April 2010 - Posts
Please, click here to read this article in pdf format: april-29-2010
What a week! It’s amazing how a few days make a difference these days. We will force ourselves to summarize into a few main points our views:
In our previous letter, we wrote: “The ECB has its hands tied and hikes in policy rates cannot happen any time soon. The Euro will continue to be tossed off the proverbial cliff. But the question here is: What will the Euro fall more against, in relative terms? The USD? The CAD? Gold?
In our view, speed here is of the essence. If the Euro devaluation is not carried out in order, global liquidity will be affected. If it is orderly carried out, then the quiet and underlying shift of other central banks’ reserves (i.e. Russia , China ) out of the Euro and into the CAD, the AUD or gold will be more relevant, in relative terms. Hence, it is critical to understand what can cause a “disorderly” devaluation of the Euro and what its corresponding likelihood is. We think that anything that hints towards the dissolution of the monetary union, institutionally, will generate confusion and disorder. Under this scenario, Euros, gold, CAD, AUD and commodities will be sold, while USD and US Treasuries will be bought. Anything else that hints towards a slow and steady debasement of the Euro, will favor gold, CAD, AUD and commodities, at the expense of USD and US Treasuries demand…”
And now, post Greece/Portugal/Spain downgrades, we realize we were half right, or half wrong. The downgrades put the Union in a really tough spot. Commodities, stocks were sold and the USD strengthened. But gold….gold rallied. What happened?
In general, money serves three main purposes: It’s a unit of account, a medium of indirect exchange and a reserve asset. These uses are deeply interconnected. The demand for money is therefore usually conceived as the sum of the demand for liquidity purposes and for saving purposes: Md = Ld + Sd.
What we saw on Tuesday is proof to us that Md (=demand for money) is now STARTING TO BE (the operative word here is “Starting”) at a global level: Md = L (in USD) + S (in Gold). That is, the world may now be starting to use USD for liquidity/funding purposes and gold as a reserve asset. “Starting” again is the operative word. Some people may call this Gresham ’s law. Gresham ’s law would be currently at work on the Euro. People toss the Euro for USD and whatever else that is not needed for liquidity, is exchanged for gold.
Since Tuesday, it is evident to us that Europe has only two choices: Either Germany/France guarantee Greece’s debt (and soon Portugal’s) or the European Central Bank lifts the veil and accepts junk sovereign debt as collateral to fund PIGS banks. Which one do you think is politically easier to implement? In our view, it is the latter, which means the Euro will be devalued big time.
Until Tuesday, we considered gold as just another asset. Now, we’ve changed our view, which forces us to pay attention to this detail: Every time a risk position is unwound and a certain percentage is recycled back to USD for liquidity purposes, while another percentage goes to gold, we think that the capital that moves to gold is capital OUT of the system. Who will fill the gap? Will the ECB (i.e. central banks) fill the gap? Has that gap to be filled anyway? Why?
When a central bank tries to fill the gap, we have low inflation morphing into dynamic inflation which, if allowed to blossom, later becomes hyperinflation. At that point, and perhaps we are closer to that point than many of us want to believe, gold becomes “THE” reserve asset. What has to happen for this to materialize? It has to be a global shift in nature. Contagion out of Europe has to spread, it is a necessary condition, in our view.
Under such scenario, would commodities drop in price because Europeans wouldn’t be able to afford them? This is the key question for us in Canada and we think the answer is positive. Therefore, perhaps and only perhaps, we will not see any exit strategies after all. How do we position against this scenario? We want to start buying weakness in gold.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
Please, click here to read this article in pdf format: april-26-2010
We left our desk on Friday with a smile. Post-Goldman and with the seriousness of the Greece drama, we stuck to our view that nothing fundamentally had changed and that the rally in stocks would continue. And it did, with the S&P500 index closing at 1,217.28pts, the Canadian dollar still not below parity and gold stronger.
We like a quote from a certain Macedonio Fernández (http://en.wikipedia.org/wiki/Macedonio_Fernández ) that we believe has never been more proper to describe market sentiment these days. It goes like this: “We easily accept reality, perhaps because we intuit that nothing is real”. Paraphrasing then Mr. Fernandez: “The markets accept (and rally on) the reality of increased sovereign risk, because they intuit that nothing is real, that deficits shall be monetized and that this too shall pass.”
Today, we would like to write about fundamentals or the latest developments in the credit markets. But unfortunately central banks and governments continue to be the main drivers behind all action these days. On this basis, let’s take a quick bird’s-eye view on the drama.
In Europe, we have a relatively minor government that is technically insolvent and is seeking financial aid from the Union. This aid will come by way of guarantees on their sovereign debt by banks of other Union members (i.e. Kwf Bankengruppe). However, we all know that a Kfw bank can provide that guarantee because at the end of the day, the European Central Bank stands behind. It is the same central bank that will take the guaranteed debt at par and issue Euros in exchange, if liquidity is required by a financial institution holding that sovereign debt. This type of debt monetization is subtle. Herr Schmidt in Hamburg, M. Dupuy in Paris or il signor Michetti in Milano will not notice it. None of them will see their taxes raised. Even if we wanted to explain it to them how their savings are being taxed, the explanation would require a minimum understanding of basic accounting principles. If Herr Schmidt has “ein Sparkonto beim Kfw Bankgruppe” he won’t suspect at all that the collateral supporting his Konto is a mere illusion. When do these people get a hint of what’s going on? Come next winter, when they want book their week-long all-inclusive trip to the Dominican Republic, they will realize their savings are not as good as they were a year ago. Maybe it won’t matter…Maybe they will vacation in a Greek island after all. Why not?
What is the lesson here? The ECB has its hands tied and hikes in policy rates cannot happen any time soon. The Euro will continue to be tossed off the proverbial cliff. But the question here is: What will the Euro fall more against, in relative terms? The USD? The CAD? Gold?
In our view, speed here is of the essence. If the Euro devaluation is not carried out in order, global liquidity will be affected. If it is orderly carried out, then the quiet and underlying shift of other central banks’ reserves (i.e. Russia, China) out of the Euro and into the CAD, the AUD or gold will be more relevant, in relative terms. Hence, it is key to understand what can cause a “disorderly” devaluation of the Euro and what is its corresponding likelihood. We think that anything that hints towards the dissolution of the monetary union, institutionally, will generate confusion and disorder. Under this scenario, Euros, gold, CAD, AUD and commodities will be sold, while USD and US Treasuries will be bought. Anything else that hints towards a slow and steady debasement of the Euro, will favor gold, CAD, AUD and commodities, at the expense of USD and US Treasuries demand.
We believe the underlying theme in this approach cannot be captured by quantitative analysis. Institutional risk would be the so-called tail risk, leaving statistical inference useless (But feedback here is welcome). Therefore, one has to be able to read between the lines, into the messy political game that will unfold before our eyes. One must not underestimate the institutional problem of the European Union. It is not circumscribed to Greece. It involves the future monetization of Portuguese and Spanish deficits as well. It may even involve a bailout of Spanish financial institutions.
Any maneuver by the ECB to gain independence and keep up with an exit strategy, regardless of the fiscal situation of EU members, will open the door for the IMF to play a bigger role and create uncertainty as to which alliance between other EU members (i.e. German-French) will fill the gap. This type of scenarios will favor USD assets. By the same token, any validation by the ECB of sovereign deficits (i.e. extension of emergency liquidity lines for up to BBB+ debt) should push gold, CAD, AUD and commodities higher, at the expense of USD and US Treasuries. One last caveat here: This market thesis assumes things in the US and China remain “stable”.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
Please, click here to read this article in pdf format:april-22-2009
Inflation, or asset inflation, seems to be the flavor of the week. It’s in most analysts’ research notes. A month ago, on March 18th, in a letter titled “The winter of our dynamic inflation” (www.sibileau.com/martin/2010/03/18 ), we wrote that:
“…the latest action in the markets proves that they are dependent on a given rate of money supply …(…)…A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms…Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when exit strategies like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply…Regardless of expectations; the intervention of central banks in the rates markets has a real impact that distorts relative prices…”
The chart below shows Greece’s 5-yr sovereign credit default swap and the S&P500 Index (source: Bloomberg). We thought it would be useful to show two vertical lines, dividing the chart in three periods.
The first period starts in Dec/09 and ends on January 6th. It corresponds to the post-Dubai days and end with the violent shooting of Greece’s sovereign risk. Right after, Greece started to steal headlines. We too wrote a letter on this issue (refer: “Don’t forget Greece”, www.sibileau.com/martin/2010/01/07 ). All markets sold off, while European Union leaders sought to show a unified front in addressing the short-term aspect of the problem: Greece’s upcoming debt refinancings. Of course, the problem remains unsolved. However, during this second period, macroeconomic readings began to surface, signaling that the recovery was not as weak as expected, while at the same time, EU leaders publicly committed to support Greece. This period ended on March 18th, with Greece’s 5-yr sovereign risk touching just below 300bps. It was then when we wrote the comments quoted above, about the upcoming dynamic inflation.
The next period, from March 18th to date shows that the market indeed did well by assuming accommodating policies were going to continue. This is reflected in the markets’ indifference towards sovereign risk, fueled by above-expectations earnings and other macroeconomic metrics that seem to show a steady but slow recovery. You can see that both trends, the rally in stocks and the increase in sovereign risk run in parallel. However, there is no need for stocks to rally or credit to tighten, in light of increasing sovereign default risk. But as we wrote then, investors know and have gotten used to a rate of money supply, which is challenging the measured promises of central bankers regarding inflation control mechanisms. The European Central Bank (also during the last period) announced its intention to extend the emergency contingency lines, which as we showed in our last letter, are nothing else but a mechanism for the indirect monetization of fiscal deficits. Meanwhile, the Fed also made clear that we are still far away from a policy rate hike. On Tuesday, Bloomberg reported Mr. Jörg Asmussen, Staatsekretär im Bundesfinanzministerium, saying Greece would get a loan from the German KfW Bankengruppe (with government guarantee)
Now, why should we write about this today? Why should we all care about this?
Mainstream economists, among which a great majority works for government institutions, are increasingly pointing fingers at the asset bubbles or asset inflation that the world is witnessing in different markets. In China, the case is very obvious. Underneath this observation is the implicit desire to ignore there is a problem. Policy makers find themselves at odds explaining how “asset” prices increase, while unemployment remains high. To us, this is not extraordinary. To us, this is not an aberration, but the perfectly normal results of quantitative easing. In fact, we would be seriously concerned if under monetary expansions, asset prices would not increase. But we do not dictate policy…
A tiresome and wearing battle, on a global scale, is in its infancy. In this battle, governments will seek to regulate every aspect of our lives to delay the unavoidable. Unfortunately, nobody ever wins these battles. Nations, as a whole, end poorer. In the near term and on a relative basis, we continue to like those nations that will delay the less (in our view, Canada), owning stocks and gold.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
Please, click here to read this article in pdf format: april-19-2010
Indeed, we can’t start the week without referring to the SEC’s securities fraud action vs. Goldman Sachs. We will not comment on the case itself, but on what we think is its macro consequence. For those interested in the case in particular, please, click on the link: http://online.wsj.com/public/resources/documents/secgoldman2010-04-16.pdf
We agree with those who see this case as the start of a major move to press financial institutions in the US to accept tougher regulations on lending, derivatives, etc. We are concerned about the rhetoric used by politicians, who continue to blame Wall Street’s greed for all their credit expansion. Frankly, the comments made by certain US senators on Friday were no different than those one can hear from Hugo Chavez on his weekly TV show. But long term, we don’t think this should impact the compression in credit spreads or stocks valuations…The driver of the rally that started in March ‘09 has never been fundamentals, but quantitative easing policies. In Europe, the monetization of deficits is becoming increasingly more explicit. With sovereign risk on the rise, government debt is placed in the banking system, which in turn places it as collateral at the European Central Bank (ECB), to raise liquidity. In summary, the graph below shows the process taking place in Greece:
As you can see, in step 1, governments place debt at banks. Among other sources of funding, Banks use deposits (in Euro) to leverage their capital in this transaction. In step 2, banks may turn to the ECB to exchange the government debt for liquidity, at face value (at par). The final outcome is shown in step 3: Basically, the ECB has bought government bonds, in exchange of fresh money. This is an indirect monetization, which transfers wealth from all the holders of Euro notes to the taxpayers who enjoy the fiscal spending of governments that use the ECB. The size of this transfer equals the fall in purchasing power of the Euro vs. other currencies/commodities, multiplied by the amount of Euros in circulation. It is easy to see that soon, every government will compete to place its debt at the ECB, to win this game.
In the US, monetization is undergoing a change. It has temporarily stopped with the unwinding of the quantitative easing programs, but given the unbalanced nature of the federal, state and municipal budgets, it shall continue. Meanwhile, foreign investors (central banks) and increasingly banks buy US debt. The upcoming financial regulatory framework will be supportive of monetization. Hence, the need to press institutions, as we first glimpsed on Friday. As the issuance of Treasuries and rise in policy rates eventually increase the cost of capital, it will be evident that the sustainability of the recovery/valuations will be more fragile. The government will continue to blame Wall Street for not lending enough to Main Street, while it simultaneously generates a crowding-out effect on corporate credit with the implementation of Basel 3. Under Basel 3, regardless of its final shape, banks will be forced to hold government debt as liquid assets (vs. other corporates) and to issue more equity to raise capital. In countries like Argentina, we have seen this coercion take place already. How was the liquidity shortage circumvented? The government itself became the major lender (i.e. Banco Nación). Would the US not do the same through its Agencies? In our opinion, US financial institutions will be the losers in this game, while gold starts to look like the real winner. Fortunately, on Friday, gold sold off, as investors long financials needed to raise liquidity.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
Please, click here to read this article in pdf format: april-15-2010
Perhaps the most relevant theme this week is how the market is
digesting the announcement of the EUR45BN aid package (some now
speculate it can go even further) for Greece. Briefly, credit has
tightened, stocks are rallying, while sovereigns are underperforming. On
this note, we want to go back to our first letter of 2010, titled: “The
capital structure game” (www.sibileau.com/martin/2010/01/04 ). Back then, we
wrote:
Part 1 (On relative value):
“We think that 2010 will be the year of the capital structure game,
because the set of relative prices that will be the most distorted is
precisely that of the components of a firm’s capital structure…If we
take the simpler view that the spectrum of liabilities of a firm is
split into debt and equity, in 2010, it will be very clear that the
value of equity is only a function of the value of debt. As central
banks reduce their stimulus programs or unwind them and as governments
continue to run into fiscal deficits, both of them will significantly
affect the markets in which they operate (i.e. Treasuries, Agency debt,
mortgage-backed securities, state/provincial and municipal debt)…(…)… In
2010, most companies will have refinanced their short-term debt.
However, with central banks unwinding their quantitative easing
policies, the decrease in demand for fixed income securities together
with the huge issuance of governments’ debt will put pressure on rates.
As credit spreads are already very low again, the increase in sovereign
risk (yield) should make debt a less profitable investment, when
compared against equity…”
What has happened so far:
We think this game has played out relatively well. Spreads in both
investment grade and high yield have compressed, given the strong
issuance in Q1/10 (record for High Yield), while sovereign risk has
underperformed, given the volatility out of Europe. The issuance has
been so strong, that in our view it has been the main factor driving
10-yr swaps into negative territory. Interestingly, the US Treasuries
curve, today, is not dramatically different vs. the beginning of 2010.
This in our view is due to the central banks’ reserves arbitrage, out of
the Euro and into gold and non-US dollars mainly, as well as the same
compression in credit spreads, which has forced institutions to
reallocate capital out of US corporates and into Treasuries. The clear
winner here has been stocks, as we anticipated in January. Below, we
show the SP500 index vs. 5-yr generic Inv. Grade Credit Default Swap
Index (CDX, source: Bloomberg):
Part 2 (on Foreign Exchange):
“In December, I associated this process with USD strength. Now, I am
not so sure. Since my last letter of 2009, the US Treasury announced it
would lift the cap on the Preferred Stock Purchase Program (refer
Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited
support”, Bank of America’ “US Agencies” report of Dec 29/09). This
explicit show of support for agency debt (which I assumed it was going
to smoothly disappear in 2010) tells me that the USD strength will be
only a relative notion in 2010. I say relative because the strength
should show vs. those countries that explicitly decide to import USD
inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro
zone), while the weakness should show vs. those countries that will
profit from the credit-inflated recovery (Emerging markets or commodity
currencies, like the CAD).”
What has happened so far:
Our case has been made more than evident here. We were spot on (check
the CAD/Brazilian real cross, chart not included). Going forward, we
fear this theme will last longer than initially expected. The rise in
policy rates from either the USD or Eurozone will take longer than most
thought, as the Greece rescue package is demonstrating and as the
municipal/state deficits in the US will demonstrate (and the FOMC’s
statements make clear). Hence, our late bullish sentiment on gold
(refer: www.sibileau.com/martin/2010/04/08 )
Part 3 (On Gold):
“Companies choose to finance their operations or projects with debt
or equity for a reason. When their respective markets are distorted,
non-efficient decisions are made. That will be the case in 2010, with
more companies taking debt for M&A, or share buybacks. Investment
banks will love the action and financials and energy should have a good
year. Gold should find it hard to outperform, unless some political
event breaks the existing “entente” among central banks. I don’t think
such a political event would come from either US/Canada, Europe or
Japan.”
What has happened so far:
The political event that broke the entente among central banks, we
believe, is the Greece situation. (We implicitly thought it would come
from China, but it came from Europe). This has caused a revision of
central bank reserves allocations, favoring among others the CAD and the
sense that coordination is no longer there. The European Central Bank,
the Fed, the Bank of Japan, the Bank of Canada, the People’s Bank of
China…they all have to attend their own internal problems and will fine
tune their respective policies accordingly. It is not chaos,
but the indetermination in currency crosses is temporarily paused. The
flight out of the Euro put gold as the common price deflator, in our
view.
Conclusion:
Sovereign risks continue to shadow the overall picture here, but the
market does not seem to pay enough attention to it…Well, that could be
one of the explanations. In our view, the market is not ignoring it. It
simply believes that monetization will be the solution and therefore
allocates out of liquidity and into risk, favoring currency zones that
will monetize less, relative to others.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments provide general information only. Neither the
information nor any opinion expressed constitutes a solicitation, an
offer or an invitation to make an offer, to buy or sell any securities
or other financial instrument or any derivative related to such
securities or instruments (e.g., options, futures, warrants, and
contracts for differences). My comments are not intended to provide
personal investment advice and they do not take into account the
specific investment objectives, financial situation and the particular
needs of any specific person.
Please, click here to read this article in pdf format: april-12-2010
This was a “busy” weekend, and we are left with no alternative but to
write about it on a Sunday night…
First, we offer our deepest condolences to the people of Poland on the
tragic deaths of their President, Mr. Kaczynski, First Lady Maria
Kaczynski, and those who were traveling with them, on the 70th
anniversary of the Katyn massacre.
Europe was also on the front pages, with the announcement of a
EUR45BN rescue package, consisting of EUR30BN by European Union members
and EUR15BN by the IMF. Of course, this money is at below-market interest rates. We suspect that Greece shorts will be squeezed
this morning, although much of the rally we saw at the end of last week
was on the speculation of this outcome. Personally, we believe this is
only buying time for the European Union and we fail to understand the
logic behind this package, if it is real. To us, it looks more like a
threat, for it seems Greece’s Finance Minister, Mr. Papaconstantinou,
said the government still plans to issue debt, without taking up the
offer for aid. Another relevant point here is that from now on, we
should expect the same kind of response to other worsening fiscal
deficits, as in the case of Spain or Portugal. Will the Union be there
for them? If so, what kind of exit policy can the European Central Bank
(ECB) undertake?
On this note, in our last letter (Thursday, April 8th) we had assumed
the graded haircut schedule announced by the ECB was going to include
government debt. We were wrong. Details were subsequently released and
the program will exclude government debt.
Thus, one more act has closed on the European theater and we have no
choice but to think the world can only print its way out of this crisis.
This is the reason why we turned bullish on gold last week, for as our
market thesis states (refer: www.sibileau.com/martin/2009/04/21 ), every major
central bank has now to face internal unique problems that prevents a
global coordination in monetary policy. Gold therefore will increasingly
play a role as the common denominator for all fiat currencies.
As central banks are (unsuccessfully) seeking to structure their
respective exit strategies, governments are looking for a way to build
the next line of defense against a future liquidity crisis. Sometimes,
the line looks like the Maginot line…
On Saturday, Canada’s National Post reported that Ms. Julie Dickson,
Canada’s chief bank regulator, prefers a scheme whereby banks could
insure themselves against failure with debt that converts to equity
(refer: “OSFI offers conversion as bank shield”, at : http://www.financialpost.com/story.html?id=2785584 ). If
correct, we think Ms. Dickson may be referring to contingent notes,
similar to those recently issued by Rabobank. On March 12th, Rabobank
issued a EUR 1.25 billion, benchmark 10-yr Senior Contingent Note, at an
annual coupon of 6.875%. These notes are contingent on Rabobank’s
capital, as a percentage of assets. If this ratio falls to less than
7%, the notes will be written down to 25% of face value. Therefore, the
bank will record a gain on the issue, which increases its capital.
We have no view on this particular debt issue. But we believe that
encouraging this type of financing as a buffer against a liquidity
crisis is absurd. We cannot mince words here. In fact, the widespread
use of this type of debt will only help precipitate a crisis, in a
self-fulfilling dynamic.
No investor in any
part of the capital structure of a financial institution should feel
any safer with this scheme. As soon as an event triggers only the mere
likelihood of a liquidity squeeze, noteholders will dump the notes with
the proverbial violence. The transfer of wealth from noteholders to
shareholders will only be temporary, for immediately after this event,
the capital gain will never, ever, offset the liquidity costs financial
institutions will face to remain going concerns. Depositors will feel at
risk and a serious run against those financial institutions will
trigger a swift downward spiral.
Indeed, with senior contingent notes, financial institutions are
buying a put from the note holders. However, believing that these notes
constitute a solid cushion against systemic risk equals to ignoring the
leveraged and correlated nature of financial institutions under a fiat
currency system.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments provide general information only. Neither the
information nor any opinion expressed constitutes a solicitation, an
offer or an invitation to make an offer, to buy or sell any securities
or other financial instrument or any derivative related to such
securities or instruments (e.g., options, futures, warrants, and
contracts for differences). My comments are not intended to provide
personal investment advice and they do not take into account the
specific investment objectives, financial situation and the particular
needs of any specific person.
Please, click here to read this article in pdf format: april-8-2010
We’re back from Chicago, where we spent the Easter weekend, a holiday
in Canada. Since last week, we have the feeling that some changes of
consequence have taken place at the macro level, globally. We will try
to summarize what we believe is the most relevant:
-Sovereign risk: Europe/Greece
On Tuesday, we heard/read rumors that depositors in Greek banks are
withdrawing/not renewing their deposits. Only rumors… What was not a
rumor was the European Central Bank’s (ECB) decision to introduce a
“graded haircut schedule” on government debt (i.e. Greek debt) in
January 2011. The details of this decision will be released today, but
we think this would be inconsistent with the role of a lender of last
resort. Think about this for a moment…To accept junk collateral at a
discount sends two signals: a) the recognition of a junk paper, with the
establishment of a cap price for that paper, and b) the explicit
monetization of a fiscal deficit, at a specific rate (the rate of
issuance of the government that places the debt as collateral)! Besides,
it will inevitably create frictions between the issuing governments and
the ECB. The difference between inflation and hyperinflation is nothing
else but the incorporation of inflation expectations to prices by
investors. If a central bank facilitates the job, then we are entering
dangerous waters. We, at “A View from the Trenches” had anticipated this
back on December 17th (www.sibileau.com/martin/2009/12/17 ) and later laid
out the scenario, on January 7th (www.sibileau.com/martin/2010/01/07 ). We were clear,
we wrote we would be sellers of Euro. These events remind us of our
years at the Univ. of Buenos Aires, when a professor that shall remain
anonymous compared inflation with pregnancy: “Nobody can indefinitely be
just a “little” pregnant”, which brings us to our next point:
-Gold:
Almost a year ago (refer: www.sibileau.com/martin/2009/04/21 , “Two main
market theses”), we put forward a simple thesis on gold: “…when there
is global coordination of inflationary monetary policies, gold cannot be
a safe and lucrative asset. When inflationary monetary policies are not
globally coordinated, gold is a safe and lucrative asset…”. This thesis
was very useful and has never proved us wrong so far… On Tuesday, we
turned bullish on gold. With the ECB’ decision to monetize peripherals’
sovereign debt, China’s recent signal that the Yuan will gain
flexibility while still manipulating interest rates (the government
announced yesterday its intention to begin issuance of 3-yr debt), the
upcoming election in the UK and fiscal crisis in the US (see further
below), global monetary coordination is taking a pause (the Fed
concluded last week its unprecedented purchase of mortgages). Since the
Dubai event, we had been neutral-to-bearish of gold (refer: www.sibileau.com/martin/2009/11/30 ), preferring
Canadian equities, to ride the safe-haven bid theme on the Canadian
dollar. We had showed the spread between the ETFs XIU.TO (TSX 60) and
IGT.TO (gold, in CAD), to make our case. As the chart below shows
(source: Bloomberg), the spread tightened this week. We were waiting for
IGT.TO to touch the C$112 level for confirmation of the trend and that
happened yesterday. The trigger however was, in our view, the ratings
downgrade of Greek banks (National Bank of Greece, EFG Eurobank
Ergasias, Alpha Bank, Piraeus Bank, Emporiki Bank of Greece,
Agricultural Bank of Greece and General Bank of Greece) on March 31, at
8:31am ET.
-Sovereign risk: US (the next big thing)
While we have seen an impressive increase in the volume of public
issuance lately driving swaps into negative territory, since last week, a
series of news has muddied the waters: Harrisburg, PA, announced it
will miss a loan payment, Fitch cut Illinois’ rating on $23.4BN of
municipal bonds one notch to A-, citing a rising budget deficit for
2011, and New York state announced a delay in $2.1BN of school aid,
given its $9BN deficit for 2010. The news yesterday of an 11.5BN (vs.
+5BN) fall in consumer credit and the Healthcare bill don’t help at all
in the face of the massive state/municipal deficits. Yes, other central
banks are reallocating what they can from what they had in the form of
Euro to US Treasuries, but the yield curve is still steeper vs. last
month (with yesterday’s news, the 2y10y spread flattened by -3.2 bps to
279.4 bps). How is this going to work out within an increasing interest
rates environment? Exactly! There will be no increases in the near term,
or at least, not as quickly as most expected, according to Tuesday’s
Federal Open Markets Committee’s statement, which brings us back to our
point on gold…
Martin Sibileau
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