April 2011 - Posts
Please, click here to read this article in pdf format: april-18-2011
Two weeks ago, we called our readers’ collective attention towards gold, noting that: “… we think higher highs are soon to come…”. A week ago, we expressed our concern that stagflation seemed to be manifesting itself before its time. We defined stagflation and went on to describe what made us believe that we were facing it. Over the past two weeks, markets have told us that our call was correct. They told us so by making our positions in our personal accounts profitable. Simply, their verdict is always the only one we pay attention to. But perhaps we were actually wrong and even then, we got lucky! Wise people are people full of doubts. We want to “wise up”, so we will devote today’s comments to raise doubts on our call…
If our stagflation call was right, shorting stocks and going long gold was the right thing to do. We think it was but what could tell us this is sustainable in the future?
Let’s leave gold aside for a moment. Its long-term trend is naturally from the lower left to the upper right, if only because of the steady increase in money supply coupled with the credit multiplier.
What could then make stocks return to a bull trend, proving us wrong? We think we would need to see certainty on a few fronts. Let’s see…
In the US, we don’t need to necessarily see sustainability on its fiscal deficit (to push stocks higher over the next weeks, that is…). All we need to see is that politicians of both sides tend to agree on a deficit cutting program, in a reliable way. On Friday, the US House passed a Republican budget in favour of cutting spending by more than $6 trillion over a decade. But no Democrats voted it and because Republicans oppose higher taxes and the cutting program involves the privatization of Medicare, both sides in Congress are worlds apart. Nothing tells us that this situation may change sooner than later.
It is not easy, we must say, to see how this affects markets. To begin with, it poses the question of how markets will react once QE2 ends in June, assuming no agreement on the fiscal issue. Opinions are divided here with those analysts on the street telling us that the Fed will just end QE policies, stop reinvesting mortgage backed securities proceeds and slowly raise rates. We cannot agree with them because the main assumption they have is that QE2 was to support the recovery in the private sector, and it succeeded. We disagree on both points. To us, QE2 was not to boost private growth but to finance the fiscal deficit and even that was not a success, as yields are higher. In this scenario, how can the Fed afford to leave the fiscal deficit problem unresolved and trigger a currency crisis? Perhaps the Fed governors are “lucky” and the surprising increase in jobless claims we saw last Thursday repeats itself next Thursday, showing that a trend in the making is at hand, and giving the Fed the perfect excuse to continue printing money. For brevity, we will leave this point here, only adding that there is a lot of confusion around this, with plenty of curve trades being recommended in Treasuries and misunderstanding of what backwardation is telling us, in terms of inflationary expectations (we will elaborate further on this, if it becomes more relevant).
Another source of global uncertainty remains that of sovereign risk within the European Union. During the last week, EU officials let it be known that a restructuring of Greece’s debt would not be catastrophic and immediately after, speculation began on whether such restructuring would trigger a credit event under the outstanding credit default swap contracts. We are not in a position (nor are we allowed to) to opine here. All we can say is that, on the margin, this doesn’t bring certainty. In addition, Moody’s downgraded Ireland by two notches to Baa3 from Baa1 (still investment grade) and this always leads us back to questioning the strength of the country’s financial system first, and that of all the EU at last.
Finally, no matter where one captures inflation statistics from, the story is unanimously the same and of higher inflation. A friend made the point that the latest release in the US, showing 50bps increase in CPI month over month implies a 6% annualized rate. We wrote here last week about this issue in relation to Emerging Markets. On that note also last week, China showed that the pace of increase in prices remains unabated and has announced another increase in the reserve requirement ratio over this weekend. It shall do nothing to the trend, only making things worse on the way.
In conclusion, we frankly see nothing new on the horizon that may derail us from heading towards a worsening “stagflationary” process. We will continue to trade accordingly.
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.
Last week marked an important step in the history of this crisis. We had started the week calling our readers’ collective attention towards the consolidation that gold had witnessed on Friday, April 1st, and wrote that: “… we think higher highs are soon to come…”. Well,…the higher highs came and we fear, they came to stay.
If we had to define in one sentence the action last week and that which is to develop in the future, we would say it in actually one word, not even a sentence. That word is “stagflation”. We truly believed stagflation would present itself to us later this year or even next year. However, we think it is here now. This leaves us on the contrarian side, because almost everyone we read, hear or watch is telling us that “growth” (a misnomer used by mainstream economists, including those at the helm of the Fed, to refer to a higher GDP) will be high in 2011 and that the Fed will be forced to raise rates in 2012.
Before we go any further, let’s define “stagflation”. The easiest way is to refer to Wikipedia, where we are told that: “In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. It raises a dilemma for economic policy since actions designed to lower inflation may worsen economic growth and vice versa.” The description of stagflation is further elaborated and given within its historical context.
Ludwig von Mises, in Chapter XX (“ Interest, Credit Expansion and the Trade Cycle”), of his magnum opus “Human Action” writes that: “…It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption…” (p. 549, 4th Edition, 1963). And we think this is key to understand stagflation.
Why do we fear that we may be facing stagflation?
If you have been following energy stocks lately, particularly those in the TSX Energy Index, you will have noticed that as oil (West-Texas Intermediate) approached and passed $110/bbl, this group of stocks, collectively, did not make higher highs. Yes, on Thursday and Friday, their valuations improved, but oil closed above $113/bl after hours and these stocks have not really impressed us. In “normal conditions”, this should not have happened. The highs in this group were made when chaos unfolded in Egypt, at the beginning of the year. Now that the anarchy in the Middle East is to stay and oil prices are making higher highs every week, we should see energy stocks strongly outperforming. But this is not the case. Capital is not going to that sector as the price of oil should signal. This can only mean that in the future, with a lower stock of capital to produce oil, we will see higher oil prices. This can only point towards stagflation.
The same can be said even about gold mining shares and, in general, stocks collectively, as an asset class. Capital is being consumed! On the lending side of things, we don’t see anything but refinancings to take advantage of low interest rates, while they last, and to extend maturities. We, personally (not objectively) believe we are not seeing the same level of M&A that most market participants were expecting at this stage of the so-called “recovery”.
On the other hand, we still have big, unresolved macro issues:
-European Union:
We have, for a long time already, written that last week’s decision by the European Central Bank to raise rates is a big mistake. Since a year ago, we have been very clear on this: The survival of the Euro depends on its flexibility, and by this we mean, its ability to go lower, to depreciate. Right now, the opposite is taking place and it is only a matter of time until we see the political consequences of this move. We have patience.
-US fiscal deficit/QE2:
Last week’s debate on the US budget was a complete embarrassment and has exposed the challenges the Fed will face, if it really means to undertake an exit strategy.
-Inflation in EMs
Finally, we cannot expect high inflation to be confined to Emerging markets only. Most of these nations have sought to keep their currencies from appreciating against the US dollar, thereby increasing their supply and with it, inflation. These nations are net exporters. If wages in them increase, the developing world that imports their goods will see its purchasing power suffer.
Most likely, we are not telling anything new here, but we think it is good to remind ourselves of these issues, within the current context. Therefore, to dream of a Fed raising rates because of a “recovery” is to ignore important flags like a stock market that lags commodity prices, a worsening situation in Europe and the US, as well as a-soon-to-come impact from the emerging markets.
Of course, by the time the prices of imported goods will affect developed nations, mainstream economists will seek to convince us that the inflation is of a structural nature, because central banks in developed nations cannot influence prices in emerging markets. But our readers will know that that is a fallacy at best, and a lie at worst. The only structural thing about it all will have been the quantitative easing of central banks in the developed world.
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-4-2011
We don’t trade upon technicals but we take note of them. On Friday, we think gold went through an important test. After the announcement, at 8:30am, that the US unemployment rate had fallen to 8.8% (the lowest for the past two years), gold sold off to $1,415/oz. This fall came after having briefly touched $1,440/oz the day earlier. We were disappointed, because the markets in our view, had misinterpreted the new information. Relative prices on Friday morning seemed to reflect this line of reasoning: The lower unemployment rate, given the “stable” inflation rate, will push the Fed to hike rates sooner rather than later. Why? Because it would seem that the so-called stimulus of QE2 is working. If it is working, the Fed can now focus on fighting inflation.
What is wrong with this view? In our opinion, it is simply absurd. The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold.
By the end of the session, gold had bounced back from $1,415/oz (making a higher low, vs. the previous of $1,409) and consolidating around $1,430/oz. We don’t trade upon technicals, but we certainly took note of this consolidation and we think higher highs are soon to come.
Continuing our analysis of the Fed, we applaud the result of Bloomberg and News Corp.’s Fox News Network LLC lawsuit against the Fed for records under the Freedom of Information Act. The US Supreme Court rejected the Fed’s attempt to block the disclosure of records related to its discount window operations. The release of this information showed how the Fed made significant loans to overseas banks, that is, banks outside the US currency zone.
At “A View from the Trenches” we have repeatedly discussed the role that these loans, including cross-currency swaps, have in magnifying global leverage. The first to point at cross currency swaps between central banks as a potential transmission channel for global imbalances, was M. Jacques Rueff, who blamed them for the “…long duration of the substantial credit inflation that preceded the 1929 crisis in the United States (our note: under the gold-exchange standard)”. M. Rueff, who was Financial Attachée in the French Embassy in London, made this opinion public for the first time on a letter dated Oct 1st, 1931, to France’s Prime Minister (J. Rueff, “The Monetary Sin of the West”, 1971).
These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.
In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs. This of course, is ironic, because Ron Paul, who wants to end the Fed and is chairman of the House subcommittee overseeing the Fed, will seek to stop such loans and swaps from being offered. We, on the other hand, would follow Napoléon’s advice, when he said: “N’interrompez jamais un ennemi qui est en train de faire une erreur” (Never interrupt an enemy, when he is making a mistake).
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.