pay. It's sort of ok - the CBO seems to net it out on the other side by also allocating the employee taxes paid to households taxes as well. It's confusing to me, but you can read the report for more details.

Changes in the distribution of household income over time.

There is no denying that the rich are getting richer - as the highest quintile has made enormous gains in average household income, while the rest of the income distribution more or less treads water. 

But before you start gnashing your teeth about how rich doctors, lawyers and wall street bankers are (and they are, those jerks) let's take a closer look at the breakdown of income gains in of that top 20%. 

That's pretty amazing, really. The vast majority of the income gains have not accrued to "the top 20%" of households, but to the top 1% - or households with total income that averaged about $1.4 million in 2011, down from $2.0 million in 2007. 

How do people make that much money?

About 1.1 million households are in the top 1% (since there are 121 million households in the U.S.). Surprisingly, only about one-third of that total household income comes from labor income, e.g. wages and salaries. The other two-thirds comes mostly from capital gains, capital income and business income. Think stock and stock options granted to top corporate executives, very successful business founders, partners and owners, and others where the bulk of income does not come from salary and cash bonus. At least that's my best guess.

Also not surprisingly, these ultra high income households are heavily clustered along the northeast corridor from Washington DC to Boston, and in southern California. (The geographic distribution is not included in the CBO report, but you can google and find it - I think it pops up on Business Insider with some regularity.)

What about taxes?

So tomorrow we will look at how much in federal taxes all these groups pay. If it makes you feel any better (it doesn't for me, but you're probably a better person than I am), those people in the top 20% and the top 1% pay a tremendous amount in taxes, and their total tax burden has increased on average over time compared to the other 80% whose tax burden has declined. "Fair" is not a word I like to use in this context nor a topic I'm willing to address at this time. But the data is objective and we will review more of it tomorrow.   

Red velvet Oreos!!

According to media reports, the long-rumored, finally confirmed debut of the quintessential southern dessert flavored Oreo will be just before Valentine's Day, and available on your grocer's shelves for about 6 weeks. 

I plan on having some red velvet Oreos and a Coke. That's "Co-oak", two syllables, for those of you not from the south. Also can be referred to as "Co-Cola", three syllables, not "Coca-Cola". Words that are pronounced as single syllables are reserved for calling hunting dogs in the field - Pearl! Duke! Bing! (short for Bingo). Words of four syllables or more are typically strings of shorter words run together, like "yeradangfoolidgit." 

The ECB's Day in Court

Today, Jan 14, 2015, the European Court of Justice (ECJ) will hand down a legal decision on the ECB's Outright Monetary Transactions (OMT) program. This non-binding decision could potentially derail, or pave the way, for ECB sovereign bond purchases as part of (1) an ongoing Greek bail-out; and (2) a widely anticipated Fed-style quantitative easing (QE) program. Or the ECJ's decision may be wishy-washy and do neither. In that case, the German Constitutional Court - who deferred judgment on the issue to the ECJ - will eventually decide whether the provisions of the OMT violate their own constitution.

Market reaction could swing wildly based on the direction and strength of the decision. Since I'm not European sovereign debt specialist I won't make any strong predictions, but I will note that the rock-bottom interest rates and tight spreads (ex-Greece) probably reflect a presumption that sovereign QE is coming. In spades (spades >= EUR 500 billion?). If that presumption is rattled, it could get ugly for a bit, which probably means a panic flight into US Treasuries and a 10y yield bouncing off 1.60%. No guesses as to which way the court leans, as its way outside my expertise to handicap it.

We start with the barest outline of relevant EU law leading up to the OMT court case, and hand it off to some international law specialists for their opinions.

That's a lot of acronyms, and FWIW I apologize in advance that there are a lot more are coming. (FTW!)

Preliminaries

The following two treaties form a kind of constitution for the European Union (EU) and serve as the primary source of  EU law.  The treaties establish a variety of governing institutions, a fiscal and a monetary union, but not a political union. There is very little loss of national sovereignty when countries join the EU.

I make absolutely no attempt to summarize the treaties or comprehensively address the legal issues surrounding the ECB's various stimulus programs. Below is the barest outline of what I find useful when considering the potential ramifications of the court decision scheduled for Jan 14, 2015.

The Treaty on European Union (TEU) 

• Also known as the Maastricht Treaty, it was signed February 1992. After ratification by votes in all member nations, it became effective November, 1993. 
• This treaty established the European Union (EU) and set a variety of criteria that member states had to meet and uphold in order join the EU. 
• Within the TEU are the euro convergence criteria. The euro convergence criteria are five economic conditions that EU member states must meet before they can join the European and Monetary Union (EMU) and adopt the euro as their currency. These criteria set conditions on inflation rates, budget deficits, debt to GDP ratios, exchange rates and long term interest rates. 
• Note: The United Kingdom was one of the countries that joined the EU but opted out of becoming a member of the EMU and adopting the euro. 
• Articles within this treaty also established the institutions of the European Court of Justice (ECJ) and the European Central Bank (ECB), among many others. 

The Treaty on the Functioning of the European Union (TFEU)

• Developed from the European Community (EC) Treaty (1951) and the Treaties of Rome (1957); both the TEU and the TFEU have been amended several times by other treaties. 
•  The following articles within the TFEU are of particular importance for the court decision on the OMT and its potential ramifications for the ECB's quantitative easing program (summaries excerpted from here, except for Article 122 which is excerpted from here; formatting added, edited for brevity):
• Article 127(1) - the primary objective of the ECB ‘shall be to maintain price stability.’ 
• Article 123(1) - the 'no financing' clause. This article was included to prevent the national, regional and local governments of the Member States from borrowing from the ECB or the ECSB. In order to prevent the financing of government deficits by printing money, Article 123 prohibits the granting of ‘overdraft or other types of credit facilities’ by the ECB to the EU institutions or member states including regional or local government authorities as well as ‘the purchase directly of government bonds by the ECB or national central banks.’ 
• Article 125 - the ‘no bail-out’ clause. It states that the EU institutions including the ECB must not assume liability for the debts of central, regional, or local governments of the member states of the euro zone, nor must one member state assume liability for the debts of another. 
• Article 126 - provides that ‘Member States shall avoid excessive government deficits.’ As part of the  Stability and Growth Pact (SGP), Member States have agreed that their annual government budget deficit should not exceed 3% of GDP and that gross government debt should not exceed 60% of GDP.
• Article 122 - the emergency exception clause. Where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control, the Council, on a proposal from the Commission, may grant, under certain conditions, Union financial assistance to the Member State concerned. 

The European Crisis and the European Stability Mechanism (ESM)

There is an important legal decision from 2012 on the ESM that could shed light on the OMT ruling. Here is where I completely hand the analysis over to experts. First, from a German law journal article, The ESM and European Court's Predicament in Pringle (edited for clarity and brevity):

The legal framework of the Economic and Monetary Union (EMU) was not built to withstand a crisis of the current proportions. When it erupted late 2009, no mechanism existed to support Member States facing debt and bond-market difficulties. Under great market pressure, the Union and the euro area Member States pursued improvised solutions. 

During the last several years, these improvised solution funds - the EFSM and EFSF - have proven their worth as they have been used to provide financial assistance to Greece, Ireland, Portugal and Spain’s ailing banking sector. But they could only provide a temporary solution. In order to structurally strengthen EMU, a permanent rescue facility had to be established. Realizing this, the European Council took the initiative at its meeting of 28–29 October 2010 to create a permanent crisis mechanism in order to safeguard the financial stability of the euro area as a whole.  

And the European Stability Mechanism (ESM) was constructed and amended to the TFEU via the ESM treaty. From the ESM website:

The European Stability Mechanism is the permanent crisis resolution mechanism for the countries of the euro area. The ESM issues debt instruments in order to finance loans and other forms of financial assistance to euro area Member States. 

The decision leading to the creation of the ESM was taken by the European Council in December 2010. The euro area Member States signed an intergovernmental treaty establishing the ESM on 2 February 2012. The ESM was inaugurated on 8 October 2012.

The ESM is authorised to make use of the following lending instruments for the benefit of its Members, subject to appropriate conditionality:

• Provide loans in the framework of a macroeconomic adjustment programme;
• Purchase debt in the primary and secondary debt markets;
• Provide precautionary financial assistance in the form of credit lines;
• Finance recapitalisations of financial institutions through loans to the governments of ESM Members.
• Directly recapitalise financial institutions (as an instrument of last resort - when bail-in and contribution from resolution fund are insufficient to return an institution to viability)

If you think that sounds an awful lot like a bail-out mechanism - which contradicts the prohibition in Article 125 of the TFEU - then you understand why the ESM was challenged in court in Pringle. 

Here is an analysis of the ECJ's decision legally authorizing the ESM from Ashoka Mody in The OMT's fragile foundations (excerpts edited for brevity):

At the height of the crisis, the ECJ was asked to review the legality of the European Stability Mechanism (ESM), the vehicle established to ‘bailout’ sovereigns in financial distress. The ECJ’s decision gives us a preview on how it may react. 

The ECJ found a narrow legal space to authorise the ESM. From Article 122 of the TFEU, which permits financial support to sovereigns in circumstances beyond their control, the Court inferred that ‘financial assistance’ was not prohibited. The Court then stretched the ‘no bailout’ interpretation of Article 125 to allow financial assistance in the form of a loan (‘credit line’) to be repaid with ‘an appropriate margin’. Even so, the ECJ was clear. The distressed member state retains the ultimate responsibility of repaying its debts -- others cannot take on that burden. 

But in opening the door for the ESM, the ECJ also closed the door on the ECB. Though not called on to do so, the ECJ warned that Article 123 placed the ECB under by a stricter prohibition, denying it any form of lending (“overdraft or any other type of credit facility”) to a member state.     

The spirit of the ECJ’s view is, therefore, clear. A member state cannot impose a financial burden on another member state; and even the limited form of financial assistance (inter-governmental loans with an ‘appropriate margin’) must be democratically authorised by national parliaments and cannot be routed through the ‘independent’ ECB.

Outright Monetary Transactions (OMT), Greece, and QE

In 2012 as the peripheral European debt crisis was raging, the ECB announced that it "would undertake outright transactions in secondary, sovereign bond markets, aimed at safeguarding an appropriate monetary policy transmission and the singleness of the monetary policy." One catch is the country has to ask for financial assistance from the ECB and agree to certain domestic economic measures as conditions of aid.

Returning to the Articles in TFEU, the OMT (a) almost certainly violates the "no financing" clause; and (b) probably violates the "no bail-outs" clause as well.

The Federal Reserve bought US Treasuries as part of its QE programs, printing money and financing the deficits of the US government, in part because the Congress lacked the will to impose fiscal discipline. The Federal Reserve has the mandate and legal authority to do so. The question in front of the ECJ is does the ECB have a similar authority - to continue to bail out Greece via the OMT, to engage in sovereign bond QE - based on EU law?

Ashoka Mody's opinion (same reference as above, edited for brevity and formatting added):

The Greek bailout is almost certainly illegal by the ECJ’s benchmarks. To be legal under Article 125, the financial assistance must be repaid with an appropriate margin. The size of the appropriate margin is presumably a policy decision. But Greece will not repay the vast bulk of its official financial assistance. At the end of a grossly inefficient process, the burden of the sizeable eventual fiscal transfer to Greece will be shared without democratic accountability. In questioning the legality of the OMT, the German Court is essentially asking why the collective incentives will not lead once again to a Greece-like outcome. 

Either the Eurozone authorities must have a clear and credible policy of imposing losses on private creditors -- so that solvency is achieved with high probability -- or they must create a politically-sanctioned method of sharing the burden of other member states’ debts. Neither seems on the cards. If the member states fail to move in either of these directions, and the ECJ – as its own logic dictates – does agree with the German Court, the Eurozone will be once again left without a safety net. 

Mody just represents one opinion. Others think there are ways the ECJ could wave in parts of the OMT under the existing treaties, or sidestep the question altogether by ruling very narrowly and tossing it back to the German court. 

There is an excellent piece written by Deutsche Bank economists which addresses some of the legal issues of the OMT court case. I had a difficult time following all of it, so I won't pretend to incorporate it into my own thoughts or analysis, but you may have a better sense of it.

Private/Public QE: Repercussions of the OMT case at the ECJ

That's all I have for now. I will try to follow up once the decision comes out. Best of luck trading.

Dollar Dominance and the Oil Conspiracy

A Brief Recap

• In my previous post, The US Dollar Still Rules, to the Apparent Dismay of the BIS, we reviewed a brief history of money, and how in the post-WWII era the US dollar came to be the dominant global reserve currency. The dollar took over from British sterling - after its nearly 200 year run of being the favored international currency - thanks to the Bretton Woods Agreement of 1944.
• The Agreement established a new international monetary system where US dollars were convertible into gold at a fixed price, and other currencies were pegged to the dollar.
• The economics behind the collapse of the Bretton Woods system are honestly beyond me - in that they are beyond my tolerance for boredom. You can read about them here. The final reckoning began in the late 60s, when the US no longer had enough gold reserves to back the amount of currency at home and abroad, meaning the Federal Reserve was de facto insolvent. The rest of the world was understandably chapped.
• In 1971, West Germany and Switzerland were the first two to exit the Bretton Woods system, and other nations were demanding gold and threatening to leave as well. 
• Nixon, acting on advice of Treasury Secretary John Connally, Federal Reserve Chairman Arthur Burns, and a then-undersecretary at Treasury Paul Volcker, unilaterally took the US - and effectively the rest of the world - off the modified gold standard in 1971. 
• Currencies began to float after an adjustment period, though some retained a deliberate soft or hard peg to the US dollar.  
• In the early 70s as the world converted to fiat currency and the US dollar devalued, economists, financial analysts, and politicians the world over predicted the demise of the dollar as the global reserve currency. It didn't happen.

There is an interesting theory about why it didn't happen then. This is worth discussing because some analysts make investment recommendations based on the supposed link between oil trading and the dollar's status as global reserve currency.

The Big Oil Conspiracy

The crux of the big oil conspiracy is that as the US was backing out of Bretton Woods in the early 70s, US leaders entered into secret deals with Saudi Arabia to have oil invoiced and settled exclusively in US dollars in exchange for military protection and supplies. These deals supposedly secured oil production for the US, put the US dollar on an oil basis instead of a fiat basis, and ensured that the dollar would remain the dominant global reserve currency by monopolizing the oil trade. The US dollars paid for oil - nicknamed "petrodollars" - would then be recycled into US dollar assets, effectively subsidizing US energy needs and economic growth at the expense of other oil importers. The conspiracy goes a little bit further, alleging that the dramatic oil shocks of the early 70s were not due to political disagreements over the Arab-Israeli conflict, but supposedly secretly planned for and encouraged by former Secretary of State Henry Kissinger (you know it's always Kissinger) to inaugurate the petrodollar recycling wave and save the US and UK oil companies.

There is more if you want to read about it, complete with modestly hysterical undertones, here.

The scaffolding of the oil conspiracy is accurate, in that many of those things occurred, some no doubt hammered out during negotiations about mutually beneficial relationships between the US and its allies in the Middle East. The real cloak-and-dagger bits seem to trace back to two relatively recent books, one written by David Spiro, The Hidden Hand of American Hegemony: Petrodollar Recycling and International Markets, published in 1999; and the other by William Engdahl, A Century of War: Anglo-American Oil Politics and the New World Order, published in 2004. I haven't read either one of them, but they variously use as primary sources for their allegations recently declassified documents recovered via the Freedom of Information Act (Spiro), interviews with high level attendees at the meetings, and - in Engdahl's case (footnoted on the Big Oil website, link above):

Engdahl was able to purchase the secret minutes of a May 1973 Bilderberg meeting from a Paris bookseller. His book contains actual photocopies of the cover page and related text discussed in chapter 1. The cover page is stamped: "SALSJOBADEN CONFERENCE 11-13 May 1973." Also stamped on the cover page are the words: "PERSONAL AND STRICTLY CONFIDENTIAL" and "NOT FOR PUBLICATION EITHER IN WHOLE OR IN PART"

In my very limited research I have not seen anyone challenge their allegations or their source materials, nor have I seen other authors offer different interpretations of the notes or state they have reviewed the original documents. Take both of these sources as you will.

Specious Market Analysis and Trade Recommendations

The problem with conspiracy theories in investment management is that they may over-emphasize or attribute causal relationships between asset classes based on specious reasoning. I'm not trying to call anyone out, as I've certainly made some lousy trade recommendations of my own over the years. Therefore I'm not going to provide links to the original sources of the trade ideas below.

Idea #1: Since the US dollar is fundamentally an oil-based currency, the price of oil and the value of the dollar are linked. The price of oil will rise and the value of the dollar will increase.

Idea #2, different version: The value of the US dollar is heavily dependent on its role in oil trading. If energy trading begins to diversify away from the dollar - perhaps due to the $400 billion Sino-Russian gas deal signed in 2014 which allows Chinese purchases to be settled in renminbi - then the US dollar's reserve status will be threatened. Foreign banks will diversify away from US dollar assets, interest rates will rise, the value of the dollar will plunge and gold will appreciate.

The US Dollar Still Rules, to the Apparent Dismay of the BIS

Not for the uninitiated. The background information provided in this post lacks the usual technical depth (I flatter myself, I know). Foreign exchange is not my specialty, and forecasting currency exchange rates makes modeling the term premium seem like an exact science. The following are my opinions, with facts, figures and links to imminently reliable sources included.

A gentle warning from the BIS about the US dollar's status as reserve currency.

I have long tracked foreign investment - particularly that of foreign central banks and foreign official sovereign wealth funds - in US dollars, and its impact on US financial markets. This is why the recent article in the BIS Quarterly Review, December 2014, "Currency movements drive reserve composition," peaked my interest.

The BIS piece essentially questions why the US dollar has maintained its global reserve currency status - as US dollar assets account for 60% of foreign exchange reserves - despite the weight of the US economy being less than 25% of global GDP.  Among their conclusions (and I'm paraphrasing here) are that:

1. Currencies that tend to be highly correlated to the dollar maintain higher shares of dollars in their official reserves. This "dollar zone" of currencies keeps the overall weight of the dollar in reserves higher and helps the dollar maintain its reserve status. 
2. Should the co-movement of currencies change rapidly, the shift away from dollars in the composition of reserves could also quickly erode the dollar's weight as a reserve currency, perhaps in favor of the Chinese renminbi. 

I'm going to go out on an interpretive limb here and say that I think what the BIS is implying is that (1) If China and other Asian countries move away from soft-pegging their currency to the dollar, and; (2) Presuming China continues to rise as a global economic power; (3) Then the renminbi could "soon" - and perhaps violently - join or supplant the US dollar as a global reserve currency.

I'm going to go on record as saying that their projection that the renminbi will move to global reserve status is both way too early and not really supported by the evidence that they site in the paper, other than that they seem to want to see the US dollar pushed aside. No countries that report the currency breakdown in their FX reserves currently have enough renminbi that it rises to the level of being significant to report as a category (less than 1% of allocated reserves are held in renminbi). Granted, most renminbi is probably held by nations that don't disclose that information, but still, it's an incredible stretch to project that such a position would go from being presumably negligible to "global reserve status" in, what, a period of a few years?

Many international economists have been claiming since before the euro was created in 1999 that it would rise to reserve currency status, challenging or overtaking the dollar (we site some more recent pieces along that vein later in the post). And I'm sure that it will - or could - occur, if the monetary union begins to function more as a fiscal and regulatory union, and the current destabilization problems are worked out. Fifteen years is certainly much too early to begin to judge. Britain had the reserve currency of the world for a couple of centuries, and many others functioned that way at times over the past two thousand years.

 Part of the persistence of the US dollar's reserve status is its role in the global oil trade, the strength and size of the US economy, and the safe haven status its securities have due to the trust and faith people all over the world ascribe to the intent of the government to make good on its debts. Like us or not, we're the best credit going. As the US dollar continues to strengthen against the euro, yen and renminbi and the oil market crashes, I don't quite know what to make of all this. History can tell us a lot, and the history of money tells us that it's just as much about faith, governance, financial and monetary stability as it is about the size of the economy. Currency crises and financial chaos have been occurring with surprising frequency for millenia. There is a trade here, it's probably in FX and energy (ha ha ha, brilliant deduction, Watson) but I'm not sure know what it is. If you have some time, give this a read and send me some suggestions.

A brief history of money.

Bartering - e.g. trading cattle for seasonal harvests for cloth for labor - being a rather cumbersome and inefficient form of economic exchange, most ancient societies developed some primitive forms of money. In ancient China it was cowrie shells, in modern day prisons it's cigarettes. Due to its durability, convenience of transport, and eventually the ability to standardize weights, most ancient civilizations had incorporated the use of various metals as proto-money by around 2000 BC. 

It is worth noting that banking preceded the development of true coinage. From Glyn Davies, Origins of Money and of Banking, 

Banking originated in Ancient Mesopotamia where the royal palaces and temples provided secure places for the safe-keeping of grain and other commodities. Receipts came to be used for transfers not only to the original depositors but also to third parties. Eventually private houses in Mesopotamia also got involved in these banking operations and laws regulating them were included in the code of Hammurabi.

In Egypt too the centralization of harvests in state warehouses also led to the development of a system of banking. Written orders for the withdrawal of separate lots of grain by owners whose crops had been deposited there for safety and convenience, or which had been compulsorily deposited to the credit of the king, soon became used as a more general method of payment of debts to other persons including tax gatherers, priests and traders. 

"Tax gatherers," ha. Who knew the ancient Egyptians were Democrats? Anyway, manufactured, stamped coins first appeared independently in India, China and cities around the Aegean sea from 700 to 500 BC. Gold and silver, along with various metal alloys, were commonly used for money and later coinage. The Egyptians used gold bars as a medium of exchange as early as 4000 BC. The first gold coins of the Grecian age were struck around 700 BC. 

Once coinage became widespread, the minting of money - along with standardizing the weights and compositions of metal coins - was rapidly taken over by governments worldwide, after which inflation, debasement and counterfeiting immediately became problems.

The first foreign exchange traders.

Another excerpt from Glyn Davies (same reference as above):

The great variety of coinages originally in use in the Hellenic world meant that money changing was the earliest and most common form of Greek banking. Usually the money changers would carry out their business in or around temples and other public buildings, setting up their trapezium-shaped tables (which usually carried a series of lines and squares for assisting calculations), from which the Greek bankers, the trapezitai derived their name, much as our name for bank comes from the Italian banca for bench or counter. The close association between banking, money changing and temples is best known to us from the episode of Christ's overturning the tables in the Temple of Jerusalem (Matthew 21.12).

Both the Egyptians and the Greeks developed a sophisticated banking and finance system, which allowed for money transfers, extensions of credit, and lending to support shipping, mining and construction operations. Unfortunately, the fall of the Roman Empire resulted in most of the banking system being lost or forgotten. Back to Glyn Davies:

Banking re-emerged in Europe at about the time of the Crusades. In Italian city states such as Rome, Venice and Genoa, and in the fairs of medieval France, the need to transfer sums of money for trading purposes led to the development of financial services including bills of exchange. Although it is possible that such bills had been used by the Arabs in the eighth century and the Jews in the tenth, the first for which definite evidence exists was a contract issued in Genoa in 1156 to enable two brothers who had borrowed 115 Genoese pounds to reimburse the bank's agents in Constantinople by paying them 460 bezants one month after their arrival.

There you go - the first known recorded forward FX contract. Pretty cool.

Coinage to paper money to the gold standard.

Like the development of coinage, several governments or financial centers in the first millenia independently developed some version of a paper guarantee. This was often due to a shortage of bullion used for making coins, the necessity of transferring large sums of money for international trade, or a drainage of coins to other countries due to payments for imports or protection from invaders (Vikings, all over Britain). However, it was China - where paper and printing were first invented - that was the first to make banknotes a common form of currency in about 960 AD. By 1020 China also suffered the world's first crippling bout of hyper-inflation, as financial authorities flooded the empire with banknotes, resulting in a dramatic devaluation of the currency.

Paper currency didn't really come into widespread use in Europe until the mid-17th century with the issuance of bearer receipts and banknotes. Again, the issuance of these instruments was quickly taken over by the government, in part to retain sole control of the money supply. Unlike metal coins, paper money obviously has no intrinsic value, and was originally backed by some physical commodity that it could be converted into or served as a claim against, usually gold or silver. Beginning in the 19th century, most countries - led by the then economic powerhouse Great Britain in 1817 - migrated from a silver or bimetallic standard to an exclusively gold standard backing their currency. That is, the domestic money supply in a country is directly tied to a country's stock of gold, held at their own central bank. Between 1870 and 1914, many countries, including Great Britain, the US and much of western Europe, were on a "classic gold standard" and the British pound was the reserve currency of the industrialized world.

The development of the modern concept of a reserve currency took place in the mid nineteenth century, with the introduction of national central banks and treasuries and an increasingly integrated global economy. By the 1860s, most industrialised countries had followed the lead of the United Kingdom and put their currency on to the gold standard. At that point the UK was the primary exporter of manufactured goods and services and over 60% of world trade was invoiced in pound sterling. British banks were also expanding overseas, London was the world centre for insurance and commodity markets and British capital was the leading source of foreign investment around the world; sterling soon became the standard currency used for international commercial transactions.  -- from Reserve Currency, Wikipedia

The gold standard falls and the US dollar ascends.

By now, those of you still reading (you, dozing off at your monitor! thank you!), are wondering why I'm dragging you through this history lesson and what on earth it has to do with foreign currency reserves and the US dollar. Hang on, we're speeding up now (mostly because there are a lot of economic models and details that I'm outright skipping).

All countries that are on a gold standard fix the prices of their currencies to a specified amount of gold. Therefore, rates of exchange between currencies tied to gold also become fixed, the price levels between those countries move together, and it vastly facilitates international trade. If enacted correctly and "all countries play by the economic rules" then the virtue of the gold standard is that it assures long-term price stability - at the expense of highly unstable prices in the short run and a lack of discretion over monetary policy.

The gold standard may have been a good idea in principle. Unfortunately in practice - particularly through WWI, the great depression and WWII - it didn't work out at all well. Countries and central banks cheated, markets and international payment systems collapsed, people started hoarding gold - all the usual stuff that happens when academic theory collides with real human behavior. It was time to come up with something else. From Wikipedia:

In 1944 in Bretton Woods, New Hampshire, representatives from 44 nations met to develop a new international monetary system that came to be known as the Bretton Woods system. Conference members had hoped that this new system would “ensure exchange rate stability, prevent competitive devaluations, and promote economic growth." It was not until 1958 that the Bretton Woods System became fully operational. Countries now settled their international accounts in dollars that could be converted to gold at a fixed exchange rate of $35 per ounce, which was redeemable by the U.S. government. Thus, the United States was committed to backing every dollar overseas with gold. Other currencies were fixed to the dollar, and the dollar was pegged to gold.

The Bretton Woods Agreement* in 1944 established the US dollar as the reserve currency of the world. All other currencies could devalue against the dollar, but only the dollar maintained the backing of gold. This may have seemed appropriate at the time, as the U.S. owned over half the world's official gold reserves and had taken over from Great Britain as the premier economic powerhouse, contributing 35% of world GDP. In the aftermath of WWII, no other country was in a very good position to argue.

*The politics on all sides surrounding this agreement were about as vicious and rife with self-dealing as you can imagine. At times - in hindsight - they are also very, very funny. If you have the time and the interest, you can read about it in Benn Steil's book, The Battle of Bretton Woods.

In 1971, Nixon takes the US off the gold standard, and currencies begin to be "free floating".

By the late 60s the US was no longer the dominant engine of world growth, public debt had increased, its gold supply was falling due to persistently negative balance of payments and the Federal Reserve was inflating the currency, resulting in the dollar becoming increasingly overvalued versus other currencies. Other countries were understandably furious at subsidizing the US spending spree, and threatened to convert their dollar reserves into gold (which the US could not afford to have them do, because it didn't have that much gold left) and exit the Bretton Woods system. West Germany did so in 1971 and promptly saw its currency and economy strengthen. Switzerland followed.

In August, 1971 President Nixon took the US off the gold standard: US dollars were no longer convertible into gold; fixed exchange rates became floating; the dollar devalued against other currencies (and the US fell headlong into stagflation).

Central banks begin to diversify their foreign exchange reserves.

Back to Wikipedia (Get off me. I send them donations every year):

Foreign-exchange reserves (also called forex reserves or FX reserves) are assets held by central banks and monetary authorities, usually in different reserve currencies, mostly the United States dollar, and to a lesser extent the Euro, the Pound sterling, and the Japanese yen, and used to back its liabilities, e.g., the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions.

Foreign exchange reserves -> fixed income investment.

Only a small portion of the foreign exchange reserves are actually held as bank deposits - that is, in currency form. Instead, most central banks invest their reserves in securities denominated in the targeted foreign currencies. Central banks being necessarily risk averse, these security portfolios are heavily weighted towards sovereign debt, highly rated asset-backed securities and investment grade corporate debt.

The US dollar is still the reserve currency of the world. For now. 

FX reserves that are tracked by the IMF (International Monetary Fund) currently total ~$12 trillion, roughly 60% of which is estimated to be held in US dollar assets. A little over half of the countries report the size and allocation by currency of their FX reserves; others - including China, the world's largest single holder of FX reserves - report only the total size. Reliable estimates and limited self-reporting leads most analysts to conclude that the currency breakdown of the ~$5 trillion in unallocated reserves is similar to that of the allocated reserves, and most likely also held 60-70%  in US dollars. Historical FX reserve data from the IMF broken down by currency for allocated reserves, plus the unallocated portion, is shown in the graph below.

The benefits of being a reserve currency - not to mention "the" reserve currency - are both tangible and meaningful: lower interest rates, cheaper financing of both public and private debt which results in improved economic growth, ease of international transactions for exports, and the prestige of being a financial world leader and a "safe haven" in times of upheaval. (Now everyone reach out and smack Ted Cruz in the head.)

Why is the US dollar still so dominant?

A clique of international economists have long projected (nee hoped) that the US dollar would lose its status as the reserve currency of the world - or at least be forced to share that status with the Euro, or perhaps China's renminbi. As an example of that faction, some Slovenian economists did an evaluation of foreign currency reserves similar to that in the recent BIS review. Their conclusions in 2007 were that the US dollar was likely to be "dethroned" as the leading reserve currency in favor of the euro. Excerpted from Compositional Analysis of Foreign Currency Reserves in the 1999-2007 Period - The Euro vs. the Dollar as Leading Reserve Currency (edited for brevity, emphasis added):

This article mainly aims to present the currency composition of the foreign currency reserves of central banks in selected countries in the 1999-2007 period and, on this basis, to establish whether the euro stands any real chances of dethroning the US dollar as the global currency. The empirical results ...theoretical and empirical expectations, confirm the hypothesis that in the near future the euro may be regarded as a global reserve currency on a par with the US dollar or it may even become the leading reserve currency.

 Given that most raw materials (oil, gold etc.) are these days globally traded in US dollars and that this currency dominates with over more than four-fifths of foreign trade and one-half of global exports, most central banks hold their foreign currency reserves in dollars. Moreover, the United States is at the helm of the world economy in terms of the size of its national economy and it is also the second largest financial center.

In recent times, an opinion has been gaining ground which mirrors the pessimistic scenario for the US currency because in the years to come the dollar is expected to gradually lose its role as the leading global reserve currency (see e.g. Bergsten (1997), Mundell (1998), Wyplosz (2001), Chinn & Frankel (2005)).This is postulated to be a consequence of changes in oil trading as oil-exporting countries will start charging for oil in euros and the latter will accordingly supplant dollars. 

Editor's note: I'm not sure, so any oil specialists please let me know, but I still don't think there is a meaningful amount of oil being priced in euros at this time.

Similarly, the beginning of the end of the dollar’s role as the leading international monetary currency could also involve the decision announced by China in July 2003 to switch some of its reserves out of dollars and into euros (Sharma et al., 2004). In the past, China tied its currency to the dollar while at present it fixes it against a basket of currencies. This example was followed by some Asian central banks which have diversified some of their reserves into euros.

China has certainly diversified some of its fx reserves, but since they do not report their currency breakdown, estimates are that at most 20-25% is held in euros. The euro diversification of allocated reserves stabilized at ~20% of FX reserves and seems not to be rising.

Unfortunately, due to recent events that are once again destabilizing the euro zone, I can't imagine that will contribute to a further FX diversification into euros at this time. It will no doubt happen that the US dollar will share "reserve status" - and eventually be completely supplanted - by another currency or basket of  currencies.

The BIS vs the Fed on the Term Premium

BIS economists see markets as fragile; urge caution. 

This is old news, but as we step into the first few trading sessions of the new year, it's worth rehashing that global central bankers are nervous about signs of froth and volatility in the market.

 

The BIS - that's Bank for International Settlements, the central bank for 60 member central banks and international organizations, from countries that account for roughly 95% of world GDP - published its latest quarterly review last month, the  BIS Quarterly Review, December 2014. The headline article, which was widely reported on in the media, was titled "Buoyant yet fragile?" The BIS provided the following summary (emphasis added):

Markets remain buoyant despite mid-October's spike in the volatility of most asset classes. This sharp retreat in risk appetite reflected growing uncertainty about the global economic outlook and monetary policy stance, as well as increased geopolitical tensions. As selling pressure increased, market liquidity temporarily dried up, amplifying market movements.

Markets rebounded quickly as economic concerns faded and some major central banks further eased monetary policy. In particular, the Bank of Japan and the ECB provided further stimulus, while the Federal Reserve ended its QE3 asset purchases. These opposing moves unsettled exchange rates, with the dollar appreciating against most other currencies.

Reprising the August sell-off and recovery in global financial markets, this rapid flip-flop from "risk-on" to "risk-off" sentiment (and back again) suggests that more than a quantum of fragility underlies the current elevated mood in financial markets. 

The BIS further cautioned investors and market participants about "this prolonged surge in financial markets over the last two years, occurring against a backdrop of low growth and unusually accommodative monetary policies in advanced economies." This echoes concerns of some Fed economists, as stated in the minutes from the October 29, 2014 FOMC meeting, "that recent developments in financial markets highlighted the potential for shocks to trigger increases in market volatility and declines in asset prices that could undermine financial stability."

 

The article seems to further suggest that a re-pricing may occur if and when the FOMC raises short-term interest rates, assuming the market aligns its view of future short-term rates to the neutral level represented by the FOMC median forecast of 3.75%. Such a revision should theoretically increase the term premium and the level of the 10yT yield. 

The BIS revisits the term premium. 

 

An interesting nugget within the above "Buoyant yet fragile?" article was an update on the BIS economists' own calculation of the term premium on the 10-year Treasury bond . 

Despite the Federal Reserve’s exit from QE3, estimates of the term premium on Treasury yields remained deep in negative territory and even declined further. On the 10-year Treasury bond they fell by more than 10 basis points from September to end-October 2014 (Graph 5, left-hand panel, reproduced below). 

Market expectations of future US short-term interest rates also decreased. Forward rates for the end of 2015 fell (Graph 5, second panel), and similar developments were evident across the maturity spectrum. Particularly sharp adjustments occurred on 15 October, and they were not reversed during the actual end of QE3. Throughout the year, primary dealers have consistently and significantly forecasted lower future rates than members of the Federal Open Market Committee (Graph 5, third panel). A future alignment of expectations could raise the risk of abrupt adjustments.

The BIS economists calculate the 10-year term premium by decomposing the nominal yield using a joint macroeconomic and term structure model. Their model shows the term premium in the 10yT deep in negative territory since at least mid-2012, having briefly turned positive early in 2014 when the 10yT yield rose above 3.00%. Based on the graph, it appears the BIS is currently estimating the 10yT term premium at about -0.80% to -1.00%. It appears that the BIS is attributing the most recent drop in the term premium to the market's falling expectations of future short term interest rates, and is warning that if those expectations reverse, then the term premium - and likely the 10yT yield - would rise rapidly. 

 

The NY Fed has a different estimate of the term premium.

Compare that to the NY Fed's daily estimate of the same term premium, which is plotted below versus the fitted 10yT nominal yield (the data is available on their website): 

The NY Fed's model shows a somewhat similar pattern of changes in the term premium, but they estimate that it has just recently pushed back into negative territory at -0.20%, having been briefly and just barely negative in late 2012.

If the dynamics are roughly similar - at least over this short period of time shown in the graphs above - does it matter if the two term premium estimates are materially different? I would argue that yes, it does, because attributing or projecting a change in nominal bond yields to a compression or expansion in the term premium is a bit meaningless when there is so little agreement on how it should be calculated, what it's value is and what proportion of the nominal yield it makes up over time. 

Background on the term premium

 

For a very high-level overview of the term premium - embedded with a fair amount of my own skepticism concerning its calculation and use - you can see my previous post, The Term Premium: the Economics Version of the Flux Capacitor. 

For a more scholarly, less cynical and considerably more authoritative commentary on the term premium, we borrow from a 2007 Economic Letter from the San Francisco Fed, What We Do and Don't Know about the Term Premium, (edited for brevity): 

Briefly stated, the term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. For example, suppose that the interest rate on the 10-year U.S. Treasury note is about 5.5%, and suppose that the interest rate on the 1-year U.S. Treasury bill is expected to average about 5% over the next 10 years. Then the term premium on the 10-year U.S. Treasury note would be about 0.5%, or 50 basis points.

Thus, a key component of the term premium is investor expectations about the future course of short-term interest rates over the lifetime of the long-term bond. In the example above, the term premium on the 10-year Treasury note depends crucially on financial market expectations about the course of shorter-term U.S. interest rates over the next ten years, a very long horizon. This foreshadows some of the difficulties of measuring the term premium that we will encounter below.

Note that, while we usually think of the term premium as being positive–that financial market participants require extra yield to induce them to hold a bond for a longer period of time–there is nothing in the definition of the term premium that requires it to be so. For example, if some purchasers of long-term debt, such as pension funds, are interested in locking in a fixed rate of return for a long period of time, they could be willing to accept a lower yield on long-term securities (a negative term premium) in order to avoid the risks associated with rolling over their investments in a series of shorter-term bonds with uncertain, fluctuating interest rates. Thus, both the sign and the magnitude of the term premium are ultimately empirical questions.

The article should be read in its entirety, as it talks succinctly and cogently about the issues surrounding the concept and calculation of the term premium. I've reproduced the graph below from the article, which shows how clearly divergent various estimates of the term premium are over time using four different models / methods. (Note: VAR stands for vector auto regression, and Rudebusch-Wu have since revised their model so it looks much more dynamic.) 

Term structure theory can't (yet?) tell you how to invest.

That pretty much sums up my issue with analysts (and FOMC members) who forecast yields (or evaluate and determine monetary policy) based on the supposed dynamics of the term premium. At this juncture I think there is so little agreement among the many economists and their models, that to forecast rates based on a change in the term premium - as if it were some tangible, market-priced, quantifiable component of the yield - is to introduce a nebulous variable into what should be a clearer discussion of monetary policy and the market's reaction to its' implementation.