A View from the Trenches, March 12, 2012: "The tide turned against the EMU"
On Friday, out of the office and away from the screens (we are currently visiting the US capital), we were spared the enormous volatility in gold. Gold tried to break through the lows made since a public institution liquidated bullion on Februrary 29th but closed making a higher high (since the sell-off, of course). This, in light of a jobs report taken mildly positively by the market and the drop in the Euro post Greek debt swap, is encouraging to gold bulls (not bugs, but bulls) like us.
The Greek resolution of their debt exchange, with its credit default swap triggered, was a real slap in the face to anyone who was educated under the mainstream portfolio theory, where the existence of a risk-free asset is cornerstone. (We don’t belong to that group of thinking, because we have always recognized that implicitly, modern portfolio theory rests on the Walrasian (refer: http://en.wikipedia.org/wiki/L%C3%A9on_Walras) view of general equilibrium and in the world of central banking, where banks lend multiple times other people’s real savings, general equilibrium theory looks like Ptolemy’s geocentric model of astronomy. But then again, Ptolemy’s model survived centuries and while it lasted, those who dared to challenge it were threatened with death and hell. We want to survive, which is why we are gold bulls, but not gold bugs J).
Indeed, the Greek debt developments, together with monetary policy in the European Union, are writing a new chapter in the history of financial crises. But first things first, we must say that those who seek to compare the situation in Greece with that in Argentina in 2001 are misled, very. When Argentina defaulted, the price of 1 USD rose from 1 peso to above 4 pesos. It was the devaluation that brought subsequent growth, not the default itself. Devaluation has so far been absent in Greece and as we wrote before, it can last as long as the Greek people are willing to put up with the austerity measures being imposed upon them by the EU Council.
Our next step is to recognize that from now on, if you are a holder of sovereign debt, you risk being deeply subordinated by a supranational institution (like the European Central Bank) and, on top of counterparty risk, you will suffer from a high degree of uncertainty related to the usefulness of credit default swaps you may own. Along the same path, you will have learned that whatever holdings you had in unsecured bank debt will also be deeply subordinated to the collateral taken by the European Central Bank to keep your borrower (i.e. the banks) solvent via long-term refinancing operations. You will also have found out that this collateral too, can be created out of thin air, as banks (as in the case of Italy) may obtain government guarantees on their debt issuance, post it at the central bank’s window and receive new, freshly printed Euros!
Capital is therefore flowing out of the European Union and the flow is set to increase, perhaps exponentially. Nobody should be surprised by the fall of the Euro last Friday. Where does that leave the European private sector? Those big conglomerates able to issue bonds in other currencies (mostly in USD) will be able to borrow. The small businesses who depended on the EU capital markets will struggle. The lesson here is that to defend their currency, the European Monetary Union has destroyed their capital markets. And we do not know which one will be easier to rebuild. If run uncontested, the European Union will end like an emerging market of the ‘80s, where foreign funding is needed to support private investments. In light of this, what are the chances that the Fed will raise real interest rates? Very slim we think, for if they are actually raised, currency swaps to the Eurozone will be needed, and that may not be politically sustainable at that time.
After this debt exchange, the public sector (ECB, IMF, etc) will be the majority owner of the debt of the public sector in Greece, and in the future, in the rest of the European Union. The way out of this mess can only be debt monetization.
We want to end with another comment on something that we think the markets may have not paid enough attention to. China is reported to start extending loans to other nations (Brazil, India, Russia) in their own currency. We are witnessing the start of a “reserves war”, where the supremacy of the US dollar will be challenged on the margin. We know so far that above 90% of the US Treasury’s issuance in long-term debt has been purchased by the Fed, while Russia and China have been selling it. What if the loans in Renmimbis from China are funded with the sale of stock in US Treasuries owned by the People’s Bank of China? What if the sale by a public institution of gold at the fixing on February 29th was a warning to the other public institutions that are accumulating gold as reserves? What if that warning had been guessed by the Bank of Israel, influencing their decision to allocate up to 10% of their reserves in US equities, rather than in gold?
What if we are wrong? What if we are right? Should gold at $1,714/oz not look cheap? Should 30-yr US Treasuries not be a good short?
Martin Sibileau