October 2010 - Posts
Please, click here to read this article in pdf format:october-26-2010
The week started on a generalized sell off of the USD, as it is evident that the United States don’t consider any way out, except through inflation. No privatizations, deregulation, more free trade or fiscal spending cuts. Inflation instead! The anecdote of the yesterday’s session was that the US Treasury sold $10 billion of 5-yr Treasury Inflation Protected Securities at a negative yield. It was the first time ever! (see: http://noir.bloomberg.com/apps/news?pid=20601009&sid=aebshL_ncvQQ )
But the perspective in the rest of the world is no different. Nobody wants to suffer pain and creditor countries are exhibiting a diversity of tricks: From the classic purchase of US dollars by central banks, without sterilization, to taxes on capital inflows (i.e. Brazil) or the development of offshore parallel financial markets (i.e. Hong Kong), where exporters park their US dollars, which never reach the exporting country (i.e. China). All this does nothing else but ultimately delay the day of reckoning.
However, today we want to focus on one country in particular: Canada. Last week, as you may already know, the Bank of Canada decided to leave its target for the overnight rate at 1 per cent. In our view, this signaled capitulation by the Bank. From now on, assuming that quantitative easing continues in the US, we believe the Bank of Canada will not do anything that may appreciate its currency. It will seek to delay interest rate increases, provide liquidity via term repo operations and if this should not work, perhaps even decrease interest rates! Yes, we would not be surprised if well into 2011, we see interest rates decreasing to discourage capital inflows from the US.
The main problem with this is that Canada has not suffered yet a correction in its real estate market. Residential property prices have seen a steady rise and are now supported by record low mortgage rates, record leverage levels by the public and the upcoming decrease in transaction costs, if the settlement between the Canadian Real Estate Association and the Competition Bureau effectively allow sellers to directly sell their houses on the Mulitple Listing Service. These developments, under stable or lower interest rates have the potential to take the Canadian real estate market through the same path the US market took.
Canada, in our opinion, has dropped the ball. As the currency has appreciated, no efforts have been made to deregulate, privatize or strengthen our financial markets with sound money. Sound money is not money that is worth more than US dollars. Sound money is money that people can confidently save in, and hence must not underperform vs. gold. The Canadian dollar, like any other currency, has lost value, in terms of gold too. During 2010, it benefited from the reserve diversification moves carried by central banks, as well as the bid on the capital of Canadian based commodity producers. But since last week, when the Bank of Canada capitulated, the Canadian dollar risks losing ground. The purchasing power of Canadians is at 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:october-21-2010
If you’ve been following the markets since our last piece, you know by now that the People’s Bank of China has increased its 1-yr lending rate by 25bps, to 2.5%. The reaction was a sell-off in risky assets on Tuesday, recovering some yesterday.
So, what’s the big deal?, you may ask. A 25bps increase in the lending rate? Here’s our view:
China did what it did because it is trying to curb inflation. Why does China have inflation? Because China seeks to keep its currency as undervalued as possible through a simple mechanism: When foreign exchange arrives to China as payment for their exports, the People’s Bank of China buys it and takes it out of circulation.
What does the People’s Bank of China pay with to take foreign exchange out of circulation? With Yuan, which is deposited in Chinese banks. The Yuans multiply thanks to the credit multiplier, and are used to buy goods produced in the country. However, the rate at which the supply of Yuan grows, both by the central bank’s interventions and by the credit multiplier is higher than that at which the supply of goods, for internal consumption, grows. Therefore, in the end, Chinese find that they have plenty of Yuans available to purchase a limited supply of goods. Prices then rise. Inflation sets in.
How could China stop this? It’s very easy: They have to stop buying foreign exchange. China could have done that yesterday, but it preferred not to. That was an important message and we took proper notice! Let’s rephrase it: On Tuesday, the news wasn’t a 25bps increase in the lending rate. On Tuesday, the news instead was that China let the rest of the world know that it will not let its currency appreciate and will distort its credit markets as much as it is necessary to address the inflationary problem. The message is that the export lobby is stronger than the financial lobby or the wishes of the average Chinese consumer. The message was also that such moves can and will be done without prior notice to other central banks, which means that policy coordination is out of the question.
What wisdom can be found in raising the lending rate? None, for it only throws more fuel to the fire. In the context of falling yields, it will only encourage to bring more capital to China, beside that which enters as payment for their exports. This will leave the People’s Bank no other alternative but to interfere the “distribution channel”, either by raising rates or reserve requirements, or even causing a market segmentation, whereby payments on exports do not enter the country. At “A View from the Trenches”, we had anticipated this back in January, where in a series of letters, we reviewed the intervention efforts by the People’s Bank of China, on the “distribution channel”. Back on January 21st (refer: www.sibileau.com/martin/2010/01/21 ) we wrote:
“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”
On this note, yesterday we came across a Bloomberg article titled” Banks’ Yuan Debt Costs 30% Cheaper in Hong Kong” (http://www.bloomberg.com/news/2010-10-19/banks-yuan-debt-costs-30-cheaper-in-hong-kong-china-credit.html ). This was exactly the point we made way, way earlier, before anyone else would examine this possibility.
In conclusion, we think this is only going to get worse and as readers know by now, unilateral policies will continue to support gold. The intervention can be easily seen in the price of the Yuan yesterday (see chart below, source: Bloomberg). The reaction was textbook classic: The currency appreciated at open, and then the intervention started bringing its price down. We are far, far away from reaching a solution to the global monetary mess. That can only be bullish of gold.
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:october-19-20101
Since our last letter, perhaps the most relevant event has been Mr. Bernanke’s speech, last Friday. Titled “Monetary policy objectives and tools in a low-inflation environment” (www.federalreserve.gov/newsevents/speech/bernanke20101015a.pdf ), this was a speech that made waves. Essentially, it made the case that given an environment with low inflation, there is room to look for alternative policy. Will it be implemented as so many expect? The market’s belief that it will grows by the day. After yesterday’s release of capacity utilization (74.7% vs. consensus of 74.8%), the strength in the USD began to give way again…
As Mr. Bernanke put it, the topic of his speech was “…the formulation and conduct of monetary policy in a low-inflation environment…”. Interestingly, he introduced the subject reflecting on the fact that: “…From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world…”. We wonder if Mr. Bernanke ever asked himself why it would be the case that since the Great Depression and until the late ‘60s the greatest challenge was to bring inflation under control. In fact, in the case of emerging markets, this challenge lasted well into the ‘90s and is the topic of the day again, as these markets seek to avoid the appreciation of their currencies by “printing” money to buy the US dollars Bernanke prints, thereby importing Ben’s inflation.
If Mr. Bernanke would have asked himself why central banks in the past decades had such challenges, he would have surely found out that it was because his predecessors, just like he today, thought that a little bit of inflation would do no harm, and that the pain of having a high unemployment rate was bigger than that of high inflation.
If Mr. Bernanke did not underestimate our intelligence, he would surely realize that we know that in the end, even that little or high inflation generated no employment. In fact, inflation generates unemployment. Here’s why:
Inflation destroys savings and produces a lower savings rate. This destruction also generates a shortage in the stock of capital, which deteriorates productivity. To be certain, productivity also declines driven by the uncertainty in relative prices generated by inflation. As productivity falls, it is less feasible to maintain a labour force at the existing level of wages. Therefore, entrepreneurs/firms can only survive if they can get access to lower “real” wages or to “cheap” credit, to finance their working capital (i.e. collections deteriorate as clients seek to delay payments to profit from inflation, and inventories rise because firms anticipate future higher input prices). Naturally, with inflation, credit disappears and governments find that the only way to keep the music going is by further debasing the wages of those employed.
This cycle spirals even faster in a global economy, because as a consequence of the fall in productivity and unemployment of resources, citizens of the affected nation must now import those goods that were previously profitably produced in their land. However, as their currency depreciates (“wins” the currency war) against the rest of the world, the cost of those imports rises, further cutting their ability to save. If the nation initially required an increase in the supply of money of $1trillion of US dollars per year (as it is speculated Quantitative Easing 2 will entail) to keep the original demand level for goods, as this cycle runs its course, the need for additional liquidity will increase to replace the reduction in savings, wealth, chasing an even smaller amount of goods produced. The need for additional liquidity grows linearly at the beginning and exponentially at the end. This why it is never “politically” feasible to return to a “normal” state.
Yes, Mr. Bernanke is right. Any central bank has the tools to fight inflation later on. But none, absolutely none, has the political power to assume the cost when inflation is evident and high. It takes radical political change to break the cycle, the likes of which Reagan and Thatcher brought in the ‘80s. We see nothing close to this on the horizon for the next couple of years coming from any country.
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: october-15-2010
We are back after a relaxing and extended Canadian Thanksgiving weekend. We could have written earlier but we thought we would sound like a broken record. Everything we are currently seeing we anticipated long, long time ago. In fact, we anticipated it on our first letters, in April 2009, when we first wrote that
a) Quantitative easing would only bring inflation, but not economic growth, and hence, we should be long stocks and commodities (refer our first letter: www.sibileau.com/martin/2009/04/14 )
b) Gold would outperform if central banks could not coordinate their policies (refer: www.sibileau.com/martin/2009/04/21 )
We wrote about these issues extensively way before anybody else would explicitly think of them. However, all we did was to recite old texts that the world had forgotten or always ignored, from the Austrian school of Economics. The merit goes to all those Austrian thinkers who during the ‘30s came up with a good theory that can make strong predictions.
So far, we are enjoying a good run from the rally that started with the speculation of QE 2. But with yesterday’s action, we have the feeling that the recent strength may have been overdone and that with the upcoming election in the US, profits may be taken sooner than later. Call it intuition…Accordingly, we have rigorous stop loss levels on our positions. The long term trend is however one of careless debasement of currencies worldwide, which at the extreme, can only be good for gold.
Having said this, we want to end this letter bringing collective attention to two concepts, ideas, that are being published these days, which we think are flawed. They are both related to monetary policy, but we will only deal with one today.
The first concept is about monetary policy coordination. Perhaps the best example of this is a research note published by the Foreign Exchange Research team of Barclays Capital on October 7th titled “Be careful what you wish for”, although we have come across other analysts expressing the same concept on Bloomberg TV. We are referring to the idea that a successful coordination has to be able to simultaneously address external and internal balances. We think this is a wrong perspective in a global economy, because it ignores the role of prices in the resource allocation process. The idea of equilibrium of external and internal balances is nothing short of mercantilist, but at the same time, it ignores the fact that today most products are made out of a diversity of inputs produced in different countries. Foreign exchange crosses (i.e. CAD/EUR, CAD/MXP, CAD/RMB) are thus all relevant to every entrepreneur, and not just to those who export their produce. Coordination, in our view, implies that there is an indeterminacy in the levels of foreign exchange crosses that allows the world to keep running without stress.
This idea, first elaborated at a smaller scale by Don Patinkin in its famous paper titled “The Indeterminacy of Absolute Prices in Classical Economic Theory” and published in 1949 in Econometrica , tells us that for instance, the world is today as comfortable with a CAD/USD, EUR/USD, Yen/USD, GBP/USD, …X/USD at (1.0049, 1.403, 1.6005, …,X/USD) respectively as with a level that would be, say twice the current: (2.0098, 2.806, 3.201,….2x/USD).
To achieve this indeterminacy (i.e. flexibility), in our view, is more critical to address the rates (i.e. a dynamic problem) at which money is supplied by all the different central banks via their respective open market operations, rather than to focus on external vs. internal balances or policy goals. This concept is what first moved us to write on April 16th, 2009 that:
“All currencies are being debased in calculated order. It is precisely this order that is denying gold the chance of playing a safe and lucrative asset. If the debasement had not been orderly, if it had been amid uncertainty and chaos, gold would have had a chance…”(www.sibileau.com/martin/2009/04/16 )
How did that coordination took place back in 2009? Essentially, it was supported by three pillars: 1) There was a genuine demand excess for liquidity by the private sector; 2) the quantitative easing was carried out by only one central bank on behalf of the rest, because US dollars were supplied via currency swaps to the other central banks, and 3) the quantitative easing represented a transfer of assets (i.e. mortgage-backed securities), not fiscal deficits, which afforded other governments the possibility to remain quiet.
Today, there is no genuine demand for liquidity, which is evident by looking at prices in all the liquidity markets. Therefore, the mere expectation of quantitative easing fuels a flight to physical assets, away from currencies. Today, central banks have different goals and quantitative easing is no longer about a transfer of assets from the private sector to the public sector, but the monetization of fiscal deficits, which are intrinsically uncertain in their final size. Thus, coordination is not feasible and expectations are slowly adjusting to this fact, as expressed in the steepening of the US yield curve.
In our next letters, we will also address the other flawed concept that is tightly connected to the idea that coordination is about focusing on balances, rather than the differentials in the rate of money supply by central banks. This is the idea that inflation expectations can be managed by central banks and hence, the notion of a “temporary” inflation above target is possible, with central banks later returning to the “normal” state.
Finally, we leave with what we wrote at the end of our letter on September 2nd, titled “Beware of coordination” (www.sibileau.com/martin/2010/09/02 ):
“…In summary, we are entering the final stakes of this game of musical chairs and with the coordination of central banks to keep the music going, it will be difficult to invest following macro fundamentals. In the US we are faced with technical insolvency at all levels of government (municipal, state and federal) and yet, with the Fed and other central banks buying Treasuries, we can see record low yields and tighter credit spreads.
In this environment, should gold not be able to rise and establish its price beyond $1,250/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.
Please, click here to read this article in pdf format: october-8-2010
Today, we want to briefly discuss a few points:
1. Since the past week, we see a much clearer landscape supporting gold than stocks, because the rise in gold is based on the discoordination of monetary policies, which generate relative price changes and affect stocks in different ways (refer: “The Yen intervention supports gold”, on Sept 17th: www.sibileau.com/martin/2010/09/17 ).
We first brought up the issue of policy coordination on April 17th, 2009, when we actually proposed this thesis:
“…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…”
(For those interested in this relationship, which we see stronger by the day, Don Patinkin (1922-1995) was the first to imply it in his famous article “The Indeterminacy of Absolute Prices in Classical Economic Theory”, 1949, Econometrica.. We merely adapted the concept to a global economy)
2. The Bank of Japan also announced they will consider quantitative easing of their own to depreciate the Yen. We had proposed this earlier, because buying only USDs is a losing proposition for Japan (and we explained why). We expect that the Yen will depreciate only as fast as this policy is implemented. On September 23rd, we wrote:
“…What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!…” (www.sibileau.com/martin/2010/09/23 )
Is this behind the recent speculation to buy protection (short cds) on Japan’s sovereign risk?
3. Beware of QE2 (quantitative easing II). If it takes off, it will be structurally very different from QE1. Here’s why:
Under QE1, the Fed funded what economists call “stocks” (i.e. mortgages, a finite amount of Treasuries), but under QE2, the Fed will be funding what economists call flows (i.e. deficits) (refer: http://en.wikipedia.org/wiki/Stock_and_flow ).
Flows can only be known at the end of a period. An example of a flow is consumption. Consumption is measured monthly or quarterly or annually. We can only know then what was consumed at the end of each chosen term. However, a stock, is measured at a certain point in time. An example is mortgages held by a bank. We can know how many dollars are in a bank’s balance sheet, with certainty, at a specific time. When a central bank buys these mortgages, it’s quantity is known. The mortgages were originated, closed, “prior” to the transaction. But when a central bank states that the supply of money will be driven by their purchases of Treasuries and such purchases will depend on the level of unemployment, which is a flow, the certainty is lost. What will be the level of unemployment? How does that translate in demand for money? How does the Fed address the excess or fall of that demand? What Treasuries will be bought?
We commented on this difference at the peak of the European Union currency crisis and note here that the Fed would actually engage in a more aggressive move. Unlike the ECB, it certainly doesn’t intend to sterilize its actions. Here’s then something to start thinking about: If banks currently have a decent amount of deposits and there isn’t enough lending, what would happen when inflation accelerates and deposits begin to shrink? People will need the cash sitting in their savings accounts to offset the loss in purchasing power of their wages.
4. Finally, we’ve read a few comments expressing fear that central banks may sell gold, meaningfully impacting the bullish trend. Although a sell-off is possible if not likely in the short-term, to examine this point, we must ask ourselves what would the gold being sold be exchanged for.
Broadly speaking, with gold being an asset of central banks, the sale of gold may trigger either:
a) a change in the composition of the asset side of their balance sheet or
b) a decrease in their liabilities.
If central banks had meaningful equity, gold could also be used to “buy it back”, but that is not the case. Let’s examine the first possibility, namely, a change in the composition of the asset side of their balance sheet. The main asset classes central banks carry are: Foreign exchange, government debt, loans to other banks, gold and lately, corporate debt. Gold therefore could possibly be sold to increase the component of any of these other asset classes.
If gold was to be sold to increase foreign exchange holdings, the sale could not be executed in the FX market, which trades currencies. In order to be neutral to the liquidity markets, it would have to take the form of a swap. This means that central bank A would sell gold to central bank B, in exchange of currency from country B. But if that is the case, gold would still be held by a central bank and the transaction would not affect the market and hence the price of gold. If the sale was not neutral, it would take the central bank’s currency out of circulation, gold would be sold in the market and money would flows back to central banks. This would require immediate sterilization, to return to the original level of liquidity. Otherwise, interest rates would increase, which is the opposite of what central banks are currently aiming at.
If the currency taken out of circulation is used to purchase back government bonds or corporate bonds, it would have the same effect as quantitative easing. But as the market sees the final outcome (i.e. less gold and more debt), the currency of that central bank would be sold off and the price of gold and bonds would continue to rise (sounds familiar?). Would this always occur? No, not if the nation in question fights a credible battle to eliminate fiscal deficits. It is also more difficult to see in net creditor countries like China, which shows that such a move could not be coordinated with other central banks.
Having run out of options to change the composition of the asset side of the balance sheet, let’s next consider a decrease in liabilities (=if gold (=asset) is sold, liabilities have to fall too, in the absence of meaningful equity).
Central banks could simply sell gold and keep the money collected out of circulation. But as we noted, this would go against the common notion that interest rates must remain low for an extended period. The world cannot afford an increase in interest rates. The other component of liabilities of central banks is the banks’ reserves held at the central banks. Gold could be debited and these reserves credited. But that would amount to an explicit subsidy by the government to the banks, which is politically unacceptable. If banks want to back their deposits with gold, they should go to the market, rather than get it from the taxpayer at a “special” price.
For all the reasons mentioned above, which simply go back to the same issue (i.e. no reduction of fiscal deficits), we do not believe that central banks will engage in a coordinated sale of gold without losing the battle.
Martin Sibileau
The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.
As I wrote before:
1.-I still see a much, much clearer landscape supporting gold than stocks. Why? Because the rise in gold is based on the uncoordinated monetary policies, that generate relative price changes affecting stocks in different ways, but affecitng gold unanimously (refer: "The Yen intervention supports gold, on Sept 17th: www.sibileau.com/martin/2010/09/17 ).
2.-The BOJ just announced they will consider quantitative easing of their own to depreciate the Yen. This is what I suggested they should do, because buying USDs was a losing proposition. I expect that the Yen will depreciate as fast as this policy is implemented ("...What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!..." Sep 23rd, at: www.sibileau.com/martin/2010/09/23)
3.-On my next letter/s, I will address where financials, with Basel III risk behind, are left with, should QE 2 unfold. For those interested in the subject, Ludwig Von Mises wrote a masterpiece on this in "Human Action", Chapter XXII (very clear and simple:http://mises.org/Books//humanaction.pdf ). But essentially, I think we must not be confused on this point: QE2 will be structurally very different from QE1. Under QE1, the Fed funded stocks (i.e. mortgages, a finite amount of Treasuries), while under QE2, the Fed will be funding flows (i.e. deficits; refer: http://en.wikipedia.org/wiki/Stock_and_flow ), and unlike the ECB, it certainly doesn't intend to sterilize them. Now, think about this: If banks are flooding with deposits now and there isn't enough lending, what do you think will happen if CPI picks up and deposits begin to shrink, as people need them to offset the loss in purchasing power? This is even more supportive of gold!!!!
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: october-4-20101
It’s Friday, October 1st. We’ve had a very busy week dealing with loan refinancings and as we go for a late afternoon walk in downtown Toronto, we wonder what we will write on our next letter. Everything we can write about is obvious and we have written about it in the past. We ask our friend André for his opinion. His answer is quick and short: “Then write the obvious!”
Today, therefore, we will write the obvious. In fact, we have already written about it too. In our first (public) letter, on April 14th, we presented this graph:
This graph corresponded to the beginnings of what is now called Quantitative Easing 1, which assumes we are about to embark on Quantitative Easing 2. As you can see, the Fed was filling the bucket of treasuries, mortgages and commercial paper. Now, it will only be filling that of treasuries, as mortgages are being paid down. (We will have to write more about this in our next letter)
Back then, we wrote (see: “Remembering Haberler”, April 14th, 2009, at www.sibileau.com/martin/2009/04/19 ):
“…We will keep reading the bearish comments from those who see a bear market rally in stocks, as they single out all the horrifying figures of the real estate, labour, retail, etc. markets. There is nothing wrong with those figures, but this is not a bear market rally. It’s just the “relative” inflation Gottfried Haberler wrote about 77 years ago. Now, some people recognize inflation only by stage 5 above, when liquidity reaches consumption goods (They are the same who then tell you we consume too much and don’t save enough!). In conclusion, as long as the Fed and all the other central banks keep flooding buckets with liquidity and feed us with daily announcements, we can see prices NOT falling. Looking at the picture above, do you think that by stage 5, an exit strategy by the Fed will be effective? Why…?”
Today, 18 months later, this seems obvious. It wasn’t then. In fact, we were writing in answer to the bearish comments Mr. David Rosenberg was making, which we thought were wrong. But we refrained ourselves from mentioning the explicit allusion (refer: Bank of America’s Economic Commentary, April 3rd, 2009: “Recession ebbing? Someone forgot to tell the labor market”, by David Rosenberg”).
Eighteen months later, looking at stage 5, in the above graph, and knowing the current levels of interest rates and the stagnation we are in, which was caused by the distortion in relative prices triggered by central banks, it is clear that there will not be an exit strategy. Therefore, we need to return to comments made on March 18th, of this year (see: “The winter of our dynamic inflation” March 18th, 2010, at: www.sibileau.com/martin/2010/03/18 )
“…let us add that although most agree that credit is already too tight and can still become tighter, default expectations have not necessarily decreased, particularly in High Yield. Finally, fundamentals are signaling a stronger than expected recovery in the US, Canada and Europe.
Is this all the lagged consequence of the earlier quantitative easing policies? Certainly, but why should we care?
In our view, the latest action in the markets proves that they are dependent on a given rate of money supply. This is a difficult concept to grasp in the developed world, for it is the base upon which the dynamic theory of inflation was developed. A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms. The dynamic approach to inflation evolved during the ‘60s, mostly under the so-called “heterodox” line of economists. …(…)
Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when an exit strategy like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply.
Regardless of expectations, the intervention of central banks in the rates markets has a real impact that distorts relative prices. In our present case, the intervention has been steady and consistent, and we have become too comfortable with it.
Think about it for a moment. Think about the message the markets are sending: “Don’t worry about the upcoming supply of public debt, because there will be demand for it”…But, what is supporting that demand? Low-yield investment alternatives and a sea of liquidity. Where does that liquidity come from? From the Fed’s purchases of public debt…”
There you are! We’ve reiterated the obvious, which might have not been so obvious to everyone so many months ago. The market has indeed got used to a certain rate in the supply of money. In fact, it bases all its investment decisions on that rate, with analysts updating on a weekly basis net debt supply of Treasuries vs. demand by central banks, vs. net debt supply of corporate issuances, to calculate movements in spreads. This is not new, of course, but it had never been so critical or even worse: So easy to calculate and understand.
Without an rise in productivity, prices are left to the operations of central banks. And there cannot be a rise in productivity because there are no investments. But there are no investments because the future is uncertain, even institutionally: We don’t know what our fiat currencies are going to be worth say, in five years, !!! Even the operations of central banks are not coordinated. A protectionist currency war is in full display before us, as the Bank of Japan and the Fed went on their own.
The thesis for gold has never been so clear to us. We intuit there might be a temporary pullback if the Republicans decisively win in the upcoming election, as the market wrongly interprets that win as a sign of future fiscal austerity. It would be wrong to conclude that, because the Tea Party “sect” within Republicans is still weak, in our view, and President Obama would still remain in power.
Martin Sibileau
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