February 2010 - Posts
Please, click here to read this article in pdf format: march-1-2010
Over the weekend, we came across an article from U.S. Congressman and former Presidential Candidate Ron Paul, with whom we sympathize (refer: www.ronpaul.com ). The article was titled “Are U.S. taxpayers bailing out Greece?” and published on February 16th (refer: http://www.ronpaul.com/2010-02-16/ron-paul-are-us-taxpayers-bailing-out-greece/ ).
Briefly, Mr. Paul wrote: “…Is it possible that our Federal Reserve has had some hand in bailing out Greece? The fact is, we don’t know(…)Unless laws are changed to allow a complete and meaningful audit of the Federal Reserve, including its agreements with foreign central banks, we might never know if this is occurring or not…”
Mr. Paul left us thinking, and after careful consideration, we realized that the implication of this exercise may (or not) be in contradiction with what we wrote on Friday. Let us explain:
To begin with, we believe that indeed, there would be a cost to U.S. taxpayers, if Greece defaulted. We don’t think Greece will default, at least not in the near term, but there would be a cost nevertheless. The cost is not explicit and it would show its ugly face if a credit event was triggered under a sovereign (i.e. Greece’s) credit default swap.
Why?
Any US financial institution with a net long exposure to Greece’s sovereign credit default swaps would face an immediate funding problem. Therefore, the Fed would be pressed to rescue such institutions, while at the same time, it would have to provide currency swap lines to the European Central Bank, to avoid a collapse of the Eurodollar market.
The cost regarding the financial rescue would be on US taxpayers. This would be an unnecessary and most disappointing cost. After so much “quatsch” on regulation, how would the current US Administration justify having missed a flag as big as that of sovereign credit default swaps. There is currently a lot of quatsch about sovereign credit default swaps, but all superficial. The economic ignorance of politicians prevents them from understanding what these derivatives really imply. As we wrote earlier, under a system of fiat currency, allowing banks to sell insurance on sovereign debt is no different than allowing children to sell insurance on the financial risk of their parents. But politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons. If somebody bought credit insurance on the parents of the seller of that insurance, be it the most educated, hardworking or honest kid, he or she would still be dreadfully misled by the formal aspects of the contract, which lacks any solid content. The solution does not reside in prohibiting them, but in requiring that collateral on such trades, at least on non-Emerging markets credit default swaps, be posted in gold. (Note: Why do you think I believe that a commodity collateral would not be required on credit default swaps on emerging market countries?)
On the other hand, the cost needed to save the Eurodollar market would be global. The global feature of this cost is driven by the violent foreign exchange volatility the world would have to bear, where the notion of a global reserve currency would be clearly challenged. This brings us back to the point made last Friday, when we wrote that a sovereign credit event would be deflationary, and that liquidity preference, in particular a strong demand for USD, would challenge the value of gold.
We kept and keep thinking about this one. Given the hypothetical nature of this event, we can only speculate as to what conditions would be necessary for gold to rally. The first one that comes to mind is a catastrophic situation, where the Fed actually bails both the financial institutions and the Euro market but the market no longer trusts monetary authorities and every USD facilitated by currency swap lines is swiftly bought with Euros and immediately exchanged for gold.
If you think this twice, you will acknowledge it would not be the first time a flight to safety of this nature takes place. In fact, it would make sense. But again, this should occur under a total lack of monetary policy coordination and something else: The firm conviction that stimuli programs are useless. This would be a true capitulation. What is the probability for this scenario? Not too high for now, but not too low either, in our view.
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.
With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold.
We’ve seen this pattern before too, but it did not go too far, when it happened in 2008. Indeed, one could explain the behaviour by pointing at Mr. Bernanke’s comments yesterday, who made every effort before the Senate’s Banking Committee to be clear on the Fed’s intention to maintain a level of liquidity consistent with that of economic activity (weakness = low rate environment). Or maybe his comments on the possibility of reviewing MBS purchases, if required? But if that was the case, why would stocks not also rise, along with gold and oil? Why would the USD not weaken as well?
Clearly, the above factors cannot explain what happened yesterday. But if gold was bought as a way out of future currency debasements, then we have some comments to add here this morning.
If you have been reading “A View from the Trenches” long enough, you will remember that we turned neutral to bearish on gold (in USD) after the Dubai event, at the end of November 2009. Essentially, we believe the power of monetary policy coordination is a formidable challenge on gold’s prospects as a reserve currency. Therefore, if yesterday’s rally on gold and gold mining stocks was due to the increasingly likely fall of the Euro, as a consequence of the peripherals’ problems, we think gold bugs could later be disappointed.
Why?
In the 21st century, there are two global social classes: Politicians and taxpayers (This social stratification truly has global characteristics). If you think politicians will let you taxpayers get away from the inflation tax easily, think it twice. Let’s specifically consider the scenario where the Euro plunges. We think that if this happened, there would be an immediate increase in liquidity preference, expressed as a flight to the USD and the Treasuries markets. In that case, gold and stocks would be sold in favour of liquidity.
To those who disagree with this view, believing this chaotic situation would get off hands, we suggest that the Fed would be able to establish again, as it did in 2008, currency swap lines with other central banks, cushioning the impact of this move. This would be a deflationary event and no central bank would hesitate to provide extra liquidity. In summary, we fail to see a compelling story to be long of gold. And yet we are indeed worried, because the market proved us wrong yesterday and will prove us wrong today too, for gold is already at $1,112/oz.
For an historical perspective on this dynamic, let me quote below part of an interview M. Jacques Rueff gave to The Economist (Jacques Rueff: (http://en.wikipedia.org/wiki/Jacques_Rueff ). The interview was published on June 1965, and titled “The Role and the Rule of Gold.” The entire interview was reprinted in Jacques Rueff’s book “The Monetary Sin of the West”, MacMillan Co., New York, 1971, Part III. Its online version can be found at (www.mises.org/books/monetarysin.pdf ):
The Economist: …one of the countries that saw the biggest constriction imposed by the gold standard was, of course, Britain, which held no foreign exchange in its reserves. And, as we have always recognized, Britain at this time suffered precisely because of the harsh and inflexible disciplines of the gold standard, which you now want to restore.
J.R.: Let me tell you that you touch a point on which I have quite a few personal recollections. In 1930 I was financial attaché in the French Embassy in London, and in that capacity I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.
The Economist: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances, that was in part responsible for the general collapse later on?
J.R. Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed. We were too gentle in complying with official appeals not to convert our sterling balances into gold…
The analogy here consists in that France did the same 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. But politicians only care about the present.
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-25-2010
We are back from a relaxing vacation and strangely glad to see that
not much has happened since we last wrote. Indeed, the markets bounced
from the lows we went through earlier this month, and we were stopped
out on our short positions, as we invest on fundamentals, but trade
like technicians.
Why do we insist that nothing really changed?
We have not witnessed a single catalyst on the Greek/Euro-zone
situation. In the US, Bernanke only continued to confirm the Fed’s view
of a weak recovery but recovery at last, while at the same time, he
asked Congress to think about a fiscal exit strategy. China continues
to expand output on its pegged currency and commodities, in our view,
are starting to price unavoidable currency collapses.
We believe that by now, it is self-evident that the world has lost
one of the most important functions money provides: Its use as a unit
of account. Please, take a moment to think about this, but not in the
standard way you have been taught to. Do not think of the USD as a unit
of account. Do not think of the EUR for the same reason, or any other
currency. Why? Because production, distribution, sales, collections,
etc. today are global processes. If you don’t believe this, just look
around you. Look at where your watch was manufactured and think of all
the different components that had to be assembled, the raw materials
that had to be used, where they came from, how they were purchased,
paid for and, as important, think about what each of the entrepreneurs
responsible for these operations did with their respective profits.
What currency did they invest them in? What was the volatility of those
profits, after adjusting them for their currency crosses (inputs vs.
output)?
If the world wants to continue growing, it will need a strong reserve
currency. There is no such a thing today. Yes, the USD continues to be
the world’s reserve currency, but by default. And this does not and
will not foster economic growth. Hence, our bearish outlook.
We recommend the reader to watch a recent interview (Feb. 21st) with
Greece’s Prime Minister George Papandreou, by Andre Marr, at: http://www.youtube.com/watch?v=EJP1Z85Hs9g
. This interview painfully reminded us of Argentina’s Plan Blindaje, in
2000-01, when it was announced by the then President De La Rua. We
wrote before that Greece’ situation is not comparable with Argentina
(refer: www.sibileau.com/martin/2009/12/17 ), but the similarities are striking.
This brings us to our final point. We read today’s Morgan Stanley’s Global Monetary Analyst research note titled “Default or Inflate or…”.
In this note, Morgan Stanley’s Global Economics Team suggests that
neither defaults nor inflation are likely or even optimal for
sovereigns. There are many reasons for this conclusion, which we will
not deal with here. However, because of this conclusion, the authors of
the note propose that governments in developed countries will push
banks to purchase and hold their upcoming debt issuances, “as a
prudential measure”. This did actually occur in Argentina and it was
precisely what led to the financial collapse of 2001. We admit we had
thought about this many times before in 2008. We even thought that the
US ownership of banks after their respective bailouts had no other
final purpose but to later have the power to steer their portfolio
allocation decisions. In particular, we thought that by owning Citi,
the US government could raise deposits outside the US to buy
Treasuries. Call us crazy, but stranger things have happened…
However, we believe there is merit to this suggestion, although it
is a bit early to worry. Under this scenario, there are two issues that
concern us. First, this would have an immediate and meaningful
crowding-out effect on the private sector. If this was the case, we
would even consider another jump in default rates, particularly in the
high yield space, which according to Bank Of America (“HY Maturity Wall – How big a Worry”,
in “Situation Room” Report, Feb. 23rd , 2010) will see over 85% of all
loans outstanding mature between 2012 and 2014. Second, we are
concerned about the sovereign credit default swap market, which we
think is the real weapon of mass destruction. Strangely enough, no
regulator has set its eyes upon it yet and honestly, we don’t think
they ever will. It is in the sovereigns best interest, as issuers, to
ensure that investors buy their issuances comfortably, under the
misleading belief that the systemic risk entailed in such purchases is
hedged away with these swaps. But we ask who in his/her right mind
would feel safe buying sovereign risk protection from banks that a few
months ago could only obtain liquidity under the guarantee of the same
sovereigns they now sell protection on, banks which would be forced to
invest up to a considerable percentage of their portfolios in sovereign
debt? Is this not as crazy as having children sell insurance on their
parents’ financial risk?
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-12-2010
(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)
The statement released by European authorities yesterday was a mere
expression of support for Greece, explicitly denying a request by
Greece, for financial aid. The markets accordingly sold all things
European, including and in particular Spanish financials. The picture
does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.
What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for
$16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended
4bps steeper at 285bps. The Czech Republic was also deceived when it
raised 15-yr debt on Wednesday and Greek banks seem to be facing
funding problems. We also face significant uncertainty with the latest
developments in Iran. But on the other hand, the markets received some
“optimistic” releases too. Continuing job claims in the US kept their
downward trend, Australia also saw an improvement in its labour market
and the CPI reading in China was stronger than expected.
Briefly, of one thing we may be certain: Capital is flowing out of
the Eurozone and into the rest of the world. But at the same time,
capital seemed yesterday to also be preferring commodities and basic
materials, which puzzles us, because the macroeconomic backdrop is
bearish for us.
In our view, we
should not see yesterday’s rally in North American stocks and credit,
as well as in crude and oil, as a bullish signal, after the EU
meeting’s statement. Why? Because for this rally to be interpreted as
bullish, the Euro should have rallied as well! It didn’t and in fact
plunged from a tall cliff, specially against the Canadian dollar. A
reduction in the purchasing power of the Eurozone should not be seen as
something positive for global growth (= for oil demand and hence for the Canadian market!)
Interestingly enough, Freddie Mac yesterday announced that it will
buy practically all 120+days delinquent mortgage loans from its fixed
rate and adjustable rate mortgage Participation Certificate securities.
We had foreseen a move of this type and discussed it in December and on
our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:
“…As credit spreads are already very low again, the increase in
sovereign risk (yield) should make debt a less profitable investment,
when compared against equity. In December, I associated this process
with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer
Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited
support”, Bank of America’ “US Agencies” report of Dec 29/09). This
explicit show of support for agency debt (which I assumed it was going
to smoothly disappear in 2010) tells me that the USD strength will be
only a relative notion in 2010. I say relative because the strength
should show vs. those countries that explicitly decide to import USD
inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro
zone), while the weakness should show vs. those countries that will
profit from the credit-inflated recovery (Emerging markets or commodity
currencies, like the CAD)…”
Back to the impressive strength shown yesterday by the Canadian
Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At
close, 1.05 were enough. The CAD was even stronger of course vs. the
Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted
such a move? In our view, the strength in the CAD was not fully
reflected in the stocks market (TSX 60), which closed +1.32% higher, at
11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.
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-11-2010
The world is speculating on the outcome of the meeting of European
leaders later today, in Brussels. In the meantime, yesterday Mr.
Bernanke made clear his intention to raise the discount rate, sooner
than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries
auction was weak. It’s true, there were a lot of other problems markets
were focused on, including the weather on the east coast, but then
again, are Treasuries not supposed to act as a safe haven in times of
chaos? We took note of this and of the fact that yields rose in
parallel (shift upwards), with the 2y10y curve ending at 281.1bps,
flat. We will be watching this market closer as well as its impact on
swaps and Agencies, for we feel this may be signaling an upcoming
tectonic shift. It’s pure intuition for now, we acknowledge, but
sometimes intuition has merits too…
On another note, we continue to insist with the view that Europe is
facing an institutional crisis, rather than the short-term liquidity
crisis seen by so many mainstream analysts. What is the difference?
Here is a defining point:
If the crisis was indeed about short-term liquidity (with long term
solvency concerns), then it should not matter whether it is the IMF or
the European Union that bails out stressed peripherals. If
the problem was only short-term liquidity, form should be subordinated
to facts. Yet facts are subordinated to form. It is precisely because
nobody seems to be able to come up with a sustainable and acceptable
“form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)
If the crisis was only about short-term liquidity also, the Euro
should have not been impacted as it has. How measurable is the impact
of the liquidity situation in California on the USD? How can therefore
Greece have such an impact on the Euro? It is the very sustainability
of the European Union that is at the core of this crisis.
Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.
Lastly and related to this crisis too, we want to draw collective
attention to an issue that in our view has not received enough
consideration. Much has been made and written on financial regulation
necessary to prevent financial crisis. We, at “A View from the
Trenches” have also written many times that regulation is useless and
counterproductive, for the root of the problem is the monetary system
that the world is embracing. A central banking system is intrinsically
weak, arbitrary and leveraged, and attacking the distributors of a
currency (i.e. financial institutions) will not make the system any
stronger. However, there are other issues regulators can positively
address, which we think have not been addressed yet. One of those is
the potentially destructive nature of sovereign credit default swap
contracts, which are currently booming.
In our opinion, these swaps are true weapons of mass destruction.
Essentially, if a sovereign defaults, the party that bought protection
should be compensated for the loss on the corresponding reference
securities. But who thinks any counterparty would have enough liquidity
to honor these contracts, if say, we see a default in the US or the UK,
for instance? What would be the value of billions of credit protection
on US sovereign risk sold by Citi or Goldman, if the US defaulted on
its debt? What would be the value of credit protection on German
sovereign risk sold by Deutsche Bank, if Germany or France actually
defaulted? Zero! Given the fiat monetary system we live in, no
financial institution would be able to have enough liquidity to fund
the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises.
Under such scenario, things would spiral out of control and it would be
evident that either central banks end up bailing out both the financial
system and the sovereign, triggering a massive hyperinflation in the
process, or the biggest of all depressions would be upon us.
Restrictions on this market would be useless, because they would not
acknowledge the intrinsically leveraged nature of the contracts. The
solution, in our opinion, is that counterparty risk be collateralized
with gold, instead of fiat currency, for those sovereigns with the
strongest currencies (=the most leverage!).
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-10-2010
We’re back and still concerned about the situation the capital
markets face and will continue to face. Essentially, (we differ with
the mainstream view and) we stand by our interpretation that Europe does not face a short-term liquidity crisis, but an institutional crisis.
Institutional economics is one of those underappreciated and
misunderstood branches of Economics (in our view, if economists had
properly read Von Mises’ “Human Action”, Institutional Economics or
Behavioural Economics would have never taken off as disciplines.
Perhaps the best known economist within the Institutional tradition is
James Buchanan (1986 Nobel Memorial Prize), but we also enjoyed very
much and recommend reading the works of Peruvian economist Hernando De
Soto).
The institutional economist asks the following question: “If
the European Union is actually not a Union, but a Confederation, why
should Euros be held as the world’s alternative reserve currency,
instead of Canadian Dollars or Australian Dollars or Swiss Francs?” We
think this is a valid question and a question markets are asking as we
write. But first, let’s briefly describe what a Confederation and a Union are:
Confederations are alliances of sovereign states. “…In a Confederation,
the links among members are weaker. The legal instrument of the
alliance is a “treaty”. The purpose of a Confederation is economic
integration and military assistance among members. Member states remain
sovereign and as such, keep the powers of self-determination.
Confederated states reserve the right to nullify, reject legislation
and eventually, of secession. They may issue currency, keep customs and
sustain armed forces. They lack a strong common government, although
they may unify their foreign policy.
In a Union, the links among member states are
more vigorous. In a Union, one finds a definitive purpose to integrate
the states. There is a sovereign federal government, while the states
are autonomous. The states can govern themselves, have their own
legislation, but these acts are subordinated to the Union’s
constitution and federal laws. Secession is not allowed, although
member states conserve those rights that they did not delegate to the
federal government, when the Union was established….” (our translation
from “Curso de Derecho Político”, H. Sanguinetti, 4th Edition, 2000)
As investors, what should we interpret as a catalyst, as a
defining moment? Here’s our view: If the IMF has to intervene, the
European Union will definitely be a Confederation. This is
unfortunately the path of least resistance. This is the easiest and
less painful path. If the IMF is engaged, the Euro will no longer be
considered an alternative global reserve currency and the bid that
there was under such belief will no longer be there. We shall be
sellers of Euros under this scenario. This is the worst-case scenario,
for if the EU citizens lose purchasing power, the global recovery will
become a long-term dream. Note that we don’t care about Debt/GDP ratios
or other metrics. The relevant issue here is that on the margin, the
Euro would no longer offer more safety than other strong, healthy
currencies. In fact, its complex institutional framework would be a
burden, compared to other ones, simpler to understand.
In the world of corporate credit, when lenders are not satisfied with
the credit quality of borrowing subsidiaries, they may demand
cross-guarantees, in addition to an irrevocable guarantee of the
parent. Unfortunately, this cannot happen with sovereign debt. The more
difficult and painful path for the European Union is to stand up to the
challenge and lay the ground for a stronger integration, under a
central government that can provide legally and operationally a
guarantee for not just the debt of Greece, but of any other state under
stress (i.e. Portugal, Spain, Ireland).
Such integration demands political will and time. Unfortunately, the
world lacks both. Therefore, we were very suspicious, when at 12:19pm
yesterday, Bloomberg announced that Germany was considering assisting
Greece. In fact, we smelled something wrong earlier, when after 10am,
the Canadian dollar broke its correlation with oil (chart above,
source: Bloomberg).
At 11am, it was clear that the source was the cross with the Euro.
Somebody knew something that the rest of us ignored (chart below,
Eur/USD, source: Bloomberg). And then, the rumor was officially out at
12:19pm, that a member of the German’s Christian Democratic Union had
said Germany was considering assisting Greece. The Euro had gained 1%
and profits were immediately taken!
We are of the view that the market sold into this strength, for if
it the rumor had had real merit, the bounce should have been way
stronger. However, we are also concerned about the existing
misinformation. As we write (11pm ET), the “Frankfurter Allgemeine” (at
11:02pm ET) reports Mr. Joaquín Almunia (ex-economy commissioner, since
Feb 10th, according to Bloomberg) to have only expressed that the
European Union should
promise protection to Greece. However, Madrid’s “El País” reports that
the European Union and Germany are preparing a package for Greece. Le
Monde and Financial Times back the latter interpretation.
All we are certain of is that a European plan should put the IMF
alternative farther rather than closer, and that’s a good thing.
However, a plan for Greece is hardly going to solve the situation, for
it is the European Union that is in crisis, not just Greece. And the
upcoming strike of public employees in Greece is not going to make life
simpler.
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-8-2010
During the weekend, we did a fair bit of reading and, among other
things, watched an interview Mr. Martin Redrado (now ex-President of
the Banco Central de la República Argentina) gave. It was an unusually
interesting interview to watch (the interview was in Spanish and can be
replayed at: http://www.tn.com.ar/2010/02/04/politica/02133330.html . We will refer to his comments made from minute 10:30 to 11:42).
As you may know, Mr. Redrado gained public attention after he refused
to hand over $6.6Bn in reserves of the Banco Central to the Argentina’s
Treasury, to service upcoming debt maturities. Mr. Redrado had to
eventually resign. In the interview, Mr. Redrado was asked why he
thought the Treasury should not use the so called “excess reserves” of
the Central Bank, if the amount of reserves is higher than the monetary
base in pesos (which the reserves back)? Mr. Redrado answered that the question denoted a misunderstanding
and gave an historical example: In 1989, at the time Argentina had
hyperinflation, the amount of reserves was actually higher than the
amount of “currency in circulation”. Redrado continued to point that
the relevant metric a Central Bank should follow is not “Demand for
currency”, but the potential demand for currency. He explained that under the institutional uncertainty
Argentines face, they may not renew term deposits at maturity (a
component of M2). As these term deposits mature, they become demand
deposits, which people then convert into USD. Therefore, the Banco
Central has to maintain an optimal level of reserves that will guarantee enough supply, to a potential
demand of USD . Term deposits must not be ignored. Therefore, according
to Mr. Redrado, Argentina has no such a thing as “excess reserves”.
(Here, the concept of currency is tricky. Argentines demand USD as a
reserve currency, while they demand pesos as a transaction currency).
Why do I take you precious time to tell you this? Why should you care about this story, if you live in the developed world?
Last Friday, Mr. Jeffrey Rosenberg, Bank of America’s Credit
Strategist wrote an interpretation on the current crisis that the
so-called Euro zone peripherals face (i.e. Greece, Italy, Portugal and
Spain; “Default (even a sovereign one) is a liquidity event”
in “US Fixed Income Situation”, Fixed Income Strategy, February 5th,
2010, Bank of America). According to Mr. Rosenberg, there is no
currency crisis. As these peripherals have their debt denominated in
Euros,”… this crisis is a long term “solvency” crisis precipitating a short term liquidity crisis…”.
Therefore, this is not a typical sovereign currency crisis (not your
father’s crisis), with investors fleeing the countries financial
markets, and all we need is “liquidity support”.
What does Mr. Rosenberg mean by liquidity? He shows us two tables.
In Table 2, we see “Fundamentals behind solvency concern”. Which ones
are these? Fiscal Deficit as % of GDP, GDP, Sovereign debt (in $ and in
% of GDP) and the required adjustment, as a % of GDP. In Table 3, there
is a display of liquidity needs of the Eurozone. The metrics are (for
each member country, in Euro) 2010 bond maturities, Rolling short term
debt, Fiscal deficits and total financing needed. From this point of
view, the natural conclusion is to obtain the scale of the liquidity
support required.
After having heard Mr. Redrado, I could not help smiling at Mr. Rosenberg’s naiveness. Every currency crisis, absolutely every one of them,
is the consequence of the assessment made by its holders, that their
currency no longer can serve both to transact and to act as an asset to
save. The currency can no longer be used to save. Why? The
reason is always institutional. It doesn’t matter what the trade or
fiscal deficits are (the USD is the best example) or what a
government’s financing need is. At the heart of a currency crisis you
have a crisis of confidence in the government. The currency holders ask
themselves: “Will we be “taxed” for holding pesos, or Euros?” The
extreme case of Argentina is a good example. Note that if the Central
Bank’s reserves belong to a government’s Treasury, changing pesos for
another currency constitutes an act of fiscal rebellion!
In conclusion, in my view, the Eurozone peripherals are not facing a liquidity crisis. The
issue is far more serious. The whole European Union is facing an
institutional crisis. Will the Eurozone behave as a Confederation or as
a Union? Under our perspective, the cost for the Eurozone of not
standing up to the circumstance and showing a firm resolution, will be
far, far more expensive than the product of the existing government
financing needs times a higher cost of borrowing, as Mr. Rosenberg
wants us to believe. The European Central Bank must not believe for a
second that what is at stake is a “short term liquidity problem of
peripherals”. Paraphrasing Mr. Redrado’s wise comments, the European
Central Bank must understand that in these peripherals there is also a
potential demand for a reserve currency that will be triggered
violently without notice, if the Eurozone acts as a Confederation,
rather than a Union. In this case, liquidity support lines will be
useless and will only delay a horrible end. What does the Eurozone
need? A unified bond market.
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-5-20101
Below, we attach the same chart shown yesterday (Source: Bloomberg) on
the IBEX (Spanish stocks), with banks’ share prices at yesterday’s
close (i.e. updated). As days go by, our earlier comments sound more
and more prophetic. By now, it should be obvious to everyone that the
dam is broken, that the bears are out to do more damage but also….that
this problem has a solution. That solution is more quantitative easing,
by the European Central Bank. Will we see it? No! Will it be there?
Yes. Mr. Trichet & Co. are currently trying to find a way to
simultaneously rescue the Euro (and its financial system) and to save
face. We know he can’t get both, but we are optimistic that the ongoing
situation has a solution. It will still get uglier before it gets
better, but such is human nature and our duty is to profit from any
circumstance as much as we can.
The damage has been mainly driven by valuations in financials. So
far, and this is our personal view, the fact that the Euro is still not
the main reserve currency, is saving the day for the rest of the world.
Liquidity costs for the world’s reserve currency, the USD, have not
reacted accordingly. If this sovereign risk contagion (from public
sector to financials) had happened in the US, things would be
different. We should keep this very much in mind, which is why I
believe both the price of gold and the Canadian dollar (in USD) are
still holding relatively within their upward trend, although the
challenge rises by the hour. But we must also keep it in mind because
when the finest hour arrives for the US, a steeper yield curve will
push us to review our default rate assumptions.
As well, it seems as if the market (still) shared our view on the
temporary nature of this problem, and that there is light at the end of
the tunnel. That light is the explicit recognition by monetary
authorities worldwide, but especially in Europe, that inflation will be
the only way to make the debt burden bearable. When that recognition is
finally made, we will be buyers of gold, commodities and commodity
currencies. Perhaps the recognition comes sooner rather than later. In
the meantime, we see central banks holding their policy rates at record
lows, like the European Central Bank did yesterday. That’s a good sign,
but it is not enough. Perhaps we need an explicit commitment, like the
one the Bank of Canada made last year, to calm animal spirits. However,
the time to only play monetary policy is gone. None of this will work, anywhere, if a commitment of the same weight is not done on the fiscal front too.
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-4-2010
In the previous letter, I framed my review of 2010 in three stages.
The bottom line is that I am bearish, and expect the bearishness to
progress. The progress will be marked by the lack of credit expansion,
caused by central banks unwinding quantitative easing policies or by
governments limiting the credit expansion, through regulation. Without
this lifeline, the onus is on fundamentals. So far, they don’t seem to
surprise nor disappoint. I think there is merit in my intuition, proved
perhaps by the fact that both the Reserve Bank of Australia and the
Norges Bank took a break from rising policy rates this week.
In this context of stagnation, monetary authorities will be
increasingly pressed to leave the status quo unchanged. However, in the
case of Europe , the situation may be different. As the fiscal
situation deteriorates seemingly faster than previously thought, the
European Central Bank will have to take an holistic approach to the
problem. As I mentioned on December 17th (www.sibileau.com/martin/2009/12/17),
I expect the path of least resistance to be the abuse of the private
placement market (bank debt) to finance peripherals’ deficits (i.e.
Greece , Portugal , Spain , Italy , Ireland ). This will guarantee that
the European Central Bank will be forced to extend liquidity to the
affected financial institutions, providing a hidden subsidy. This is
clearly bearish of the Euro. The chart below is very ominous in this
respect. It shows the IBEX (Spain) stock index, which is approx. 11%
off its January peak (Source: Bloomberg). Yesterday, the weakness was
noticeable, driven by financials (bank stocks). This is the worst kind
of weakness you can see and a bull market will never rise from it.
Yesterday, the markets surprised me. Stocks and fixed income sold
off, while credit remained flat. Credit, it is true, is undergoing a
lot of technicals, which make the picture blurry. However, on average,
the market sought liquidity, for the sake of liquidity given the
steepening of the US yield curve (2y10y by 3.8 bps, to 282.2 bps). The
USD strengthened, while I believe the strength in oil was merely a
bounce within a bearish trend. If I am correct, not even the upcoming
G7 meeting (where neither China , India or Russia will be present) will
be able to coordinate the required global exit strategy. On this basis,
I see an increasingly bigger role for gold as a reserve asset (not
currency). But we will still have to see a lot more water running under
the bridge, before gold shows us the way. All along, the social
backdrop will grow uglier, as unemployment will remain high.
How to trade with this outlook? Keep it liquid, and keep it simple,
when you short the stock market or play the curve in European sovereign
credit. As I previously said, I don’t see volatility waning in 2010,
given the global fiscal front, which means that complex trades can get
killed by tail risk, courtesy of liquidity preference behavior.
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-2-2010
When Maynard Keynes wrote the already famous sentence: “…And
when output has increased and prices have risen, the effect of this on
liquidity-preference will be to increase the quantity of money
necessary to maintain a given rate of interest…”, he was clearly considering “time” as a magnitude in his analysis.
It takes time to increase output and it takes time for prices to rise,
reacting to such increase. The rise in prices and the speed of the
output increase have to be matched by the nominal interest rate
referred above. This is why Keynes also wrote, in the same paragraph: “…prices
will rise in a degree partly governed by the shapes of the physical
supply functions, and partly by the liability of the wage-unit to rise
in terms of money…” (The General Theory of Employment, Interest
and Money”, Ch 13, S. III). Briefly, Keynes’ idea was to coordinate
monetary policy to debase a currency taking advantage of productivity
slack (i.e. the shapes of the physical supply functions) and unemployment (i.e. the liability of the wage-unit to rise in terms of money).
Since the start of 2010, it seems that of all sudden, central
bankers have forgotten this idea, while at the same time, governments
attack banks with higher reserve requirements and capitalization
ratios. Banks are not to blame for the shocks. Shocks are produced by
central banks, which determine the money supply function, but I guess
somebody has to be blamed.
With the above in mind, I thought of 3 phases that may unfold in
2010. In all of them, the challenge of matching monetary policy to
productivity is omnipresent. This framework suggests a long-term
bullish view of gold and commodity based currencies, and a definite
path to inflation by 2011, when it is most likely that the real
tightening will take place.
These phases are presented in the chart below, which I think is
self-explanatory. In the next letter, I will nevertheless elaborate
more on this framework. In terms of timing, the only certainty we may
have is that we will need to wait another quarter to see earnings
disappointing.
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.