A View from the Trenches, January 28th, 2011: "Why the Euro could rise even higher (and gold fall even lower)"
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We were as surprised as many others when the lows of $1325/oz were taken yesterday and gold made it all the way down to $1,310/oz, after the previous post-FOMC rally. We were the more surprised to see this drop without major movements in rates or anything else that would have explained the “testing” of the gold-as-reserve-currency thesis.
So…what was that? We began our last letter saying that “…we think that the lower commodity prices we are testing this week are driven by the developments in Europe…”. We will try to explain ourselves better this time. Since last year, but specifically since early January of 2011, politicians and central bankers in the European Union have been hinting at the possibility of using the funds raised by the European Financial Stability Facility to repurchase outstanding sovereign debt of peripheral EU governments, rather than to finance such governments’ deficits.
Today, we want to examine what this repurchase transaction means in terms of macroeconomic variables, but we anticipate the following: A higher Euro, possibly a lower price of gold and a higher valuation in Euro bank stocks. There are many risks to this view, but we believe that the mere possibility of this transaction can move markets. In fact, we think that the late weakness in gold, strength in Euro and Euro bank stocks is driven by this speculation. Let’s see why:
In the figure below, we show the aggregate balance sheet of EU peripheral governments (“EU Sovs”), the European Central Bank (“ECB”), Euro-zone banks (“EU Banks”) and the European Financial Stability Facility, a special-purpose vehicle (“EFSF”) that issues Aaa/AAA debt guaranteed collectively by all the EU-zone members:
In step 1 above, the EFSF issues EFSF bonds, at a yield lower than that at which the EU sovs would be able to. The EFSF increases its liabilities in exchange of Euros, provided by the EU Banks. The EU Banks keep the EFSF bonds as assets. In step 2, the EFSF uses the Euros to purchase Sov Bonds held as assets by the EU banks. In the end, as shown on step 3, the EFSF holds Sov bonds as assets, matched by EFSF Bonds. The EU Banks effectively exchanged Sov Bonds for EFSF bonds, of higher rating, at no cost. They keep the same amount of Euros they had before the exercise. Therefore, the EU Banks have had a capital gain. Do we think that this is what has been driving the outperformance of Euro bank stocks lately? Interestingly enough, the MSCI Europe Financials Sector Index Fund (ticker: EUFN) has risen on significant volume since January 10th, when the possibility of carrying out sov debt purchases with the EFSF began to be taken seriously. Below, we show the corresponding chart (source: Bloomberg):
Was this a coincidence on the back of “good earnings”? How would EU leaders, who take pleasure in blaming greedy bankers for this crisis, explain this transfer of wealth, from the EU taxpayers to the EU Banks shareholders?
But this is not all. As the EFSF buys this outstanding debt, if the purchases surpass the 2011 net issuance of EU sovs, the supply of EU sov bonds falls, and their price rises. This is a virtuous cycle through which EU sovs are able to raise funds at lower yields, the debt remaining in the asset side of the EU banks’ balance sheets appreciates and the EFSF vehicle produces a capital gain (the value of the assets, EU sov bonds increases, while their liabilities remain unchanged):
Now, as you can see from steps 1 to 3 above, until here, the European Central Bank has not been involved, which means that their options are open….Open to what?, you may ask…
As we explained on May 13th of 2010, since the European Central Bank got itself fully involved in the bailout of peripherals, it has been buying and holding EU sov bonds (EUR77BN at Jan 26th) and sterilizing these purchases via the so-called Securities Market Program.
Now, the virtuous cycle by which EU sov bonds rise in value also affects the balance sheet of the ECB, producing a capital gain. As the supply of EU sov bonds in circulation decreases with the EFSF purchases, the ECB can, but may choose not to, sell back the EU sov bonds it had bought to the banks, returning their supply to the previous “equilibrium” amount:
As we show in step 4 below, if the ECB did sell the EU sov bonds it holds, the respective amount of Euros raised by the sale would be taken out of circulation (i.e. there would be a decrease in the liabilities of the ECB):
Why would the ECB want to sell back to the market the sovereign debt it bought? Simply put, to fight upcoming inflation. If they could “pull this one”, they would be simultaneously avoiding the default of EU peripheral debt, decreasing the yields the EU zone pays, strengthening their financial system and stabilizing prices.
Now, if this scenario took place and the Euro strengthened, on the margin, the demand for gold as an alternative reserve asset would necessarily have to fall. Have we not exactly seen a drop in gold with the strengthening of the Euro, also since January 10th? The chart below (source: Bloomberg, Euro shown in orange, gold in white) shows our point. It also shows how in the summer of 2010 too, when the ECB proved the solvency of the EU financial system, gold suffered a major correction. This would explain why gold in January has been falling without major increases in yields:
How sure are we that the scenario we just described can take place? We are not, but we are inclined to believe that it may happen. It has its costs though, for as the Euro strengthens, the competitiveness of the Euro zone falls in the short-term, affecting employment both in core Europe, which will have to pay the bill, and in peripheral Europe, where cost cutting will have to continue, to rein fiscal deficits. Remember that this is only provisory, for as step 5 shows below, in the end, the Euro banks end up holding both EU sov bonds and EFSF bonds. If the risk of these is seen to increase as the Euro strengthens, the ECB will be under a lot of political pressure.
Are we too late to trade this thesis? We don’t think so, because investors in EU bank bonds still see a relevant political risk in the conversion of senior debt to contingent capital. This explains why credit spreads in EU financials have only tightened little, underperforming stocks. But once clarity is gained on this issue and on a positive note, the trade (long Euro, long EU banks stocks/credit, short gold) could find another leg upwards.
Martin Sibileau
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