A View from the Trenches

A View from the Trenches, August 13th, 2009: A Visible Inconsistency

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Let me begin with the obvious: the 3-mo Libor - Overnight Index Swap spread. It made a new low. 3-mo Libor was 44.97bps, driving this spread to 26.07bps. The system is increasingly receiving liquidity, which needs to be placed somewhere, and hence, after the explicit FOMC announcement on low rates for a long time, Treasuries sold and equities rallied.

Before I go any further anywhere, I need to make a quick stop and discuss the FOMC statement released yesterday. The most significant paragraph, in my view, was the one related to the ongoing monetization of the US federal fiscal deficit. The FOMC wrote the following: “…the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets…”

As you may have read many times by now, I had a strong view that this purchase program was going to be upsized. I still am, even in the face of this statement. Why? Because the supply of Treasuries will still be there and someone will have to buy it. The problem is not the Fed’s policies with regards to supplying liquidity. The problem is the fiscal deficits, and personally, I can’t see these coming down in the near term. Therefore, the monetization is likely to continue, albeit perhaps not in its present form. To some extent, the market sided with this view post statement, as investors wondered who’s going to be there to bid the 20-30% the Fed has been swallowing. In the chart below (source: Bloomberg), we can see how the 2-10 yr Treasury spread widened intraday, expressing the view:

In my letter of August 4th (”Updating the forecast”: www.sibileau.com/martin/2009/08/04 ), I proposed the possibility that stocks could go higher. Since then, the S&P500 is basically unchanged, having tried the 1012.78 level yesterday, after the FOMC statement. Having said this, I can see stocks higher, but not without the public sector taking the heat. This is based on the fact that stocks are, in my view, being bought with the liquidity that central banks have been pumping. If that was the case, with governments’ debt levels increasing, the natural reaction would be to see sovereign credit default swaps rising along. Yet, this is definitely not happening, and constitutes an INCONSISTENCY…unless…unless the real levels of debt are expected to drop, as currencies get debased. Simple, isn’t it? Let’s recap: If we see stocks increasing thanks to additional liquidity provided by quantitative easing policies worldwide, we should see deterioration in the credit ratings of the governments that fuel this risk transfer. It did happen in the case of the UK, when it first launched its own quantitative easing program, and it has also been clear in the case of Canada where, given the lack of quantitative easing policies, the country’s credit default swap is not even quoted. But lately, sovereign credit default swaps have compressed significantly. And this only signals future conflict, future competition for financing between public and private sectors worldwide. In the meantime, as demand pick-up is not visible, capital expenditures or M&A financing is anemic and therefore, the conflict is muted.

Should the conflict be supportive of gold? Not if the debasement is coordinated. In the ’60s / ’70s, we had people like De Gaulle in Europe or Mao Tse-Tung in Asia, and of course, we had a Cold War going on. Coordination was not possible. Today, the political classes of the world are on the same program: They have to defend the status quo, be it in North America, Western or Eastern Europe, Asia and of course, in Latin America.

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