March 2011 - Posts
Please, click here to read this article in pdf format:march-29-2011
Unfortunately, the theme we began elaborating on January 28th, has now become “the” theme, particularly since this weekend, with Japan’s nuclear disaster and the anarchy of the Middle East as backdrop.
What was the theme? The theme has been and will continue to be the EU institutional crisis. Since March 3rd, when the European Central Bank let it be known that future rate hikes were on the way and since March 11th, when the EU decided that the funds from the European Financial Stability Facility were not going to be used for sovereign bond buy backs (in the secondary markets), a slow but certain chain of events began to unfold, for the worse. These two new “variables” pushed peripheral sovereign debt spreads wider, putting Portugal out of the market. The situation is still not reflected in the ratings, since technically Portugal’s credit risk is still investment grade, after S&P’s recent downgrade to BBB from A-. Nevertheless, last week Portugal’s Primer Minister Socrates offered his resignation.
In summary, the lack of “wise” institutional moves by the EU is resulting in political changes. Last weekend, the CDU, Germany’s official party, lost in the election that took place in Baden-Wuerttemberg. Now, not only do we face uncertainty over those countries that need to undertake huge fiscal sacrifices, but we also face uncertainty over those whose shoulders were originally relied on to back the structural reforms.
As we wrote in our last piece, the only reason this mess hasn’t yet become a brutal correction, is the implicit belief that the bucket stops here and Spain will be spared. That is a strong assumption and the onus to prove it befalls to those who trade upon it. We certainly don’t belong in that group.
Since we are discussing assumptions, let’s bring another one to the table. This latest one is perhaps more interesting and consists in believing that the fiscal crisis in the US can last forever. Indeed, we were totally surprised to read a few research notes over the past weekend, reaching the same bearish conclusions we have, but on a different, inconsistent, ground. The bearish thesis these analysts elaborate are based on the expectation that the Fed will first finish all quantitative easing policies with QE2 and then embark on rate hikes in 2012. This is nothing else but saying that: (a) these people really think that QE2 was about financing negative real rates for the private sector, and (b) the US will embrace historical fiscal policies that will reduce deficits, thereby making the Fed’s intervention in the Treasuries market unnecessary.
For consistency’s sake, there cannot be a different way around this. If you believe US dollar rate hikes are coming, you must believe in (a) and (b) above. However, we think there is convincing evidence that neither the Fed is buying Treasuries to support the private sector nor has the US even begun to imagine fiscal austerity. Therefore, the rate hikes view, if correct, should actually by bullish, not bearish: If you think the rate hikes are coming because you assume the Fed has done a good job with QE2 and because fiscal deficits are on the path to shrink, you have no reason to be bearish. Yet, the recommendation by those who believe in (a) and (b) (for instance, refer Barclay’s Global Outlook: “Winding down the recovery trade”, March 24th, 2011) is bearish.
We are bearish, but exactly because we don’t believe in (a) and (b), and therefore, we think that once the Fed finishes QE2, it will be more than evident that there was no other game in town. And that recognition, if the Euro one doesn’t kick in first (the EU council is set to meet in June, to decide, once again, the final shape of the EFSF), will set the tone for the rest of 2011. Unless the cards materially change here, we fear that this story is not going to have a good ending.
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: march-23-2011
Since we last wrote a week ago, nothing of fundamental weight has changed (being this the main reason for our absence).
It’s true, unlike last week, the markets now see the nuclear disaster in Japan contained and, perhaps too, something close to a “managed” transition in the Middle East. Even if it takes a coalition to apply force and even if it is not clear what the main goal is and which country actually leads that coalition. It doesn’t matter. Stocks kept rallying until Monday and credit spreads continued tightening.
However, there is a key assumption behind all this behaviour. As Portuguese and Irish sovereign risk widens, the main assumption that prices seem to be signaling is that there will be no domino effect, should any these countries, and Greece, have to restructure their liabilities. To be honest, these countries are already undertaking a restructuring, although with those liabilities related to the bailout effected by the European Union. Interest rate decreases, term extensions and liquidity lines are all undeniably telling a story of restructuring.
The main assumption then is that as the EU funds, via the European Financial Stability Facility or via purchases or liquidity injections by the European Central Bank, are applied to simultaneously avoid a default and allow the Euro to strengthen, the problems will not spill over to Spain or Italy. If that is the case, we can justify the rally in stocks, the tighter credit spreads, the price of gold and WTI oil above $1,400/oz and $100/bl, respectively.
We will not write about the politics taking place in the background, as the EU negotiations are carried out. Ireland is still fighting to keep whatever trace of sovereignty has left and the symbolic 12.5% corporate tax rate that Brussels wants dead seems to be the last line. Portugal is playing games with the EU and Greece does what it can to show that somewhere down the road, default is avoidable.
The message we want to leave today is this: In order to (a) avoid a domino effect in the EU involving Spain and Italy and (b) remain with a single currency called Euro… whatever final form a debt restructuring is pushed to take, the EU will have to avert by all means a run against any country’s banking system.
The first thing that is crucial here is to send a clear message that there will be a lender of last resort, if there is a run against deposits in a country’s financial system. This goes against Trichet’s notion that it is possible to establish what he called a “separation principle”. The ECB cannot sustainably switch (it has not done so yet, but it has sent the message it will) from fixed rate to variable rate auctions and at the same time raise interest rates, within this fiscal context. In the long term, it cannot even sterilize either (When the ECB offers liquidity at a fixed rate, Banks can take all the liquidity they need, at a fixed price. Effectively, the ECB loses control of its balance sheet. When the ECB offers liquidity at a variable rate, Banks can only bid for the amount offered by the ECB, and the rates are the product of the auction process).
So far, a retreat of 30-50bps in stocks yesterday may be telling us that the market is giving the EU and ECB the benefit of the doubt. If you are a gold bug, you want the ECB to push this inconsistency further, for it would bring the collapse of the monetary union, making room for gold to take over. If the ECB backs off and postpones the “separation”, showing it is there for the banks, then the road up for gold will be a rough one and marked by the next fiscal crisis: That of the US.
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: march-15-2011
We are back from the 2011 Austrians Scholars Conference, at the Ludwig Von Mises Institute, in the USA, where we were exposed to an incredible diversity of people and ideas. We highly recommend!
During our time at the conference, two main, market driving events, took place. The first one, of course, was the earthquake in Japan. On this matter, all we can say is that in no way, besides the terrible human loss, this can be considered bullish. The reconstruction of the areas hit is only catastrophic and cannot be positively construed (here is another example of how Keynesianism taken to the extreme is nothing short of absurd). The strength seen in the Yen is driven by the repatriation of capital, required to assist with the reconstruction efforts. It remains to be seen how much weight this situation poses on global markets. It would seem that given the acknowledged danger posed by nuclear reactors, from now on, alternative energy sources will be demanded in higher quantity in Japan. But all this belongs to the sphere of long-term speculation. Right now, Japanese risk is selling off, as the damages are reassessed by the hour.
The second event takes us back to the European Union, where we have been placing our focus since late January. It was on January 28th that we wrote a letter titled: “Why the Euro could rise even higher (and gold fall even lower)”. The main thesis here was that if the European Financial Stability Facility, a special-purpose vehicle (“EFSF”) that issues Aaa/AAA debt guaranteed collectively by all the EU-zone members, was used to repurchase EU sovereign bonds in the secondary market, the Euro would strengthen considerably (at approx. $1.50 USD), within a win-win situation for the European Central Bank, the EU banks and sovereigns.
During the weekend, an agreement was reached at the summit of the European Monetary Union council, where we understand the EFSF has been allowed to increase to EUR440BN (from EUR260BN) and if used to purchase sovereign debt, under exceptional circumstances (from countries with ongoing adjustment programmes), the purchases will take place in the primary, not the secondary, market (i.e. directly from governments). In addition, Greece has been granted a maturity extension to 7.5 years and 100bps reduction in the interest the EU/IMF charges on its loans, in exchange for a commitment to accelerate privatizations to raise EUR50BN. We will not discuss the political background here, which is complex (i.e. Ireland, for instance, got nothing, apparently due to its resistance to increase its corporate tax rate still at 12.5%). But what we can say is that this is a missed opportunity and leaves little room to be fixed on the final meeting of the EU Council, on March 24-25.
Indeed, the use of the EFSF to directly finance liquidity needs does nothing to solve the institutional problem affecting the EU, which is the lack of a unified bond market. This approach finances flows (i.e. deficits), instead of stocks (i.e. secondary market bond inventory), and that is almost always a bad thing. When stocks are financed (i.e. the Fed’s MBS purchases, not QE2), a quantity known ex-ante to investors is dealt with. Investors know how much will be purchased, within a certain period, and can make a reasonable calculation of the impact it will have on the market and market constituents (i.e. EU banks). When flows are financed however, quantities are by nature only known ex-post, after the deficits are disclosed and expectations reassessed. This keeps uncertainty alive and uncertainty is expensive.
With reason, it seems this decision was against the ECB, as M. Trichet seems to have pushed to allow the EFSF to intervene in the secondary market. This was our position in January and the confirmation of the ECB’s alignment with it is to us understandable. If we thought that intervention was capable of strengthening the Euro to $1.50 USD, now we know it should not reach that level. If we thought that it would strengthen the capital of EU banks, now we know it should not. If thought it would establish a proto federalist base off which federal taxation would eventually be born, now we know it should not. Most importantly, if we thought it would weaken gold, now we know it should not!
The result of this agreement will only be an agonizing wait until unavoidable sovereign defaults must be again confronted. In the meantime, in our view, this context should be bearish of stocks, neutral-to-bullish of gold, bearish of sovereign risk and neutral-to-bullish of corporate 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.
We want to write a few thoughts today, before we leave, on Wednesday, to attend the Austrian Scholars Conference, at the Ludwig Von Mises Institute, in the USA. If we are able, we will write from there our impressions on the different topics and views we encounter.
Our recent letters are beginning to read more and more ominous. We think we have been lucky at identifying the main issue affecting the markets these days: The European Central Bank’s policy.
Since Mr. Trichet surprised everyone last week with the announcement that the ECB may soon start hiking rates, investors are slowly starting to realize that if this indeed takes place, the resulting strong Euro will trigger Greece’s default (and possibly others will follow). Underscoring this problem, yesterday Moody’s downgraded Greece’s sovereign risk by three notches, to B1, from Ba1. Greece’s credit curve is already seriously inverted and its 5-yr point is above 1000bps.
Besides a good research note from Bank of America’s Rates Research team, we were surprised and perhaps even angered to see that nobody else has come to the front to call Mr. Trichet wrong. The mainstream story the media was feeding the masses yesterday went like this: “…Stocks are weak (not selling off) because of the uncertainty in the Middle East, which puts a bid on the price of oil. But this shock, which is impacting the “recovery”, is temporary and once this oil “bubble” bursts, the rally will continue. So, back to your point, I see a great buying opportunity, Jim!…”
Those who make these comments also wonder why is it that the Euro is so strong, when Greece is about to default. They see the relationship inversely, incorrectly we may add, for Greece is about to default “because” the Euro is strong. Therefore, we should not be surprised if peripheral bonds drop with the currency strength. We should be surprised if their price actually rose!
We don’t know if this should make us laugh or make us feel sorry. Worse, if this situation spirals, Ben Bernanke will be seen a wiser man, for having had the patience, unlike Trichet, to leave rates at negative real values for the “extended period” everyone criticizes today…In summary, there is no buying opportunity here and we even fear that gold may soon no longer resist the deleveraging forces at play, if Greece’s default becomes imminent, once the EU Council meeting of March 24-25 ends without clear resolution on the future of the EFSF. Indeed, if the situation deteriorates, counterparty risk will increase exponentially and liquidity will be sought everywhere. Gold would also be a victim.
We have already dealt here with counterparty risk in sovereign default swaps. This is something regulators have not addressed at all and is in fact the weakest link. Will we see it escalate in 2011? We have no idea, but we must be prepared and therefore, we briefly elaborate on it below:
When a bank sells a credit default swap on a sovereign within the Euro zone, say Greece, it promises to pay, if default occurs, par on the protected notional under the contract. But that notional is denominated in US dollars. As you can imagine, even if that default is caused by a strong Euro, at default, there will be a rush to USD liquidity, as those financial institutions that sold protection on Greece’s sovereign risk need to buy US dollars to deliver on their promise to pay. Therefore, the strength in the Euro that we currently see can swiftly turn into weakness, because in the presence of jump-to-default risk (i.e. right before the actual default takes place), margin calls in US dollars on the contracts will be triggered, to mitigate counterparty risk.
Now, at this point, it should be clear that this counterparty risk will violently transform into systemic risk. Funding in US dollars, within the Euro zone will be limited, pushing Libor higher and leaving the Fed without a choice. The Fed will need to extend currency swaps to the European Central Bank. Why? Because at the end of the day, the ECB will have defacto renounced its monetary authority. The funds that Trichet refused to print on March 3 would eventually be lent, in multiples, by the Fed to European (and non-European) banks. Will Congress allow this? Until this point, gold would be under a lot of pressure. But it would soon become clear that the Fed cannot bail out the entire world and gold would then reach unthinkable highs.
Could this actually happen? It all depends on what the EU Council decides on March 24-25. Until then, in our personal accounts, we want to hold cash and gold. No stocks or bonds. Not even energy stocks or gold mining stocks, for they end with the word “stocks” and that will be enough for margin clerks to sell them (the case was made yesterday, as both gold and oil managed to make intraday highs and yet, the respective energy and mining stock ETFs sold off).
Lastly, it will be very useful to understand that for this to happen, it is not even necessary that the ECB actually hikes rates. In fact, we think there is a chance they won’t. However, with last week’s threat, the technical damage has been done.
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: march-04-2011
There are times when we wish we had listened to ourselves more rigorously. Yesterday was certainly one of those times. Exactly a week ago, we had walked to the sidelines entirely, and written that:
“…As we write, the Euro is trading above 1.38 USD, in spite of all the noise coming out of Ireland (elections today!) and Spain (recent 1.5% increase in minimum wage). The strength is explained by the hawkish messages that have been coming out of the European Central Bank lately and, if we may add, the total absence of clarity on where the European Financial Stability Facility will end. The higher Euro, via higher rates, is simply recessive and it will push Greece and others to restructure or default sooner than later. This, in addition to the folly of the new regulations on bank capital, is the sort of things that may end up in a run against a country’s financial system on a gray Monday morning…This is the sort of thing that could explain bearishness in gold, oil and stocks simultaneously, for the sake of bearishness, in spite of a $600bn quantitative easing program, strong earnings, lower jobless claims, etc. etc.
We are not saying that the strong Euro caused the yesterday’s action. We cannot prove causality here (at least not us). What we are saying is that this explanation is more consistent than any other we’ve come across, and we like it because it means that someone out there knows something we don’t know, which is proof enough, if we follow Occam’s razor principle. On this note, we take this weekend off, preferring to remain on the sidelines until the ECB meeting, scheduled for March 3rd…”
(“Why gold and oil sold off yesterday”, February 25th, 2011)
Indeed, the then strong and now stronger Euro brought gold and energy stocks to their knees. We were bruised, but not beaten, fully understanding that we need to survive to fight tomorrow’s war. Yesterday, Mr. Trichet surprised everyone by announcing the ECB will increase interest rates, perhaps as soon as April. The debate that now follows is on the possibility that that increase be a one-time action or the beginning of a more comprehensive monetary initiative.
In any case, the only market that seemed to react wisely, in our view, was the credit market: Greece’s and Portugal’s sovereign risk, which had been increasing in the last days, together with the Euro, widened even more (+15bps and +10bps intraday). In the chart below (source: Bloomberg) we can clearly visualize the point we have been making, namely, that the strong Euro is is pushing Greece towards restructuring/default (Euro in orange, 5-yr Greece’s credit default swap in white):
This leads us to take a contrarian view with the rally in Euro stocks we saw yesterday, which is no fun for us. However, in our opinion the ECB took the wrong path, which eventually, if not amended by the EFSF (whose future is decided on Mar 23-24 by the EU Council), will end in tears, with a run against banks in the periphery of Europe.
Does it make sense to see US stocks rallying? Only if it represented a global reallocation, which we doubt. The short-term myopic perspective seems to be that since a major central bank is raising rates to stop inflation, growth is around the corner and therefore, higher valuations are justified. This is however a view that totally dismisses the solvency problems of the sovereigns of every country on Earth.
When does will this end? When we see the first relevant default, be it corporate or sovereign. If corporate, a default led by margin compression driven by inflation (i.e. company has higher costs which cannot pass on to customers) will be catch everyone’s attention…
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.