May 2010 - Posts
Please, click here to read this article in pdf format: may-31-2010
This is a short week for the markets, as they are closed today in the US. Today, we want to take the opportunity to disagree with two mainstream perspectives on some of the most “popular” market themes:
-The fall of the Euro is an escape valve that offsets the impact of fiscal tightening
This is by now a widespread myth, that will have to test reality, for it is still too early to tell. We disagree with this view mainly because it ignores the cause of the fall of the Euro. It is certainly not an oversupply of Euros, because the European Central Bank, so far seems to be sterilizing the sovereign debt purchases. But above all, because the fall began way before any sovereign debt purchases were made. The fall of the Euro is simply a run against the currency, a crisis of confidence.
What does a crisis of confidence in a currency mean? Currencies are the liabilities of central banks. When people lose trust in the liabilities of an issuer, it’s because they no longer believe in the quality of the assets backing such liabilities. This is exactly what is driving the Euro lower, even before the ECB would announce its purchase and sterilization programs. The Euro is partly backed by gold, but mainly backed , ultimately, by sovereign risk.
Having said this, to believe that the fall of the Euro will serve as an escape valve implies two assumptions:
Assumption No.1: The fiscal tightening will be successful. We have our doubts on this issue, because the fiscal deficits are not the result of just a few tough years or a bad investment decision (i.e. sub-prime mortgages in the US). The deficits are structural. They are the natural result of a lifestyle. There are demographic drivers (i.e. aging population), taxation and fiscal spending asymmetries within Euro members, and a deeply-rooted market interventionism, causing them. A cut in public employees’ wages or a spending freeze will do the trick? If you believe this, please call us. We have a bridge for sale!
Assumption No. 2: There is an optimal value for the Euro, and this value is “stable”.
This assumption is in total disconnect with the root of the devaluation. It assumes that exogenously, there was a previous value for the Euro, a degree of purchasing power that Europeans did not deserve, given their fiscal deficits. This is a mercantilist view. This is 17th century economic thinking. It’s absurd. People were holding Euros as an alternative reserve asset regardless of the fiscal situation of EU members, because they trusted the Euro and until that confidence is restored the Euro will continue to drop. The Euro will not be any more stable at 1.10USD than it was at 1.30USD, if the structural problem, the fiscal deficits of the Union, continue to be linked to the balance sheet of the ECB, affecting the quality of its assets. Furthermore, this is not a linear development, but it will escalate exponentially, as it gets uglier.
There is a deeper problem here. Why did assumptions 1 and 2 first come to life? They are the result of an indiscriminate use the “comparative statics method”. As we wrote in our last letter, comparative statics macroeconomic models (http://en.wikipedia.org/wiki/Comparative_statics ) ex-ante and by necessity, are based on the general equilibrium theory. This line of reasoning is a typical case of arguing in a circle, because the equations already involve the final equilibrium they try to prove.
-Deflation, or weaker inflation, has won the day
Those who believe in the effectiveness of fiscal tightening and the stability of a lower Euro, are right to believe in deflation. Why? Because they chose to ignore that the ECB is facing a run against its currency. In a typical run against a currency, things don’t remain stable. Politicians fight back and try to kill “speculators”. The holders of the affected currency have realized they are subject to the inflation tax, that as long as they hold that currency, their savings will be taxed. Therefore, politicians strike back and first, they seek to close all the exit doors. We are currently seeing this coming from Germany. But this is not the only thing they do. They always go for more and they commit their one deadly sin: They raise the bets and escalate the debasement. We are months (at best) and perhaps years (at worst, though not many) from getting there.
As well, those on the deflation side always look at “asset bubbles” as a market anomaly, as much as they see the current volatility as the result of “animal spirits”, as if there was no rationale behind shorting a currency whose central bank has been taken hostage by Athens. We believe those bubbles are the natural features of an inflationary process, just as pregnancy is the natural feature prior to birth. We cannot have a birth without pregnancy and vice versa, once we observe pregnancy, we know birth is on its way. Does it matter if it takes 9 months? Certainly not.
What are the latest bubbles? Here are a few:
a) USD funding costs (3-mo Libor –OIS spread):
We will surprise some readers here but we don’t see the recent minor spike in funding costs as proof that the crisis is temporary nor as a result of “adaptive expectations” (on this latest point, refer: Bank of America’s “Situation Room” report, May 27th, 2010).
With volatility levels approaching those of 2008, the fact that funding costs are no way near those of 2008 are a clear sign to us of a “bubble” in the funding market. This bubble is being bred by the currency swaps (at OIS+100bps) the Fed is providing the ECB with, at the US taxpayers expense. This is the point Congressman Ron Paul made before the Subcommittee on International Monetary Policy and Trade, on May 21st (please, watch at: http://www.youtube.com/watch?v=hMo-V8HoNdc ).
Mr. Paul (on minute 7:35 of the link) asks:
R. Paul: “…where do we get the USDs to give them (i.e. the ECB) for the Euros…”
Fed answers: “… it is created as a reserve and then unwound, when it comes back…”
Do we need to say more here to prove our case???? Can you imagine a risk manager of any bank replying to her employer’s Risk Committee: “Don’t worry about those lending facilities we provided to our customer. We know they are under priced, but we expect the customer will not use them”? She would be fired instantly! Yet, the Fed is not even audited on these issues!!!
b) Price of oil
How can it be that, having the European Union members lost 23% of their purchasing power (i.e. from 1.60USD/EUR to 1.23USD/EUR) oil does not fall below $70/bbl? Do we need to show a chart here to make this more visual?
These are not bubbles. This is the proof of a monetary debasement that is looking us straight in the face. There is nothing deflationary here and we could go on and on with property prices that do not fall, food prices that increase, air fuel surcharges that keep being charged, etc.. There is only one way to protect ourselves from this: Civil disobedience. Sell your fiat currencies and buy gold. Having seen where the last debasement led us to (i.e. World War II), the Mahatma Gandhi would approve of this pacifist and preemptive method!
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: may-26-2010
We have not written since last Thursday because in our view, nothing really new has taken place. We discussed why we were bearish of the Euro and bullish of gold, and so far, the market has told us we are right. We also mentioned that if the Euro Union did not show political unity, jurisdictional arbitrage of deposits would follow (www.sibileau.com/martin/2010/05/17 ). The first stage of this shift has occurred in Spain, where deposits have left the Cajas looking for bigger players. The next move will be (and to a certain degree currently is) out of a peripheral and into Germany or directly out of the Euro system, into gold, Swiss Francs or USDs. We had also warned about the systemic risk of sovereign credit default swaps, back in March, as well as the risk of contagion outside the Eurozone, via currency swaps. These issues, which we suggested months ago, are currently being debated. Since our last letter, three things are occupying our mind:
1. - Evolution of European Central Bank’s intervention (and its opposite, the value of gold!)
This is perhaps the issue we’ve most thoroughly discussed. Our view is that as long as the ECB does not lower the Euro benchmark rate (as the Fed lowered the USD benchmark rate), there is no healing.
The benchmark rate is indeed decreasing, but we don’t think it is as a result of a successful intervention. On the contrary, it is decreasing as the market sees Bunds as a safe heaven vs. peripheral’s debt (An interesting perspective on this issue appeared on Barclays Capital’s Global Rates Weekly, May 21st : “Euro Inflation-Linked: GGBЄi25-A dysfunctional bond”. For obvious reasons, we cannot opine on this trade recommendation, although we disagree on the writer’s view that the behavior of this bond is an anomaly that will revert to the “normal”. We explain our view below)
If you think Germany is going to finally foot the bill, the flight to safety doesn’t make sense. Therefore, the fact that the benchmark rate is decreasing as the risk of peripherals increases, shows that there is no “coordination” in the intervention within the Eurozone. The unilateral decision out of Germany last week to ban naked short-selling says it all. The chart below (source: Bloomberg) shows how the spread between Greece and Germany’s 5-yr credit default swaps is widening, exactly since active intervention by the ECB began. As you can see, the spread compressed right after the EUR750BN bailout was announced. In our view, a successful intervention should have kept that spread converging to a level between that of Germany’s and Greece’s. However, it bounced and keeps widening. The ECB has so far reported EUR26.5BN in peripherals’ sovereign debt purchases.
The lack of successful intervention, the lack of coordination, brings us back to our thesis no. 2, first proposed on April 21st, 2009: “…When there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset” (www.sibileau.com/martin/2009/04/21 ). Accordingly, gold has and will continue to outperform, under these conditions.
2.-Market optimism
We continue to be amazed at the level of optimism so many have. Over the weekend, we have come across research pieces calling this crisis a “cloud of volatility”. There are also many who suggest “shopping lists” in the bond market, for when the “volatility subsides”. Of course, there is no suggestion about what will the catalyst be for the volatility to subside.
Others have decided to do extensive research to compare the fiscal situation of Euro members, and calculate the impact of fiscal tightening over GDP, to conclude that “austerity poses no major risk to the Euro economy”…Have we not yet learned that in an overleveraged world fundamentals are worthless? How can someone explain the fact that the fiscal debt of a minor EU member took the value of the Euro from $1.60 to $1.21 in a few months? Or as a friend and reader noticed, how can the Yen be so strong when Japan’s Govt. Debt/GDP is approx. 200%? It has nothing to do with fundamentals! That’s how.
To those who are familiar with mainstream Economics, we suggest this: All the comparative statics macroeconomic models (http://en.wikipedia.org/wiki/Comparative_statics ) that analyze the outcome of the latest policies must, ex-ante and by necessity, be based on the general equilibrium theory. This line of reasoning is a typical case of arguing in a circle, for the equations already involve the final equilibrium which they try to prove.
3.-Upcoming financial regulation in the US
We strongly recommend the aforementioned report (Barclays Capital’s Global Rates Weekly, May 21st ). In it, there is an interesting discussion on the impact of the prospective financial regulation on USD money markets.
Essentially, we understand that there will be two drivers of further illiquidity. The first one is related to regulations on the Federal Home Loan Banking System (FHLB, http://en.wikipedia.org/wiki/Federal_Home_Loan_Banks ). This system of banks, FHLBs, currently provides advance lending to major banks in the US. Under the prospective regulation (Section 165), they would be prohibited from having credit exposure to unaffiliated companies (i.e. other banks) that exceeds 25% of their capital stock and surplus. According to this report, the six largest US banks would see their borrowing reduced considerably, as a consequence of this new limit.
The second driver is the almost too certain upcoming ratings downgrades on US financial institutions, cause by the removal of systemic, governmental, support. This will reduce the number of participants in the commercial paper market and leave money funds (i.e. liquidity suppliers) with the alternative of investing their monies in Treasury bills. Therefore, the outcome will be a perverse crowding out the private sector, as savings finance the pharaonic US fiscal deficits.
How disastrous will these measures be? How much will they hurt the private sector, as interest rates rise? Below we show where the 3-month Libor – OIS spread closed yesterday (source: Bloomberg). In comparison with September 2008, we are still at a relatively low level of stress. However, the pain will be undoubtedly felt, as this process unfolds.
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: may-20-2010
In our view, nothing really new has taken place, except for the German reaction on Tuesday to deteriorating market conditions. We have already addressed the issue of the systemic risk embedded in sovereign credit default swaps (refer: www.sibileau.com/martin/2010/03/01 ). However, banning their trading is wrong, it leads nowhere and makes matters worse.
Briefly, sovereign credit default swaps are instruments where counterparty risk is totally underestimated today. If Spain defaulted, what would be the value of a credit default swap on its debt, sold by Banco Santander? None, we think, for Banco Santander would suffer the same fate. As these contracts on EU sovereigns are in USDs, the shortage of USDs in case of a default would rise exponentially, pushing the ECB to request additional USDs swap lines from the Fed. It is precisely this scenario that Congressman Ron Paul sought to avoid last week, unsuccessfully. As we wrote back on March 1st, if the Fed satisfied that USD demand by extending USD swaps to the ECB, the contagion would spread 100% across the Atlantic, which is the scenario where we think paper money collapses. We give this scenario a high probability.
Given that this issue must be addressed, what would we have done differently, had we been in Germany’s shoes? We think it would have been enough to pass a resolution, EU wide, explicitly making crystal clear that the portfolios of those selling sovereign protection will not be bailed out with public funds in case of stress and that those responsible for not separating (capitalizing accordingly) those trading portfolios from other (i.e. banking) portfolios would be liable to criminal charges. On such announcement, the market alone would re-price the underlying counterparty risk on the outstanding trades and those who cannot meet the increased margins would have had to quit, leaving a healthier market.
Finally, the fact that the German ban on short-selling was unilateral and comprised a limited amount of financial institutions invites one to speculate that somebody is anticipating something. Why 10 banks? Why not 5 or 12? Why those 10 banks? As the easier explanation is usually the one closer to the truth, we are left thinking that it was mere idiocy on the part of German authorities, rather than conspiracy.
On another note, in our letter of May 13th we wrote about the alternative the ECB had, to sterilize by issuing debt (for the comments below, refer the chart we made for this scenario: Sterilization with short term debt: www.sibileau.com/martin/2010/05/13, reproduced at the end of this letter). On Monday, the ECB announced it would do so yesterday (Wednesday) with a 7-day tender at a variable rate with a maximum bid of 1%. (this rate is very good, compared to the EONIA, the effective overnight reference rate for the Euro). The total purchases of sovereign debt in the previous week had been EUR16.5BN:
-May 10-14:
a) ECB credits EUR16.5BN of sovereign bonds and debits EUR16.5BN
b) Euro Banks credit EUR16.5BN of cash and debit EUR16.5BN of sovereign bonds
-May 19th:
c) ECB credits EUR16.5BN in cash and debits a EUR16.5BN 1-week term deposit (short-term debt, for the ECB)
d) Euro Banks debit EUR16.5BN in cash and credit a EUR16.5BN 1-week term deposit
Yesterday, the term-deposit was over-offered (given the 1% rate), at EUR163BN, suggesting that thanks to the ECB initiative, there is no shortage of liquidity in the system. The weighted average rate paid (by the ECB) was EONIA-6bps.
An interesting feature of these transactions is that the deposits are eligible as collateral in refinancing. Given the liquidity in the system, we don’t expect any such usage but we ask ourselves how it is that the market cannot short banks or make naked derivatives bets, while banks can use the cash they debit as collateral! Who is playing with fire? What risk manager at any bank would not be fired if he/she allowed a customer to use as collateral funds already used to buy securities?
We continue to read abundant analysis that is positive on the impact of ECB policy, and we continue to disagree with it. Essentially, the optimistic here believe that the ECB policy will lower rates as well as drive the Euro to an optimal value. They also believe that if given time, Euro members can produce significant deficit reductions. They also bring up the fact that Greece is not a meaningful EU member, in GDP terms.
On our side, we fail to see how the ECB will lower rates by buying non-benchmark debt (benchmark debt = Bunds, non-benchmark = Greece, Portugal, Spain, etc.). We understand that this policy will deteriorate the quality of the assets backing the Euro in a spiraling process (=no optimal value or devaluation speed). We can’t see where is the motivation for countries like Greece to effectively cut their spending (or pay their taxes) when they are bailed out, and we laugh at the naïve notion that GDP weight has anything to do with currency risk, in an over-leveraged world.
Finally, on the bullish side, there is (we think) the misunderstanding that the ECB policy is passive (“passive quantitative easing”), because it is financial institutions that decide how much funding is needed. We think this is utterly wrong. The ECB is not bailing out banks. The ECB is bailing out sovereigns’ fiscal deficits, dumped on Euro banks. Euro banks here are only the middle men. How much funding is “needed” is driven by consolidated Euro fiscal deficits. This is key, folks! If the ECB was bailing out banks, the Euro would not have been sold off so dramatically!!! The market sells the Euro because it knows the Euro eventually represents the liabilities of the sovereigns, BECAUSE THE INDEPENDENCE OF THE ECB IS DEAD AND FISCAL DEFICITS ARE BEING MONETIZED. How can someone be bullish of this? How, we ask?
Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt
Figure 2, reproduced from the May 13th letter. Notice that the ECB debt supply/demand graph on Step 3, right, is not yet significant, given that there’s only been one transaction so far (discussed above) and the resulting price was EONIA-6bps. Also notice that on step 2, PIGS debt increases on the asset side of the ECB. Last week, this increase was of EUR16.5BN, representing approx. 0.8% of ECB assets, as of May 14th (Source: ECB), which means that the credit quality of the assets backing the Euro has deteriorated. At this speed (=EUR16.5BN/week), it would take 14 months to have a Euro 50% backed by PIGS debt.
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.
(These comments were published earlier, on my website: www.sibileau.com)
Please, click here to read this article in pdf format:may-17-2010
The main paradigm that has been affecting markets in the last weeks has not changed one bit. Therefore, today we want to note our surprise at reading so many optimistic research notes in light of the current events. Indeed, most of the research we’ve come across last week deems the European Union crisis as something of a temporary nature, which means that if one manages to correctly address risk via relevant capital reallocations, in terms of timing, industry or asset space, one can get by and even earn reasonable returns in this crisis.
Perhaps we are so convinced about the negative outcome of the latest fiscal and monetary policy decisions by the European Union authorities that we are blind and cannot see any reasonableness behind the optimistic argument. Therefore, we have no choice but to address what we think are the main points of our disagreement:
-The ECB will create asset inflation
This idea comes from misleadingly comparing the ECB plan, if any, with the Fed’s quantitative easing policies. We mentioned the differences between both policies in our previous letter already. Basically, the Fed was buying benchmark debt, lowering benchmark rates, to fund the purchases of assets, which are finite in quantity and identifiable. These assets were isolated from balance sheets and were a one-time event. There are no more sub-prime mortgages, no more houses built for sub-prime borrower.
The ECB is not buying benchmark debt, but junk debt. And these purchases fund fiscal deficits, flows, which are unknown in quantity or time. The only way to prevent this from spiraling is seeing fiscal surpluses from those sovereigns that issue junk debt. And that takes time and fortune. Therefore, there cannot be asset inflation.
-Devaluing the Euro will make the EU competitive
This is an issue were millions of pages have been written by thousands of economists. We are among those who believe there is enough evidence out there to confirm that devaluing a currency does nothing for a country’s productivity. In fact, devaluation only destroys the formation of capital, the ultimate driver of productivity. Does it buy time? It does, and we have been a saying too many times that the survival of the Euro required its flexibility. But not this way, not by buying junk debt. The ECB could have devalued the Euro as well by buying Bunds from a trust that would use the Euros to buy a determined and public amount of junk debt, for a determined period, where specific PIGS cash flows are ring-fenced to repay the trust. We said that indiscriminate secondary market purchases were a sure way to hyperinflation or its synonym: A run against the currency (refer end of : www.sibileau.com/martin/2010/05/10 ) .
The idea that devaluation is a potential savior implies that a) there is an optimal exchange rate and b) one can get there in a linear, smooth way. None of these exist.
Lastly, we are also very concerned about some latest news of politicians, particularly in Germany, considering the break up of the European Monetary Union. These comments are very damaging because they can and will easily become self-fulfilling. The expectation (true or false) that the end of the Euro is near would trigger a jurisdictional arbitrage within the EU banking system, that would be very difficult to defuse. Simply put, if you have a savings account at Santander in Madrid and you believe the monetary union will collapse, you will want to shift your deposits to a German financial institution, possibly in Germany. You will want your Euro deposits to be converted into Deutsche Marks, not Pesetas. In the process, the biggest winners will be Gold and the Swiss Franc, and what once was a Union will end in the most bitter resentment between nations.
On this note, not only are we bearish of the Euro and bullish of Gold, but also very bearish of stocks and credit.
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: may-13-2010
Perhaps it is very early to tell what will unfold in terms of monetary policy in Europe. Nevertheless we can’t afford to wait for more definitions by policy makers. We are forced therefore to examine two main paths the European Central Bank (ECB) may take in the weeks ahead.
On Monday, M. Trichet repeatedly noted that the ECB was going to purchase PIGS debt in the secondary market, but with sterilization. This means that as the ECB buys these assets, it needs to either sell other assets or issue debt, to withdraw the Euros it printed in the first place, for the purchases.
We looked for official statements indicating what assets could be sold, in exchange of PIGS debt. But we were not successful. However, there has been a rumor since Monday that the sterilizing assets, the assets that will be sold, could be German Bunds. We will take this as a possibility, but we give it a low likelihood. But it is important to examine this scenario and draw conclusions, to gain perspective on what is possible and what is not.
Another way to sterilize the purchases of PIGS debt would be to “issue” short-term debt (i.e. Liabilities to Euro-zone financial institutions). With this, the ECB ends up changing the composition of its liabilities, returning one of its components, the amount of Euros outstanding to its initial level (i.e. the level before the PIGS debt purchases began). The other component would be short-term ECB debt. Let’s examine both scenarios:
Scenario 1: ECB sterilizes PIGS debt purchases selling German Bunds (low probability)
Figure 1
In Fig. 1 above, we see two balance sheets, one for the ECB and one for Euro-zone banks. For simplicity and illustrative purpose, we included a few main categories in both of them (i.e. Gold, loans, FX reserves, Bunds and PIGS debt).
The purchases of PIGS debt take place in step 2. The ECB debits Euros and credits PIGS debt, while the Euros-zone banks credit Euros and debit PIGS debt. As you can see, on the asset side of the ECB’s balance sheet, PIGS debt increases, matched by an increase in the amount of Euros outstanding (liabilities). The ECB buys this debt from Euro-zone banks, which see a change in the composition of their assets: Higher amount of Euros (liquidity) and lower amount of PIGS debt. As the purchases take place, the supply of PIGS debt decreases, lifting its price, lowering its yield (seen in graph to the right).
Sterilization takes place in step 3. Here, the ECB sells Bunds to the Euro-zone banks, which pay with Euros. The ECB debits Bunds and credits Euros. The Euro-zone banks credit Bunds and debit Euros. At the end of this exercise, the composition of the asset side of the ECB has changed: It has the original amounts of Euros (i.e. prior to the transactions), a lower amount of Bunds and a higher amount of PIGS debt. On the Euro-zone banks side, the asset side composition has also changed. The banks have the same amount of Euros, prior to the beginning of the exercise, but a higher amount of Bunds and a lower amount of PIGS debt. A transfer of risk has taken place, from the Euro-zone banks to the ECB. However, this was not for free. In the process, as shown on the chart to the right on step 3, the supply of Bunds has increased, and so has its yield. The yield of the Bunds is the benchmark rate, the Euro “risk free” rate. This scenario therefore, is recessionary, because it makes borrowing more expensive. It crowds out the private sector.
A few more observations have merit here:
1.-The quantity of Euros remains unchanged, but before the transaction, they were backed by a higher amount of Bunds. Now the Euros are backed by a higher amount of PIGS debt, a riskier credit. Should the “value” of the Euros remain unchanged too? If you got the opportunity to choose, which balance sheet do you prefer, as a holder of Euros? The one in step 1 or the one in step 3? Do depositors in Euros need to be aware of this? No, not if this was a once-and-for-all transaction. But, what if this is carried out indefinitely?
2.- As the Bunds are the Benchmark rate, and the benchmark rate increases when we get to step 3, the transaction is “recessive”. We cynically asked on our last letter (www.sibileau.com/martin/2010/05/10 ) why the market would pay more for Bunds, when one could get a better yield for same risk. Well, it turns out that sometimes reality trumps fiction. The chart below (source: Bloomberg) shows the spread between Greece’s 5-yr credit default swaps (long) and Germany’s 5-yr credit default swap. We were not wrong with our contrarian view. You can see at the far right, how dramatically the spread/risk on Bunds has increased since this Monday, while the gap between Greek and German risk is decreasing.
3.-From points 1 and 2, we realize that sterilizing with Bunds generates recession, hurts growth and deteriorates the value of the Euro. The Euro will drop vs. gold and other currencies. If this is the case, we see a very low likelihood for this scenario.
——————————————————————-
Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt (Likely)
Figure 2
Figure 2 above shows the same steps 1 & 2 as in Figure 1. The difference here is in the sterilization process. Instead of selling Bunds, in Figure 2 we see the ECB selling short term debt.
Here, the ECB sells short-term paper to the Euro-zone banks. The ECB therefore credits Euros and the Euro-zone banks credit ECB debt. Effectively, the ECB has changed the composition of its liabilities, leaving the same amount of Euros outstanding prior to the transaction, in exchange for a higher amount of PIGS debt on the asset side of its balance sheet. The banks have also changed the composition of the asset side of their balance sheets. The hold the same amount of Euros, but lower PIGS debt and higher ECB debt.
From this, we can draw the following observations:
1.-The quantity of Euros remains unchanged, but are the deposits of the Euro-zone safer by being now partly backed with ECB debt? Hardly, but this question has to be answered in relative terms. For how long will this persist? If the PIGS sovereigns cannot generate a consolidated net fiscal surplus, and they continue to issue debt, the component of ECB debt backing deposits at the Euro-zone banks will increase, vs. other assets, like Euros or Bunds.
2.-We think this sterilization, at best is benchmark-rate neutral, which means that it should not decrease real interest rates. As the amount of ECB issued increases, its price has to decrease/yield has to increase, as shown in the chart to the right, on step 3. We are not familiar with the European rates markets, but with increasing issuance of ECB debt, the spread between Bunds and this debt will be impacted. How this impact will affect corporate borrowing in Europe is still something we have to work on.
What is the exit strategy under Scenario 2?
We would like now to compare this exercise with the Fed’s purchase of US Treasuries, in 2009. We, at “A View from the Trenches” were perhaps one of the first to emphasize how bullish of risky assets this program was, while others (i.e. David Rosenberg, Paul Krugman) kept telling us it would lead nowhere. (refer our very first letter, on April 14th, 2009: www.sibileau.com/martin/2009/04/14 ).
There are two fundamental, structural, institutional differences between the Fed’s program and scenarios 1 or 2.
a) The Fed bought federal debt, benchmark debt and in so doing, lowered the benchmark rate. The ECB will not buy a federal debt because there is no such a thing under the current European Union and will not buy benchmark debt, which are the German Bunds. Therefore, how can this program be accommodative? This issue underscores the institutional weakness of the European Union, namely the lack of a unified bond market. What the ECB seeks to do here would be similar to a central bank selling Texas’ debt to buy California’s debt or issuing its own debt, with the implicit guarantee of all the US states, to buy California’s debt.
What could the ECB have done differently?
A similar solution to that of the Fed in 2009 would have consisted in having the ECB buy German Bunds without sterilization, from a trust, administered by the Germans, to fund the trust’s purchase of PIGS debt. In exchange, the PIGS sovereign would have had to ring-fence a cash flow stream to repay the trust. This is similar to what takes place in federal unions, where the federal government collects through federal taxes or alternatively, through specific royalties established with provinces or states. With this structure, the ECB would have been able to carry out an accommodative policy, with specific amounts and repayment sources.
b) The Fed bought a predetermined amount ($300BN), with a predetermined timeline (until Oct. 2009). With the ECB’s plan, the market ignores both the final amount of PIGS debt in the asset side of the ECB’s balance sheet, its composition itself (i.e. how much from Greece? From Spain?) and nobody knows when it will end.
As can be easily concluded, under scenario 2, there cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system:
a) What if the so-called “short-term” ECB debt backing deposits is indefinitely rolled over and depositors see the risk and decide not to renew deposits?
b) If the ECB becomes a riskier bank, its currency will (actually is) no longer be considered an alternative reserve asset and the propensity to exchange it for gold or USDs will increase exponentially. If so, what was the wisdom behind Sunday’s decision by the central banks of the USA , Canada , UK , Switzerland and Japan to provide currency swaps to the ECB? Are currency swaps all of a sudden a “free lunch”? What for were the balance sheets of these institutions compromised? Who pays for it? Should the senior management of those central banks not be audited for decisions of this sort? Who is accountable?
This analysis suggests there could be a generalized run against the Euro as a currency. The Argentinean experience of 2001 offers a analogous case. Back then and there, the central bank did not increase the amount of pesos outstanding. It simply changed the quality of the assets backing those pesos, from USDs (i.e. FX reserves) to government bonds. Argentina did not have inflation. Nevertheless, eventually as in scenario 2, depositors realized that their deposits were not backed by the assets they had expected and decided to rush for the exit door.
Figure 3 below shows the spiraling nature of this process:
Another aspect here is that as this process takes place, the credit quality of the loans held in the Euro-zone banks would quickly deteriorate, further weakening the ECB position.
Would this lead the world to the end of paper money?
We have written many times before, that we were amazed by the fact that regulators did not understand the systemic nature of sovereign credit default swaps. These swaps, which in the case of Euro-zone sovereigns are denominated in US dollars would be the link here, connecting US financial institutions with Euro liquidity problems.
The Fed last Sunday already extended currency swaps to the ECB in a very murky way, which even caused a heated debate in the US Senate. What do you think would happen under a terminal situation, where the European banks’ risk as counterparties would jump exponentially?
And then, friends, would you hold US dollars as a reserve asset, knowing that they are thrown into a hole to fight the last battle?
Doesn’t this actually make gold look like a bargain at $1,240/oz?
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.
From an Interview with The Economist, "Return to Gold—Argument with Jacques Rueff," 13 February 1965, reproduced in “The Monetary Sin of the West” J. Rueff, The MacMillan Co., 1972. (This book is in pdf format at Mises Institute's online library)
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.Rueff: "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..."
Likewise, the fact that central banks are today, May 10th, supporting the Euro only delays an adjustment that will be even more painful in the future. Simultaneously, central banks turn such adjustment into a global problem. This is no longer a crisis confined to Europe. Those shorting Euros today at 1.30, when the Euro was at 1.26 on Friday, earned the extra 4 cent subsidy from the pockets of those holding USDs, CHFs, Sterling and CADs, courtesy of the respective central banks.
The future low rates for longer periods in those same currency zones will also have started thanks to the irresponsible currency mismanagements of today.
Martin Sibileau.
Please, click here to read this article in pdf format: may-10-2010
We had finished our comments below last night. Subsequently, a myriad of announcements have been made by policymakers. We will deal with them in our next letter. But briefly, besides the EUR750BN bailout, two other relevant decisions have been made:
a)To extend currency swap lines to the ECB by the Fed, the Bank of England, the Swiss Central Bank and the Bank of Canada. We had long ago considered this scenario (refer our letter of March 1st: "Comments on Ron Paul's article:" Are US taxpayers bailing out Greece"", www.sibileau.com/martin/2010/03/01). We said back then that if the stress on financial institutions got relevant as a consequence of the Greek situation, the Fed would have to extend such currency swaps. This move guarantees now that the European problem becomes a global problem. These currency swaps mean that from now on, Americans, UK, Swiss and Canadian taxpayers are brought to the trenches to fight a battle that is being delayed. The delay in addressing the root of this problem will only make things worse. Today is a day to mark in history. Today marks the beginning of the global chapter in the Euro crisis.
b) Monetization of sovereign debt will (actually is) for now not only carried out by the ECB but by the Bundesbank as well. This is a smart move and we'll have to write more about it on our next letter.
Finally, don't forget our useful Thesis No.2, on Gold, first postulated on April 21st 2009 (www.sibileau.com/martin/2009/04/21):
"when there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset"
A huge coordination effort of inflationary monetary policies is starting this morning. We are trading gold accordingly!
Now, please, find today's comments below. Good luck!:
Last Thursday we published a dialectic monologue to convince ourselves that the action in the markets was not justified, if the European Central Bank (ECB) was indeed going to monetize sovereign debt. Unfortunately, we underestimated the political aspect of the issue. Mr. Trichet decided it was better to say he had not discussed the possibility of buying sovereign debt, than to remain silent. Confusion reigned and we had the apparent technical glitch affecting global markets.
Before we go on, we note that over the weekend EU members agreed to a EUR750BN bailout plan to defend the Euro. We think this is delusional. A bunch of bankrupt countries setting up a fund? With what currency? The same currency they claim they will defend, when its value precisely plunged because they had their debts monetized with collateral lines from the ECB?
Let’s begin today reaffirming our view that the ECB will have to monetize sovereign debt, if it wants the Euro to survive. If it does so, a rally will follow and if it doesn’t, the situation will exponentially worsen, dragging Emerging Markets to the level it did with North America. The decision to set up a fund means that for the moment, the ECB is delaying this monetization.
With this in mind, there are two potential monetization alternatives, which we want to examine today:
-Scenario A: The ECB actively purchases sovereign debt from governments (i.e. Fed’s $300BN Treasury purchase program). Currently, the ECB cannot monetize sovereign debt. This would require special legislation.
-Scenario B: The ECB buys sovereign debt in the secondary market (i.e. from financial institutions).
We think it has merit to examine the two scenarios and suspect that also at the ECB, these scenarios must have been or are being examined in detail. Therefore, today we want to discuss their implications…what to expect while we are expecting:
-What should be the yields on an absolute and relative basis?
Under scenario A, the element of “price discovery” disappears. With the ECB purchasing directly from governments, the market relies on the price signals provided by the central bank. This would not be so bad in a normal situation (i.e. one country), however, in the case of the European Union, we don’t have only one sovereign. There are many issuers and the problem is that there is no unified bond market. Will the ECB therefore be allowed to impact the determination of relative prices/yields among issues of member governments (i.e. Greek sovereign yield vs. German sovereign yield)? On what guidelines?
To a lesser degree but also relevant, the ECB would be impacting the relative prices of sovereign debt, if it buys it in the secondary. How much from Greece or Portugal should it buy? At what prices? Par?
-Crowding-out effect on private sector:
Under scenario A, the ECB crowds the private sector out. Under B, by definition (i.e. secondary market), the market has already decided what resources to allocate to private and public sector investment opportunities. Under A, the allocation is indirect but real, because once governments get their newly printed, fresh monies, they will purchase resources they would have been unable to afford otherwise…resources that had been there for the private sector to buy, and are no longer.
-Behavioural perspective:
Probably, under scenario A, issuers (i.e. governments) are not actively encouraged to reduce their deficits. Under scenario B, on the other hand, banks would likely generate a “bubble” in sovereign debt, by arbitraging yields between sovereigns. After all, if the ECB bought distressed sovereigns (i.e. near-term probability of default turns nil), why would banks pay more for Bunds, when they could get a higher yield with the same risk out of PIGS debt. What was before default risk becomes counterparty risk, with the ECB as the counterparty. Probabilities of default (in the near term) “disappear”, and recovery is 100%.
-What would determine the supply of money and what would be the exit strategy?
We think that under scenario B, the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, under scenario B, the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy under scenario B? In the long run, the only way out for the ECB under scenario B is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy in scenario B.
In theory, under scenario A, the ECB could arbitrarily somewhat manage the supply of money, deciding when to participate in the auctions (i.e. impacting the growth rate of money supply) and manipulating the benchmark yield curve (i.e. deciding how to allocate the purchase limits to different points in the yield curves).
Under scenario A, there is more transparency. The market ex-ante knows how much will be monetized. But this is a double-edged sword, because once this amount is announced, the market has the final word. An example of this point is yesterday’s bailout announcement. We will see the reaction today, although we anticipate it will likely be positive.
Scenario A is “easier” and there are tools available to set up an exit strategy (beyond the scope of this letter). However, even if such tools are available, a successful exit strategy would need the ECB to be politically independent.
-What would be the impact on the Euro?
Under both scenarios, the value of Euro would plunge. This is an important conclusion. Would the Euro not also lose its status as a reserve currency? It is already losing it and would definitely lose it under both scenarios. Perhaps under scenario A, given that the monetization amount is known ex-ante, foreign central banks would have more certainty to speculate on the scope of the devaluation of the Euro. In that case, gold would tend to appreciate less than under scenario B. In scenario B, there is never certainty on the final amount of debt. Scenario B, in our opinion, would open the door to hyperinflation in Europe.
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: may-6-2010
We wanted to publish our letter yesterday, but given the volatility in the markets, we thought it would be more appropriate to let 24 hrs. pass by before publishing. We will mince no words here: We were surprised by the markets’ reaction in the past two days. This action has turned us into contrarians. We “disagree” with the action seen since Tuesday and we think it has been the product of confusion, idiotic rhetoric from Euro politicians and perhaps too, a certain degree of ignorance on basic macroeconomic/monetary concepts.
Since December/09, we have correctly predicted that the European Central Bank was going to have to relax its criteria to accept sovereign debt as collateral, but this issue is still not 100% clear and this is leading to confusion, which fuels the sell off. We are not fundamentalists, for in this world of fiat currencies, value is the result of undetermined equations. An example of an undetermined equation is for instance: y = 2 +x. The pairs (4, 2) or (5, 3) satisfy it. If “y” stands for value, which one is “fair value”? As you see, the “fundamental” question makes no sense, for y varies with x.
We’ve read, discussed and heard a lot, and here are the reasons for our position today:
-What we find absurd:
There is a line of reasoning that compares the current sovereign events with the credit events of 2008 (i.e. Bear Stearns, Lehman, refer “European Credit Compass”, UBS, April 30, 2010 report). We could not disagree more. Bear and Lehman were investment banks, funding on a very short-term basis, highly leveraged and were big counterparties in many markets.
Sovereigns on the other hand are not counterparties and the troubled assets, the sovereign debt, have the European Central Bank as counterparty! The fact that the Euro is devaluing on a daily basis shows that this counterparty is working fine, for it is monetizing sovereign debt. Monetizing sovereign debt is the same as paying par on leveraged debt. The ECB, as counterparty, honors the contract and when it does, it adds liquidity. Hence, the excess supply of Euros and its consequent drop in price.
In fact, we should be concerned if the Euro appreciated!!! For this would mean that the ECB, as counterparty, would not be there to pay par on the sovereign debt! That’s why we find comic that some Euro politicians like Mr. Axel Weber openly defend a strong Euro. The survival of the Euro as a currency, ironically, lies on its flexibility to be devalued!
Furthermore, sovereigns have taxing power and assets, and their funding needs are in no way comparable to those of an investment bank. We find even more absurd that those who compared the sovereign problem with the liquidity crisis of 2008 recommend selling volatility or advise that M&A activity may rise as a consequence.
-What we think is flawed
In the past days, there has been another line of reasoning, suggesting that the current actions, i.e. the aid package + debt monetization by ECB only address “liquidity but not solvency”. To make such a statement implies that monetizing debt (=liquidity) does not result in inflation. If you think that printing its way out of debt does not make a sovereign solvent, then it means that you don’t think that printing your way out of debt is inflationary. But if that was the case, why would the ECB fear printing the way out for Greece, Spain or Portugal? Indeed, the question answers itself by reduction to the absurd. The printing process brings inflation, which makes sovereigns solvent, as the burden of the debt falls.
Simultaneously, printing brings liquidity which first decreases jump-to-default risk and later opens the window for refinancings. Did this not happen when the Fed started purchasing mortgages? Did we not have an impressive issuance of corporates in the Spring of 2009? What makes you think that Greece, Spain and Portugal, would not be able to find the same way out in 2011 and refinance at longer durations? If that is not solvency, then we don’t know what solvency is, literally!
Another common belief is that the aid package + debt monetization will be recessionary, increasing real interest rates. We disagree, but in part. There is a temporal element here. We can think of this process in two periods. The first one would be inflationary and bullish, if the ECB accepts all kinds of sovereign debt. The bullishness would of course be based on the low interest rates for a long period. The second one, perhaps years ahead, is recessive, as inflation is always unsustainable and growth stagnates. The assumption here is that inflation is manageable, which is also an aggressive assumption.
Keynes in his Chapter 13 of the General Theory addressed this same point when he wrote: “…Finally, if employment increases, 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. 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...”
(What do you guess is the “liability of the wage-unit to rise in terms of money” in Europe?)
Lastly, if the ECB is going to buy sovereign debt, and we think that in the case of Greece it has openly announced so, by lifting the ratings criteria on collateral, we cannot understand the sell off in Euro banks. These banks will have an oligopolistic position in terms of the sovereign debt they own. They are the only ones with access to the ECB window. They will buy at below par, turn to the ECB window and get par. This is called arbitrage, and if quantitative easing in Europe kicks in, these banks will be an oligopoly. Oligopolies earn extraordinary rents.
-What we think is debatable
Since the news on Tuesday about the engagement of Lazard by the Greek government, the rumors of a debt restructuring have increased. Could it happen? Stranger, more idiotic things have happened, and we, for instance, remember the decision by the Argentine government to limit withdrawals from chequing and savings accounts in 2001.
From a “common sense” perspective, restructuring doesn’t pass it for us. Under restructuring, the costs to sovereigns would multiply, because it would be required to capitalize Euro banks against the respective losses. It is also inconsistent with late ECB action, for restructuring occurs under monetary rigidity (i.e. currency board in Argentina), while every day, the Euro depreciates steadily. The devaluation of the Euro acts as an exhaust mechanism, as an escape valve. Escape valves are good because they prevent explosive situations. Hence, the virtues of flexible vs. fixed exchange rate policies.
There is also another aspect that sounds not all too correct to us. It has been proposed (refer BankofAmerica’s “Situation Room” , May 4th) that the sell off was partly triggered by increasing liquidity costs. We agree that liquidity costs play an important “explanatory” role. The metric shown to make this case is Libor –OIS spread. I thought I would put the corresponding chart below (source: Bloomberg), for a picture sometimes is worth a thousand words. Silence then… (The spread was so low that of course, on a marginal basis, the increase has been relevant. But what else could you expect? Did it take anyone by surprise? Is the ounce of gold not worth +$1,1170 still?)
-What we think happened
First of all, let us say that we never subscribed to the theory that markets may sometimes be irrational. If you see a monster in a room and run out of the room, you are rational. The problem is that there is no monster. You had incorrect information. But you were very rational, for whenever there is a monster in your room, running away is the rational thing to do. It would be irrational to stay. Hence, we think that as a result of confusion, the markets are seeing a monster in the room.
As usual, the confusion is bred by governments. In the US, we have uncertainty over future financial regulation. In Europe, we don’t really have the details of what the ECB will do, but we sort of guess it. In China, we ignore what the intentions in monetary policy are. Given that we are hostage to governments’ fiat currencies, we have no alternative but to shift them from one jurisdiction to another or…take a leap of faith and exchange them for gold.
However, we already saw a similar situation in January 1995, upon Mexico’s sovereign default. Back then, the markets sold off all things Latin American. Argentina was then under convertibility and the markets had no confidence in it. The truth is, convertibility boards like Argentina’s were not well understood, since they are very unusual. Essentially, Argentina’s central bank had to buy every peso it was offered for a minimum of one USD. But the market sold off anyway. Those who shorted the ARG peso lost money. After all, why would you sell a peso under par, when at the central bank window they pay you par? The same should apply this time in the case of Euro sovereigns, if it is true that the ECB will accept ANY sovereign collateral, not just Greek. If the ECB buys all debt at par, it will devalue its currency, and nobody has ever won going against a central bank that wants to devalue its currency.
When Emperor Augustus died, he had ruled over the Roman empire for 50 years, which was approximately the average life expectancy of a human being back in those times. This means that those surviving Augustus’ death had no recollection of what life used to be like in the times of the Republic, prior to Julius Caesar. Therefore, continuing with an imperial government, with an emperor, was the natural thing to do. Today, nobody of consequence in Europe has a recollection of what life was under the hyperinflation post WWI, let alone the gold standard before WWI. The rules of the monetary game are changing and the markets get caught off guard.
-What we think is possible
We like to think in terms of propensities to act, in terms of paths of least resistance, always, always taking the force of entropy into account. Having said this, we wrote before that there were only two solutions to the sovereign debt problem: Guarantees (or cross-guarantees) of riskier sovereigns’ debt (i.e. Greece) by less riskier sovereigns (i.e. Germany) or monetization by the ECB through liquidity lines. The easiest way, the way that allows politicians to save face before their constituencies is the latter.
However, once started, we cannot go back to status quo. The consequences of quantitative easing in the USA cannot be undone. The direct consequence of quantitative easing in the Eurozone is the devaluation of the Euro now and inflation later. Why inflation? Because the purchasing power of Europeans will drop dramatically and governments addicted to monetization will have to keep the circus going. This again, is the path of least resistance, applied to the law of entropy.
The second act here is the contagion of this devaluation/inflation to the rest of the world. In North America, it will mean low rates for longer than expected, which will only keep inflating existing bubbles, like the housing market in Canada. In China? Who knows, given the uncertainties in monetary policy. However, if China is affected negatively (and this issue demands a whole article on its own merit), emerging markets, the still untouched jewel here will be tossed off.
-Conclusion
As much as we rationalize this situation, we always trade like technicians. Therefore, in the face of this bearish run, we had two alternatives: To turn bearish or walk to the sidelines. We chose the latter, remaining bullish of gold and bearish of the Euro.
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:may-3-2010
Sometimes, the questions we ask are more important than the answers we may have. Post-announcement of the EUR110BN package for Greece by the IMF and the EU over the weekend, perhaps there is merit today in asking a few questions:
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?
However, we don’t want to sound too pessimistic this morning. The package announced yesterday will bring a short relief to the markets, hopefully pushing gold to lower levels. We were a bit scared when on Friday, while gold, oil and Canadian stocks rose, the value of the Canadian dollar fell. Was that end-of-the-month profit-taking?
If gold corrects today after the April rally, should it not make sense to buy the weakness? After all, should we not believe Greece’s Finance Minister Papaconstantinou when he commits to serious cost-cutting? Personally, we have never ever heard of a successful bailout package for a nation with high tax evasion. Greece’s problem is not about cutting costs. Greece’s problem is institutional in its underlying structure and bailout packages cannot address that. When the USD40BN IMF package for Argentina was announced, it bought the country approximately a year, before the final collapse, as it didn’t count with a central bank to monetize its debt (Argentina’s central bank worked as a convertibility agency). This makes us think Greece should be luckier this time.
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.