M. Hollande has won the French presidency and fear is now widespread, that with the anti-bailout message sent by the Greek electorate, who voted this weekend too, the house of cards built by the European Central Bank may collapse. It is hard for us to see how this may take the markets by surprise, but….what do we know? We still remain long gold (although not so much as before, given the open and obscene manipulation this asset has been subject to) and bearish of stocks.
Over the past week, mainstream media sought to convince us that we, at least in North America, were enjoying a slow growth that would eventually take us out of recession, without inflation. No inflation was in sight, earnings had been showing recent strength and Europe…well, Europe was far, far away.
It all went well until U.S. jobs numbers on Thursday first and definitively on Friday, gave us an unpleasant indication of what really goes on. Of course, mainstream media, upon release of these numbers, sought to twist them in every positive way available…to no avail. Stock markets plunged at the end of the week, with Europenow in negative territory for the year…after a trillion or so of liquidity given by the European Central Bank between December 2011 and March 2012.
As is our usual approach, we won’t discuss statistics here. Readers count with an endless menu of other sources for that. But having heard the official explanation that the unemployment rate fell from 8.2% to 8.1% because the pool of people looking for employment had decreased, we were reminded of Argentina’s explanation for the increase in unemployment, leading to the financial collapse of 2001. In those years, the official story was that the rate of unemployment rose because things were looking so good that people could no longer afford to sit at home and had started looking for employment. In other words, the pool of people looking for jobs had grown because it was worthwhile, productive to work. Both explanations were ridiculous.
Now, let’s discuss the apparent perception that the world is not suffering from inflation. At least for now. We think it is valid to point out that so far, the substantial (let’s say above the explicit 2% target) increase in prices has been seen in assets, rather than in final good and services. This, for those of us within the Austrian School of Economics, makes perfect sense, since it is precisely this school that maintains that the expansion of money supply is not neutral. It begins affecting one sector and then spills over to the next. As a matter of fact, we reproduce below the first graph ever published at “A View from the Trenches”, on April 14, 2009:
If we go by this graph, we must say that we have bad news. The situation we pictured three years ago foresaw an increase in the purchase of capital goods, which if it had materialized, would have meant strong investments and economic growth. But recent data shows, as we had warned since the beginning of 2012, that funds are not flowing to investments.
While companies carry high cash balances, given the manipulation by central banks and governments of interest rates, and commodities, as well as the uncertainty over taxes, labour regulations, etc., they have decided not to throw good money after bad. It’s common sense, because over the last decade, on average, equity prices have gone nowhere at best, and down at worst. Companies are therefore transferring those cash balances to “the people”. They are distributing dividends and buying back shares, in increasing amounts. If this trend holds, this will be the transmission mechanism that will link the inflation in asset prices with general inflation, in consumption goods.
Another mechanism pointed to us by a friend and reader is vertical integration. An example of this is the recent purchase by Delta Air Lines Inc. of an oil refinery from ConocoPhillips, in a bid to save on fuel costs (announced on May 1st). Integrations like these go in opposite direction to economic growth. Economic growth is achieved with specialization, diversification that boosts productivity, complexity in the economic system and is based on ever growing economies of scale. This kind of vertical integration breaks with diversification and economies of scale. Fuel production will now not be guided by external demand but by transfer pricing. This is an isolated case, but if you generalize this example, you end up with a situation similar to that which transformed the economic system of the Roman Empire into that of the Middle Ages. The complex and vast production network that had existed within the Roman Empire, thanks to socialist economic policies, gradually gave place to groups of mediocre, inefficient, isolated and self-sufficient populations scattered over Europe. This, we think, visualizes what we mean when we see vertical integration as a negative and unintended consequence.
In summary, so far, we are seeing three different channels that would eventually link the existing asset price inflation to a general increase in consumption goods prices: Dividend increases, share buybacks and vertical integration. The first two lead the cash currently held by companies to the pockets of people, which will later use it to purchase goods. If this takes place using leverage, we run the risk of seeing inflation with a future spike in corporate defaults. Another unintended consequence of this is that this transfer of purchasing power to shareholders is a transfer of wealth from the poor who could not save to those who could. In other words, it is a generational transfer of wealth from the young to the old.
The last channel (i.e. vertical integration) takes goods off the market and leaves less production available for people with higher nominal purchasing power.
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.
If we have to summarize what drove the action last week, we will say it was the speculation over an upcoming (perhaps in June) Growth Pact in the Euro-zone. That was all. That did the trick. There is really nothing, absolutely nothing concrete. And no, we don’t think the market is speculating on a soon-to-come Quantitative Easing Version 3. But from pure intuition, it would seem that the market sees these conditions as necessary to take the any Pact seriously: a) Mario Draghi, President of the European Central Bank, would have to back such pact in a way that would guarantee some sort of deficit monetization, and b) Hollande should win France’s presidential ballotage, next weekend.
Indeed, most news were bearish last week and yet, every single asset class seemed to end on a bullish note. From the Euro zone, we saw a deceiving bond auction by Italy. We also learned that the unemployment rate in Spain (the official rate) averages between 20% and 30%, depending on which region one measures it, and that the United Kingdom is already in a double dip. This only resulted in a stronger Euro and stronger Euro stocks for the week.
Last week too, Moody’s downgraded Ontario’s credit rating to Aa2 with a stable outlook from Aa1 with a negative outlook. How did the market react? The Canadian dollar finished the week stronger. Then came the activity data release for the United States: Jobless claims, housing data, inflation data…all of them were worse than expected and yet….stocks rallied, with the S&P500 reaching again the 1,400pts. And we could say the same about oil and gold…
The lesson here is that a market that will not fall on bearish news is a bullish market. Even if it is a manipulated market, which brings us back to gold. Below is the daily chart (source: Kitco.com) for April 25th, 2012. It shows how upon the start of Bernanke’s press conference an algorithm sold whatever it could precisely at one point in time. Everybody saw it coming. We saw it coming, after what had happened on February 29th, or with the Euro peg announcement by the Swiss National Bank, in 2011. And this time, whoever was behind the move, lost money. We can only hope these moves stop or expect that newer, smarter moves will follow. We think the latter are more likely than the former:
Somehow, the idea of a “Growth Pact” reminds us of the New Deal and Ludwig Von Mises’ comment on the same. Von Mises wisely said:“…The comparatively greater prosperity of the United States is an outcome of the fact that the New Deal did not come in 1900 or 1910, but only in 1933…”. His words, in light of this Growth Pact speculation, sound to us wiser than ever…
We want to leave with this thought: As we have repeated, since the start of the Long-Term Refinancing Operations by the European Central Bank, the savings rate of the world (yes, now is the global savings rate) keeps slowly drifting lower either because of the manipulation of interest rates by central banks, or the fact that income is falling, as in the case of the European Union and the UK, or because of simple financial repression, as in the case of the debt swap between Greece and the European Central Bank, which left holders of sovereign debt suddenly subordinated. This simple observation leads us to think that this crisis will continue to unfold like a painful agony, and that we have many, indeed many more years of it to come.
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.
(Originally posted on April 23, 2012, at www.sibileau.com)
Because simplicity is a virtue, we decided to skip a week and write our comments today. Why? There had really not been any developments during the past two weeks that would have made us change our views. To be certain, even today we think nothing really fundamental has changed.
What has been keeping us awake at night however is the late and blatant manipulation of markets and key prices. The most obscene example is that of gold, where one can almost time the automatic sell-offs that are repeated continuously after 3am or between 10-11am Eastern time. Looking at the charts, the manipulation is so obvious that were it in a particular stock, the SEC would have already acted. But of course, it is gold we’re dealing with here…In general, we think the world is witnessing a phenomenon that Friedrich Von Hayek had already anticipated it could occur in a context like the one we’re living in. Here is an interesting interview on the subject:
http://youtu.be/dV7-2Aua4_4
In Von Hayek’s view, Economics is the study of social cooperation, where markets are an institution and a process for such cooperation. To be more productive and improve their standard of living, individuals specialize and allocate resources farther from the final act of consumption. But if that is the case, and the production process becomes so complex that it is carried out in different geographies by different people…how do all these people know what and how much to produce? Do men count with a signaling system to cooperate and achieve this economic calculation? The answer is fortunately positive: That signal is given by prices. The market signals that a production process is desirable by making the producer profitable and tells the same producer his resources would have been better used somewhere else, by making him unprofitable. Profit and loss therefore are nothing else but key signals needed for social cooperation.
But when men live in a levered world, with fiat currencies, these signals, particularly prices, are completely distorted. This would not be a problem if ultimately, the distortions were corrected. However, they cannot when governments start to repress markets by imposing capital ratios, bands on currencies, caps on commodity prices or manipulate interest rates (i.e. the intertemporal rate of exchange).
Taking this thought to the current context, it is clear to us, that thanks to these interventions, the European Union, to maintain its common currency has destroyed its capital markets, which consist mainly of its banks. There is a lesson to be learned: If you want to keep an overvalued currency with its banking system, you will lose both! But the authorities of the Euro zone are not alone. Back in September 2011, we had warned that the Fed currency swaps would put a floor to the Euro (just like the Swiss National Bank did), enhancing this distortion. We were not wrong here, we think, as the Euro has been able to stay above $1,30. One more thing needs to be said: The Fed swap is not targeting an exchange rate between currencies, but a maximum sovereign yield above which counterparty risk would explode generating a run against the USD financial system. The resulting implicit exchange rate is only a symptom and not the cause. If this is true, as Spain’s sovereign yield approaches key, dangerous levels, it would not be surprising to see a bailout of the Spanish system via swaps. Of course, just like they did in 2011, this time, authorities would also deny any specific bailout.
We are aware that today’s discussion may have sound too theoretical. But we are confident that very practical conclusions may be taken from it. First, this constant intervention and manipulation is going to make any economic/jobs growth unsustainable. As we mentioned in January, companies have been using this window of cheap US dollars, since December 2011, to increase dividends and leverage their operations. Default risk has consequently increased. In this regard, we maintain our bearish view of stocks, regardless of the fact that they have been making higher lows since April 10th. We think that the situation out ofSpain is going to imminently turn things for the worse. Second, and although gold may further be sold by the manipulators to the $1,500s, it will recover its value.
We should finally make some comments on the confiscation of YPF by the Argentine government, from Repsol. But we lack the space and time. Briefly, we are impressed to see how the world has been taken by surprise on this action and fear that it may become a symbol of what is to be expected in the coming years from trade and currency wars.
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.
As Easter approached, we began to see a timid sell off in US stocks (but not so timid in Europe or Canada), in corporate debt, and in Treasuries. Treasuries later in the week rallied, but if you ask, we would see them still in a downtrend. This downtrend began with the implementation of the Fed’s latest currency swaps, at 50bps, in mid December. As we argued against public opinion (refer here), the swap is a bailout that actually coupled the fate of the US with that of Europe, and not the opposite. It makes perfect sense to us because just like now, the US was also coupled to Europe in the 1930s, and ended up having to pardon what it was “owed”. Here is the moment when President Hoover announces the moratorium (ie. pardon) of the debt: http://youtu.be/MFdTISc1KG0
People back then took the matter in their own hands and forced the devaluation that ended in the bank holiday of 1933, with President Roosevelt confiscating gold. Here is the announcement by Mr. Roosevelt. Let’s keep both videos in mind, for future reference, because we have the feeling this crisis will be a horrible déjá vu: http://youtu.be/kTe4paRPEM4
As we have done many times before, we offer this excerpt from Jacques Rueff’s “The Monetary sin of the West”, 1971:
“…On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government’s attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:
There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold exchange standard. Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit….”
We are starting to get dizzy, disappointed, confused by the manipulation of capital markets, which are slowly and steadily losing liquidity.
The manipulation comes first and foremost from central banks, be it in the FX market, rates or gold. And when they intervene, they generate a volatility that is completely foreign to the “natural” changes that “Main street” (i.e. non-financial sector) would expect from a growing economy. It is this volatility that gets everyone dizzy.
Secondly, governments, via regulations and financial repression, distort the subordination points the market had established for different sectors. What do we mean by this? Every business and in aggregate, the whole economic system, has a capitalization structure, consisting, for example, of equity, preferred equity, subordinated debt, sr. unsecured debt and sr. secured debt. Each participant in these “layers” of the capital structure demands a return for the risk taken. That risk consists of two parameters: The probability of default (i.e. losing one’s capital) and what it expects to recover, if there such default takes place. Well, since the beginning of this crisis, with the bailout of the Chrysler and General Motors in the US, the Asset-Backed Commercial Paper scandal in Canada, the bailout of the financial system in the UK and most recently, the debt exchange of Greek debt with the European Central Bank which subordinated private bondholders without triggering default, both parameters (default and recovery) have been insanely disfigured. The natural consequence is a retreat by investors from pouring funds to the “system” at best, or simply reducing the savings rate, at worst. We fear both processes are well underway (last week, we received confirmation of a slight decrease in the savings rate in the US) and it is this repression that disappoints us.
Thirdly, we are confused by the ignorance leaders show. They should by now see that these policies drive people and companies to save less. We discussed this point on March 18th, when we wrote:
“How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt…”
On April 2nd, Zerohedge.com reproduced comments made by David Rosenberg, supporting this view, under the title: “How The Fed’s Visible Hand Is Forcing Corporate Cash Mismanagement” (We generally tend to disagree with mainstream economist David Rosenberg, but it looks like, over the past years, he may have been quietly reading Austrian economic literature).
Under the status quo, investors, globally, are and will continue to shift slowly their savings out of the “system”. On the margin, why would anyone that is not an insider of the financial markets want to keep their savings there? They will be levered/re-hypothecated or invested in cartelized exchange-traded funds or used to pay fees or futures rolls, or face huge bid/ask spreads or finally, if they produce good results… they will be taxed. Why would anyone want this? Why not just keep savings safely invested in farmland, or collectibles, or physical precious metals, or real estate in unique locations? These assets cannot be re-hypothecated, charged with monopolistic fund fees or unreasonable bid/ask differentials. Returns can be influenced by their owners’ commercial activity and taxes can always be minimized. But if these are the alternatives…how will corporations get funding for their projects or even normal capital expenditures? How will governments keep funding their deficits? Of course, …. Ben Bernanke and Mario Draghi assured us last week that their liquidity pumping policies are only transitory…
In the last days again, we have been exposed once more to the rhetoric of the prospective fiscal unification of the European Monetary Union (“EMU”) but based on new, mega bailout funds. We no longer care about the amounts they come up with (they came up with Eur940MM…nobody bought), even if it was true that the EMU members can raise these amounts. The fundamental issue here is that they want to address a “flow” problem (fiscal deficits) with a “stock” solution (bailout funds). It can’t be done. Flow-driven problems must be addressed with flow-based solutions, like a federal tax (If you have never heard of the terms “flow” and “stock” as used in Economics, please, read this explanation).
In particular, the situation out of Spain is rapidly worsening. Most analysts believe it is serious and a good portion of them think that once it spins out of control, the European Central Bank will intervene with plain monetization of Spanish assets. We have our doubts. Unlike other peripheral countries, Spain is a kingdom with a strong and influential king. Unlike other peripheral countries too, the fiscal deficits that hurt Spain are of a regional nature, and the independence of these regions is strong and ferociously defended. Under these circumstances, there is a high risk that the demands imposed upon Spaniards by the Euro Council be harsh enough to be refused and that upon such refusal, the Euro-zone face its final hour. We think that the fact that gold held above $1,600/oz upon the release of the Federal Open Markets Committee’s (“FOMC”) minutes last week, with stocks and the Euro selling off is a signal that this risk is not to be underestimated.
In light of this, having been stopped out of our position in gold with the release of the FOMC minutes, we bought it back on Thursday, at a lower price, but this time, hedged, shorting North American stocks. We are bearish of stocks or, better said, we think that the ratio of gold to stocks is now in gold’s favor, after a serious correction.
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 we had suggested that the strength of the Euro (by strength, we mean a Euro above $1,30) could be based on the fact that the liquidity lines extended by the European Central Bank were collateralized. As the sovereign risk of Spain,Italy and Portugal had deteriorated, so had the value of their sovereign debt diminished and, as this debt had been used as collateral by the banks of the Eurozone, these banks would be forced to sell assets and buy Euros to post on margin. It was simple and beautiful logic. However, we were wrong and the reason for that left us even more concerned. Someone better informed than us, who shall remain anonymous, wrote us the following (the highlighting is ours):
“…Hi Martin,
I just wanted to chime in on the issue of ECB (European Central Bank) margin calls. I completely agree that in theory the collateralized lending that now dominates can develop into a vicious cycle (as well as a virtuous one of course). However, in practice, a lot of the collateral that is pledged at the ECB is marked to model rather than marked to market. At least that’s what I am inferring from the ECB margin calls. The spikes that you saw relate to Greek collateral coming in and out of the ECB refi ops. Abstracting from those the margin calls themselves tend to be too small in my view to have an impact on the Euro…”
Having proved our axiom wrong (i.e. margin calls triggered by market volatility), our thesis is proved wrong. We had at the beginning of 2012 however warned that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” (“Walking the fine line”, Feb 6th, 2012).
It is time now for us to write a few lines today about Canada and India. Over the past months, we have seen crude oil appreciate. Simultaneously, the Canadian dollar did not (the Canadian dollar is positively correlated with crude oil) and the data coming from activity in Canadahas been disappointing. What makes matters worse is that in light of this, the price of housing has remained strong and even slowly increasing. In discussions with those following this market we noticed that in general, investors tend to see the Canadian context with the same lens used to see that of the USand the UK: They see a bubble in the housing market that would eventually be harmful to the financial system, and which would end in systemic weakness for Canada. This is, after all, what occurred in the USand the UK(We remind readers that at “A View from the Trenches”, we have never seen the EU crisis based on anything else but an institutional problem, rather than a liquidity or solvency problem. Refer: http://sibileau.com/martin/2010/02/10/)
We see the Canadian context differently. We think that it is likely that the barbarians will use the back, rather than the front door. Because Canadians have on average tended to put significant down payments on their houses, only a fraction of the outstanding mortgages have required insurance from the Canadian Housing Mortgage Corp. That fraction can be (but is not necessarily) securitized. The rest remains warehoused by Canadian banks, which unlike US banks, have recourse on their borrowers (if these default on their homes). Our fear then is of a potential contagion from the government. Indeed, rather than expect contagion from the banking system to the government, inCanada, we expect contagion from the government to the banking system. If the fiscal situation deteriorated (led by Ontario), the guarantee of the Canadian Housing Mortgage Corp. and the implicit comfort based on the country’s sovereign AAA rating would immediately affect the banks.
Do we expect this deterioration to be triggered by an endogenous dynamic? No. We fear that Canada may be affected by a foreign development and we can think of many, from the Euro-zone,China, or theUS…which takes us to India.
India has and is embarked in an inflationary process and, like in any other inflationary process, the outstanding amount of money is the taxing base. Following the example set by the Mahatma Gandhi, Indians peacefully protest this taxation by leaving the taxing base, the rupee, in exchange of gold. This has angered the government there which has taken a few repressive measures. It has taxed gold (a tax currently under review), set import duties and even barred gold loan companies (that lend on gold as collateral) from lending against gold bars, coins and bullion. These companies can now only lend against gold jewellery, with a cap on the loan-to value asset ratio and maintaining a minimum Tier 1 capital of 12 per cent. Does anyone think that these measures will favour the development of capital markets in India? Does anyone actually believe that because the competition from the gold loan market falls, savings in rupees will grow and investors will accept the government’s strong hand and lend in rupees? This is another example of the idiocy of bureaucrats that is destroying capital markets across the globe. Not only will savings in rupees not grow, but the overall savings rate will tend to fall, because on the margin, if savings have nowhere to go…why save?
This destruction of capital markets, as we noted, is not only taking place in India. The same is carried away slowly, by breaking the price system, whose signals no longer seem to work. Compared to July 2011, we have more than a trillion of new Euros, we have had Operation Twist, the banks of England and Japan weaken their currencies, sovereign downgrades worldwide, Ben Bernanke announcing low rates until 2014 and yet, gold is below $1,700/oz, courtesy of the interventions (see: http://www.zerohedge.com/news/paul-mylchreest-presents-various-visual-case-studies-gold-price-manipulation) . Even worse, although gold is below $1,700/oz, it is obviously higher than a year ago…but the capitalization of the gold mining sector is lower.
Repression, repression, repression…Interest rates don’t reflect anything these days. If you ask us, we don’t even know what to call capital. The price of crude oil touched $110/bl and yet the capitalization of energy sector in Canada slipped. Only a few dare to short the Euro, in the face of the massive destruction of the financial system in the Euro-zone. How can this be possible?
People wonder and at the same time praise the fact that companies nowadays hoard record amounts of cash, as a sign of strength. We think this is actually a disgrace and it shows how central banks managed to distort the relative prices of the different components of the economy’s capital structure. These companies are not investing that cash but as we mentioned a month ago, they have started to return it via dividends or share buybacks.
The final outcome of these repressive policies can only be a reduction in the savings rate and investments, a fall in productivity, an increase in consumption, if the supply of money continues and the inevitable stagflation.
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: March 25 2012
During the past week, we think, we witnessed some interesting developments. In our previous letter, we had discussed what was the KreditAnstalt event of 1931. We saw a striking similarity with the current status quo because just like then, we now have sovereigns at the brink of default, whose creditors are other public institutions or countries, rather than private investors.
But there is more to it…
During the past week, we had Fed’s Chairman Ben Bernanke answering questions at the US Congress. It was there that Rep. Dan Burton (Indiana, 5th District) took Mr. Bernanke to task on the issue of the currency swaps the Fed has extended to the European Central Bank. On Thursday, we learned that the amount outstanding, which had reduced to $67BN, has remained there and increased a little bit. All this, in the face of a 7 ½ -month record low in US dollar funding costs for EU banks, given the 3-month cross currency swap basis reached 53bps below Euribor, on that same Thursday. The fact that the Fed currency swap lines are still in demand while the cost of US dollar funding keeps falling tells us that the EU financial system is segmented, with those who can access the market and those who cannot. But it also tells us that there is, paradoxically, an oversupply of US dollars, as we explain below.
R. Dan Burton then asked Mr. Bernanke how would the Fed recover the US dollars it loaned, should the Eurozone break. We made this point at “A View from the Trenches”, many, indeed many times before. You may see our latest letter on this issue at: http://sibileau.com/martin/2012/01/23/. Of course, Mr. Bernanke categorically played down the likelihood of such a scenario. He first lied to everyone saying that the debtor, the European Central Bank, does not finance governments. It was an insulting lie because not only does the ECB finance them indirectly via LTROs, but also explicitly and directly, through its Securities Market Programme, where more than EUR200BN are booked. Mr. Bernanke could not have and does not ignore this fact. Here is the link to the discussion: http://youtu.be/HzejoDbVXXs
On the other hand, we know that exactly this scenario, where the US had to bailout Europe, has already taken place in similar conditions. Back in 1931, when Austria defaulted leaving the gold standard, there was a generalized bank run (which the LTRO of last December prevented) and the United States had to establish a moratorium on the loans it had outstanding to Germany and to others. It was precisely this decision, that later pushed the United States to abandon the gold standard too, in 1932. Obviously, Americans understood that the amount of gold at the Fed, backing those claims now in moratorium, was not enough and they run against their banks as well. We found the video that shows President Hoover announcing the moratorium. It would have been so nice to have it handy to show to Mr. Bernanke before Congress: http://youtu.be/MFdTISc1KG0
Last week too, it was painful for those of us who still hold on to gold. Gold made interim lower lows at $1,628/oz on Thursday and bounced back to $1,665/oz on Friday afternoon. Is it still trading within range or is it consolidating to retake its bullish trend. We have our doubts, but the long term fundamentals support it. Let’s see…
One of the things that really caught our curiosity was to see the Euro appreciate since March 14th, with the simultaneous deterioration in sovereign credit risk. Since then, the sovereign spreads of Portugal, Spain, Italy and even Germany have been increasing. Should we not be looking at a weaker Euro in light of this? Why would we see the Euro flirting with a $1.33 level?
That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.
There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. This is the scenario that R. Dan Burton was proposing to Mr. Bernanke. Again, if this logic is correct, that scenario is not a tail risk, but the base risk.
How do we escape this circularity? With the ECB embarking in plain, good old Quantitative Easing. The collateralization of liquidity lines forces the EU to work within a context similar to that of the gold standard, where liquidity has to be backed by a commodity! In fact, if on the margin the supply of liquidity will only grow from collateralization, the EU would be better off under the gold standard, because gold at least, does not entail any credit risk!!!!Lowering interest rates, weakening collateral rules or extending maturities will not solve this problem.
If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU. These reasons make us feel comfortable holding gold.
We run out of time here, and we wished we had had the opportunity to discuss the fragile situation in two relevant countries: India and Canada. We will in our next letter.
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: March 18 2012
We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…
Title No.1: “The market proved us wrong”
Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!
We have no doubts that the plunge in gold on February 29th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:
The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.
The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.
As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…
Title No. 2: “Financial repression, Stage 1”
Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously. It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:
“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945
The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…
Title No. 3: “Remember the KreditAnstalt”
Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.
The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.
In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21st. The countries that held sterling pounds as foreign reserves suffered heavy losses.
Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.
The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.
Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.
In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…
Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…
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.
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
Please, click here to read this article in pdf format: March 5 2012
Let’s start by confirming that we remain long-term bullish of gold, near-term neutral of stocks (and long-term bearish of stocks), bullish of corporate credit risk, neutral of sovereign risk (European and US). We are neutral on the EURUSD (but if we had to make only one trade and hold on to it, we would be bearish) and surprised by the latest performance of the Canadian dollar (happily surprised, of course, as we are long of this currency).
It is a widespread rumor by now that the huge sell off at theLondonfixing on Wednesday February 29th was not driven by Bernanke’s comments before the US Congress, but by plain manipulation, likely from a non-private seller. We, having seen no reaction in 30-yr Treasuries, decided to buy the dip, for we think that in this context one can only buy and hold gold, sitting tight in the face of all this volatility, or risking to lose one’s position in the bull trend.
Someone asked us why, if we were such believers in gold, did not buy stocks of mining companies. To answer this, we will have to first understand why we buy gold. It is not because of anything intrinsic to gold. We don’t care that we cannot eat gold or that it doesn’t give you a dividend. You cannot eat US Federal Reserve notes either and these, rather than give you a dividend…depreciate.
We have to understand that one of the services rendered by money, namely the storage of value, is no longer attached to fiat currencies. And the world needs that service. There is demand for a reserve asset and gold can address it. Is it the only asset fit for that? No! The only thing we care is that in the long run, the demand for that service will keep increasing and at the margin, even competing with other assets, gold will get a bid. It is that simple.
Now, we can dig a bit deeper and ask ourselves what are the causes and implications of witnessing fiat currencies lose their demand as a reserve asset. The causes are clear to all of us, but not the implications. The one least understood is the distortion in relative prices caused by the intervention of central banks. We write more about it below but for now, think of this: In the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?
I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place. We can intuit when it is going to happen, but will only be lucky in actually calling it. However, with gold, it is different. Hence, our buy and hold approach. We’ve seen it before: When decadence arrives with inflation, people want to own the product, not the producer. We want to own gold, not miners.
And some have brought to our attention that by doing so, we lose the leverage provided by stocks. We disagree and think that the price action in mining stocks speaks for itself. Besides, should one want to lever the bet in gold, the only thing required is to borrow and buy more gold. It is more efficient: One knows ex-ante the leverage one wants and will end up with!
Now, let’s address the distortions generated lately by central banks (We will focus on the Fed and the European Central Bank, but we could also write about the intervention of the Japanese Yen and the scary fall in Yuan deposits in China, that is forcing a steady cut in reserve requirements over there. But these are underlying, long term problems. We will have to deal with them later). When the Fed provided the currency swap at 50bps to the European Central Bank in December, US dollars that were needed to fund EU banks, all of a sudden, were no longer needed. We are speaking here of more than $90billion. This is no small change! Also in the December and a few days ago, we had two 3-yr refinancing operations by the European Central Bank. In all, more than a trillion Euros were printed to, among other things, repay previous funding, some of which was in US dollars too. As you see, suddenly, the providers of US dollar funding saw themselves with a lot of cash in their hands.
They could not offer cheaper funding to EU banks or sovereigns because a) the Euro funds from the central bank are against collateral, which deeply subordinated USD unsecured debt, and b) the latest decision by the ISDA, which considers the swap of Greek bonds with the ECB not to trigger a credit event, further guarantees the subordination of private sovereign debt holders going forward.
What did they do? They poured the money into equities, corporate bonds, commodities. But in the Eurozone, the banks that now count with cheap Euro financing, will not take risks. If they take risks, it will be in the form of sovereign risk, buying sovereign bonds. They have been doing this since January and will continue to do so. All this means that the private sector in the Eurozone will remain affected by a credit crunch, unless…..well, unless those who were previously providing US dollar funding to EU banks now use their excess balances to fund EU corporates. This, we think, is going to be the case as USD denominated debt (Yankee issuance) will be increasingly issued by EU corporates. This is why we said at the beginning that we are bullish of corporate credit risk. We make this more visual in the chart below:
The problem with this new situation is that eventually, we shall see a wave of EU corporates defaulting: Compared to US corporates, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries). However, the hunger for yield these last two central bank interventions has generated is pushing US financials to chase riskier assets and high yield EU corporates look today like sweet, low hanging fruit ready to be picked. Who’s going to be in the way??? Nobody, as this is an election year and nobody ruins parties in election years!
But, if that wave of defaults occurred…who would be bailing out theUSinstitutions that financed the EU corporates? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.
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.
Click on the link to read this article in pdf format: February 19 2012
Today, we want to follow up on the dynamics of the Euro. We go back to our comments since the beginning of 2012, when we suggested that the logical result of the monetary policy the ECB is embarking on is an increase in the velocity of circulation of the Euro.
We also wrote that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” Indeed, anyone with a short position in the Euro knows what we are talking about…
Can we better understand where the Euro is heading? In the past week, some analysts have posited the notion that a default by Greece could have consequences far worse than the Lehman’s default, in 2008. But as we will seek to prove, that may not be the case: A run for liquidity, post Fed UDS swaps (extended in Dec/11) and ECB LTROs (long-term refinancing operations) has left the market less levered in USD terms, which is bullish of risk and bearish of US Treasuries and the US dollar.
We prepared some graphs, adapting for the Eurozone, but based on an excellent paper called “The causes of price inflation and deflation: Fundamental economic principles deflationists have ignored”, by Laura Davidson, 2011. Figure 1 below shows the stocks of the Euro financial system, focusing on the balance sheets of the European Central Bank, the Euro banks and the Euro corporates/citizens (creditors), before the crisis started, in 2010.
Figure 1
As you can see, the ECB holds sovereign debt in its assets, foreign exchange and gold. The Euro banks leverage on their demand deposits, term deposits and unsecured debt (in USD) to sustain long-term loans to both the EU governments and corporations.
At the beginning of the Greek crisis, in 2010, the public in the periphery began to withdraw deposits. The reduction in the deposit base forced the ECB to start extending liquidity lines against collateral. It was the beginning of what would be later called the “Separation Principle”. This principle, conceived by M. Trichet, consists in relaxing monetary policy by influencing the price and the quantity of liquidity separately, without increasing the monetary base. Indeed, the ECB lowered interest rates and at the same time, bought and sterilized sovereign debt (with its own debt). This is represented by Figures 2.a and 2.b below:
Figure 2a
Figure 2b
It is visible from Figure 2.b that the higher demand for Euro liquidity reduced the leverage of the financial system. And, as the ECB extended Euros against sovereign debt, the crowding out of private demand for savings began.
Simultaneously (but shown in different graphs), the market began to sense a contagion in the financial system from sovereigns, and unsecured USD denominated debt began to be called, triggering a further drop (losses) to the equity/hybrid part of the capital structure of the banks. Capital left the Eurozone, as represented in Figure 3 by the increase in USD holdings of corporates/citizens. The demand for USD was so strong that the Fed had to extend swaps to the ECB, to provide USD liquidity to the market. As we said before, these swaps are the equivalent of vendor financing in favour of the counterparties of the global banks (the reader knows who we’re talking about), who saw a sharp increase in the default risk of their trading counterparties. Figure 3 below shows how, steady but slowly, the balance sheet of the ECB grew, while that of the EU banks shrank. Not only did the balance sheet of Euro banks shrink, it also became seriously dependant on monetary policy, both to finance itself and to remain profitable, as an increasing portion of its assets remained invested in sovereign or central bank liabilities. These displaced investments in the private sector, further fuelling the recession.
It is also visible in Figure 3 below, how the size of the balance sheet of the ECB is now impacted by the swaps extended by the Fed. This is why, contrary to popular opinion, we say that since December, the US are coupled to Europe. Yes, this latest rally was based on the coupling (not decoupling) of the balance sheet of the ECB on to the Fed.
Figure 3
By now, it should be easier to see why we began these comments stating that we thing the current context is bullish of risk and bearish of US Treasuries and the US dollar. The Fed is tied to the fate of the Eurozone. And as that fate looks increasingly ugly, it will involve itself more.
There is another effect here that comes into play. On one hand, as banks saw the portion of their funding from equity and unsecured debts shrink, they also saw the dependence on USD denominated debt shrink. The collateralized, long-term (3 yrs) liquidity extended by the ECB, in Euros, replaced it. Therefore, the impact of sovereign defaults on the demand for US dollars, all other things equal, should be lower than before. But not all other things are equal: Given the reduction in the demand of USD denominated debt, the suppliers of the same were forced to invest their USD holdings into loans, bonds, stocks and commodities. It was a virtuous cycle, seen since the end of December, where as the USD funding rates fell, asset prices rose.
Therefore, we find ourselves at higher price levels, with lower rates, less demand for leverage and sovereign defaults fairly priced in. What could go wrong?
In the case of a default that triggers the break up of the Eurozone, we would see a generalized run against the EU banks. This would activate the demand for US dollars (and gold?), which we believe (big assumption of ours here!) would force the Fed to extend more and more swaps, in an effort to save the Eurozone. After all, are we not facing Greece’s default and are we not seeing the ECB holding Greek debt until the last minute? Why would we not see the Fed holding its USD swap loans to the ECB…to the last minute? Precisely this action, in light of the serious set backs to global banks (and the reader knows who we are talking about) would seriously devalue not just the USD, but all currencies against gold, while at the same time, it would be negative for stock prices and, likely, for US Treasuries.
Figure 4 shows, in extremis, the what the financial system of the Eurozone would look like, moments before its break up. There would still be a minimal transactional demand of Euros and the Euro banks would be totally nationalized and heavily dependant of the Fed. The link between the financial and non-financial sector would have been broken, generating a serious crisis, possibly, with high inflation. If that high inflation does not come in then, it would come in later, as the Fed keeps pumping liquidity to the system.
Figure 4
What we just described is the logical consequence of ongoing policies, and it would be very misleading to think of them as “tail risk”. This is no tail risk. If any, the tail risk here is that we see a strong recovery, driven by an increase in productivity. We may be wrong in our assumptions, but we believe that if we are not, our logic is correct (readers’ feedback is very welcome!).
As a consequence, we have been buyers of weakness in gold, believe there is a point in starting to sell strength in US Treasuries and are neutral in stocks.
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: February 6 2012
When we last wrote two weeks ago, we took the time to lay out an analytical framework that would act as our guide. We invest following the approach of the Austrian School, which is deductive, logical, consistent and aprioristic. We reproduce below the chart we posted then.
During the last half of 2011, the world saw a run for USD liquidity that caused a general sell-off. This sell-off lasted until the Fed first reinstated and then lowered the cost of USD swaps and the European Central Bank offered refinancing operations for a term of 3 years and lowered the requirements for the corresponding collateral. This triggered the rally we witnessed in January. But now, we can see clearly that the time has come, when markets realize that the results of austerity, intervention and higher taxes are not working and that the social unrest they bring could, once again, derail the efforts of the European Monetary Union.
In particular, the role of the European Central Bank in the negotiations on Greece’s debt, in our opinion, has been horrible. We can mince no words here. The world needs leadership and what does it get in instead?…
The authorities of the central bank are going to wait and see what results from the negotiations between the Greek government and private debt holders. They are not going to come first and show they are willing to take a haircut. If they did so, they would:
1.-Show their willingness to solve this problem, with an unequivocal devaluation (because the value of the assets backing their liabilities, the Euro, would fall), as well as
2.-Provide the capital markets with a clear signal of what the floor value of sovereign debt is. Most likely, if they did so, markets would embrace the news with a minimal correction in the value of the rest of the sovereign spectrum and the “orbiting” bank capital sucked into it.
However, it appears we will not get good news. Since our last letter, we have seen the opposite: A European Union trying to flagrantly and openly seeking to eliminate the sovereignty of Greece and to manage their public finances! Have these people lost their minds? Can they not see that they are adding insult to injury? Don’t they realize what a fine line they are walking?
Our chart is very clear: If social unrest gets out of control in Europe, the whole status quo in Europe will decouple from that of the rest of the world. The markets sense this and, consequently, gold sold off on Friday, as wise money sold on the strong employment data print and looked for cover before the party is over. As we said at the end of December, in our “Recap of 2011 and thoughts for 2012 ”: “…We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy…”
The leaders of the European Union still have time to ensure Greece and its debt holders reach a reasonable agreement. Somehow, we are optimistic on this point and want to believe that the can will be kicked down the road, once again. Therefore, we have bought and will continue to buy weakness in gold. But we may be wrong here…
We think everyone is also very aware of the future consequences of the policies of the Fed and the ECB. The latest rally is not only delaying the necessary corrections but also, by distorting the price of capital, it is guaranteeing that when these corrections inevitably appear, they will be many, many times more painful. Personally, we have no doubts that the global financial system is set on a course to collapse and we fear that the strength behind gold is very much related to this view. This is the reason why in this rally, we have preferred not to chase stocks. The long-term trend, in our view, is negative for those who produce and innovate: the entrepreneurs. Here, we disagree, for instance, with Marc Faber, who has been advising to be long equities (and also gold). Long term, we see gold and real estate as the only places to store value. We lived in Argentina under high inflation and cannot recall how inflation can either yield employment or allow entrepreneurs to conserve the value of their capital.
Lastly, when we wrote two weeks ago, we had concluded that, in extremis, the velocity of circulation of the Euro would spiral, a common feature of high inflation. However, in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility.
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.
This is our first letter of 2012. The year started with a mini rally that every analyst out there attributes to something called “decoupling”. Why? Because the strength in asset inflation, although global in nature, is particularly more solid in the US.
The oddity appears to be higher asset prices, in spite of a weaker Euro, in a Eurozone whose main problems remain unsolved. Correlations are breaking! say analysts, at every opportunity they have to speak to the media.
We want to start the year tackling this issue, which we feel is very important to understand. Without mincing words, we will say that the concept of “decoupling” is completely wrong and if followed, it will lead to wrong conclusions and horrible investment decisions.
The fall in asset prices during the last quarter of 2011 was triggered by a run for liquidity, typical of fiat currency systems or systems with leverage. Euro zone banks had to sell USD denominated assets to raise liquidity, lifting the price of the USD and putting pressure on the rest of the risk asset spectrum. This was addressed in November, when the Fed confirmed its commitment to continue extending USD swaps to other central banks, at a reduced price of 50bps. At “A View from the Trenches”, not only have we dealt extensively with the mechanics and implications of currency swaps but also, we believe we would not be mistaken if we said that we were the first and only ones to point to its relevance, way before anyone else in the market. For instance, in February 2010 (almost two years ago!), we warned:
“…that France did the same (in the 1920s) that we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment…” (refer: www.sibileau.com/martin/2010/02/26 )
How relevant was this action taken in November? The chart below (source: Bloomberg) shows us how the price of the 3-month EURUSD swap reverted after November 30th:
How consequential was the amount of swaps extended by the Fed? The next chart (source: Bloomberg)gives some perspective, showing what the Fed extended in 2008, vs. what occurred last November:
The spike is certainly visible. Back in 2008, the deleveraging was just starting, so it would seem unlikely to us to see those levels again. However, we must not underestimate the magnitudes seen in November and the sovereign problem ahead, particularly if it threatens to break the Euro zone. In light of all this, it is clear to us (and not to the rest, apparently) that rather than a decoupling, we are seeing a huge coupling. In fact, we are witnessing the mother of all couplings! As we explained on December 12th, the Fed is bailing out the European Central Bank, because without US dollars, the run for liquidity in Europe would result in a general run against the ECB. But since December, the ECB is now also financing on a 3-yr basis, the liquidity, in Euros, of the Eurozone banks. There is plenty of speculation as to what the Euro zone banks do with that money but we think it is safe to say that at least, they are not forced to liquidate assets. On the accounting analysis of the 3-yr financing, we found a very interesting article, by Izabella Kaminska, at FT Alphaville, named “The curious case of ECB deposits”.
In summary, the mother of all couplings consists in linking the balance sheet of Euro zone banks indirectly with the Fed: The Euro zone banks get cheap liquidity from the ECB in Euros, supported by the US dollars provided by the Fed to the ECB. Asset are not sold now and in fact, they could actually be purchased later, if the sovereign crisis in Europe was to be addressed.
What does this all mean? Well, as we explained on December 12th, this printing of billions of US dollars by the Fed to back the ECB means that Americans need not to save any extra, to bail out Europe. This is what puzzles mainstream economists, who refer to this “oddity” as a “break in correlations”. The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps. Such a sell off would bring down the price of every single asset vs. the US dollar.
Now that we have clarified this point, we must ask ourselves how this should impact gold. On this point, we must say we are now in uncharted waters. Yes, the swaps are nothing new, but the context in which they unfold is. With this in mind, we think that the rhythm in 2012 will be marked the evolution of the fiscal situation in the Euro zone. On Friday, we saw a massive downgrade in sovereign risk by S&P that was fairly priced in by the market. Going forward, further deterioration or default surprises will accelerate the pressure on Euro banks, which in turn will force the Fed to become more coupled and to print more US dollars. We think that in this context the volatility and the bull trend in gold should both increase.
Why would we not also want to buy stocks? Because we follow the view of Friedrich Von Hayek: We believe that this process is also affecting relative prices everywhere and when relative prices are distorted, in the long term, production falls and we end with a higher amount of money in circulation, available to purchase a smaller amount of goods. Inflation, in the long term, always bankrupts producers and benefits the holder of products. If you don’t believe us, ask gold miners how they feel about the performance of their stocks vs. that of gold bullion.
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:december-22-2011
In the absence of further meaningful events, this will probably be our last letter of the year. Reflecting on our main macro thesis, things have played out the way we thought they would. Not from the beginning of 2011, but from the beginning of 2010. That’s right, already back in 2010 (refer for instance our letter from May 3rd 2010: www.sibileau.com/martin/2010/05/03 ) we envisaged a scenario exactly like the one we’re facing today. Back then we wrote:
“….It has become clear and public that European sovereign debt is being and will continue to be bought by European banks backed by the ECB, making the sovereign risk contagion back to the financial system a done deal. Therefore, how safe are those who bought sovereign credit default swaps (“cds”) from banks that are now exposed by the sovereigns?…We have mentioned this ignored side of sovereign cds in previous letters (for instance, refer: www.sibileau.com/martin/2010/03/01 ). How this issue is not discussed while every regulator in the world is still looking for ways to reduce systemic risk is beyond our understanding.
If sovereign jump-to-default risk increased, the ECB would most likely monetize sovereign debt (actually, the ECB is already doing it), further devaluing the Euro. But as long as no sovereign defaults, things will be under control. However, if a Eurozone sovereign ended in a credit event triggering the cds contract…How bad would the run for liquidity to the USD be? CDS contracts on European sovereigns trade in USD.
How much would counterparty risk (=risk between the banks that traded the cds) jump? Is the size of outstanding sovereign debt and that of the cds net notial useful to assess the impact? We think not and we guess that anyone downplaying this issue based on the size of Greece’s cds net notional outstanding doesn’t understand the leveraged nature of capital markets. Are Greece’s funding needs in 2010 not minimal compared to the impact they are causing?
The next question is whether gold would rally or fall. To answer it, we have to speculate on whether the Fed would or not extend currency swaps to the ECB to avoid the collapse of the Euro. The Fed did so in Sep/Oct-08, upon the Lehman event, and we believe the Fed would so again, which brings us to the another point… What is riskier?:
a)To have the Fed extend currency swaps to the ECB to provide liquidity to the financial system for clearing purposes (as in post-Lehman) or…..
b)to have the Fed extend currency swaps to the ECB,as a ultimate back-up on liquidity on sovereign debt?
In the first scenario, should gold not sell? (It did). In the second, should gold not rally, as a sovereign default causes the collapse of the Euro (our base case assumption here)? Would American taxpayers ever get their monies back if the Fed extended those swaps to the ECB under the second scenario?...”
What we did not anticipate is that it was possible to start in scenario (a) above, and as we think will occur during 2012, transition to scenario (b). It may now be possible that these scenarios be not mutually exclusive, as we imagined then 19 months ago, but linked with one preceding the other.
Recapping the year, we should say we had a bit of cautious optimism, back in January, when we thought there would be agreement to use the EFSF to purchase sovereign debt in the secondary market. In perspective, we realize that the refusal to go this path by Germany in March, marked the death sentence of the Euro as we know it.
The debt ceiling negotiations in the US, including its sovereign risk downgrade by S&P, and the latest drop in reserve requirements in China are symbolic of what we will see in 2012.
The view from the rest of the world is also murky. In 2011, we witnessed the fall of dictatorships in the Arab world, without any clarity on what will follow. The same applies to North Korea. South America is divided into a right-leaning block (Chile, Perú, Colombia) and a left-leaning one (Venezuela, Ecuador, Bolivia, Argentina), with Brazil still trying to figure out which way it will go. We believe it will go left. It’s the path of least resistance.
Overall, there has been disintegration in global trade, with the irony of a convergence in risk, between the developed and the emerging world. The first are being downgraded, while the second have been upgraded.
What next?
We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy. In Europe, that may mean not just the fall of the Euro but also of the European Union. In the US, the rise of Ron Paul and if not him, his ideas, may create a serious schism in the Republican Party, in favour of Obama’s re-election. In China, the rebellion should proceed at a slower pace, but steady nonetheless, as prices increase.
Back to a shorter term view, as the reader is already aware, yesterday the long term (3 year) refinancing operation resulted in almost Eur489 billion being borrowed by 523 banks. A lot has been said and written. All we want to add here today is this: We must keep in mind that all this does is to prevent the further sale of assets (sovereign) by Euro banks. Nothing else. If sovereign ratings are further downgraded, the respective losses will still have an impact. If fiscal deficits persist in the Eurozone, the value of the sovereign debt will fall and will still have an impact. If investors are further affected by the Greek situation, the value of sovereign debt will fall and will still have an impact. As you see, the substance of the problem remains alive. All eyes will be on the Fed, which will have no alternative but to remain financing the rest of the world via currency swaps.
This situation however leaves us with uncertainty and uncertainty breeds volatility. Gold and the rest of the risky assets will have a hard time.
We wish you all a prosperous 2012!
All the best,
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.
Click here to read this article in pdf format: december-12-2011
By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.
How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.
But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BNtaken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.
Let’s first begin by looking at what occurs if there is no intervention from the Fed:
As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.
Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.
In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.
Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.
In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.
As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.
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.
Click here to read this article in pdf format: october-17-2011
We apologize for not having written sooner. We usually do if we find new, market moving information. Unfortunately we have not in the past three weeks, which is also evident in the range trading all asset classes have witnessed.
As we write, the G-20 is meeting and the EU will have its own discussions, later in the week. One of the main topics markets have been paying attention to is that of EU banks recapitalization. This is not news. We have been discussing the futility of this issue since 2010. It is nothing short of circular reasoning. On June 4th, 2010, we warned that:
“…there continues to be confusion in the analysis of the EUR problem. The latest one consists in criticizing the ECB for lack of clarity in its bond purchases (…) While the Fed gave details about its unsterilized asset purchases, the ECB will not. But we explained why this is so:
“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…” (http://en.wikipedia.org/wiki/Stock_and_flow ). The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”
Again on June 29th, 2010, we added that: “…Finally, we want to discuss an idea suggested yesterday by Morgan Stanley’s Global Economics Team (ref.: “The Lure of Liquidity”, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that “…the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other…”. Essentially, monetary policy, which this report calls “Passive quantitative easing” is to blame for this spiraling circle. It is also proposed that had the ECB activated “Active quantitative easing”, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been different…the crisis would have been contained.
We could not disagree more with this flawed and misleading notion. It is flawed because it doesn’t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing “stocks” (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing “flows”, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.
This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this story….”
The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital:
However, as we write, policymakers are considering the recapitalization of EU banks again. Not only does it not make sense, but also, should this exercise be coercive in nature to the private sector, forcing bondholders to become equity investors in a mandated conversion, unspeakable damage will have been done globally to any prospects of growth. This is the path that may be taken after all and we are accordingly ready to see higher correlations, volatility and the run for USD liquidity make a comeback. Gold could be seriously affected in the process.
What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility. On January 28th, 2011, we described in detail what we think is still a viable alternative: The swap of EFSF bonds for sovereign bonds, in the secondary market.
We want to end our comments today with two observations, back on this side of the pond:
1.- Since the announcement of Operation Twist, unlike what was expected, the US yield curve has steepened, rather than flattened. Is this the result of a reallocation from US bonds to stocks, or a vote of non confidence on the Fed? For now, we are inclined to believe in the former, but only because we find stocks had been oversold too fast. Longer term, we have our doubts and we find that this steepening of the yield curve and gold stronger in USD terms rather than in Euros, is not a coincidence.
2.- Last week, the Fed created ex-nihilo approx. $1.3 billion to lend for 3 months US dollars to EU banking institutions. These are US dollars nobody in the US has saved for, and these are US dollars indirectly financing, many times via the credit multiplier, the fiscal deficits of the EU. A forced recapitalization of EU banks would eventually increase the size of these operations, because private investors would dump their holdings running for liquidity. We hope this will not occur because the only possible unwind in that case would be through global USD inflation. Again, gold stronger in USD rather than in Euros, we think, is not a coincidence.
Martin Sibileau
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