Please, click here to read this article in pdf format: august-19-2011
In light of the events yesterday, which in our view were mainly driven by fears of US dollar funding problems in the Eurozone banks, we thought it would be appropriate to reproduce our comments from June 4th, 2010, which anticipated a scenario like yesterday’s. From the comments, it should be clear that the ongoing environment is and probably will continue to be highly supportive of gold and bearish of stocks. The only thing that could change things here is a strong, determined will to fiscally integrate ALL members of the Eurozone and the simultaneous announcement of Euro bonds (to understand how they would work, please refer our letter from January 28th, 2011). Below, our comments from June 4th, 2010:
“…At “A View from the Trenches” we were ahead of the curve, anticipating this “content problem” (refer: www.sibileau.com/martin/2010/05/10, “What to expect when you are expecting”), associated with secondary market purchases even before the announcement of the ECB’s plan. Back then we wrote:
“…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…”
There is also another criticism that we think is unwarranted, namely, the short term nature of the existing currency swap contracts between the ECB and the Fed. It is maintained that because these contracts are renewed on a weekly basis, instead of a longer-term (i.e. 84 days), USD funding conditions remain “uncertain”, which does not contribute to calm the markets. We believe the opposite is true. If the Fed validated the capital investments in the Euro-zone via currency swaps, which are nothing else but a hidden bailout of financial institutions, the Fed would be feeding the bullish trend in gold, at the expense of future higher USD inflation and of US taxpayers, and delaying an adjustment that would affect the ECB’s balance sheet more violently.
The term mismatch in the currency swaps (1-week) and the 3-mo Libor-OIS benchmark, as well as the uncertainty over its renewal sends a clear signal to those yet surviving that they need to unwind and take losses. In 1965, M. Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ) described a very similar situation occurring in the ‘20s with “currency swaps” between Britain and France, in this way:
“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.” (J. Rueff, “The Monetary Sin of the West”, 1972)
Back in those days, as the Sterling and French Franc were backed by gold, the currency swap consisted in having Paris “lend” gold reserves to London, to address funding problems. The 2010 version of the same problem could read like this:
“There is a very interesting document from this period, a letter from M. Trichet, who was then the European Central Bank’s President, to Mr. Bernanke, who was the Chairman of the U.S. Federal Reserve; it must be of 2011. M. Trichet said, “We know that you are entitled to ask dollars for your dollars, but in the frame of the close friendship between the European Union and the United States we ask you, so as to avoid trouble for the European Union, not to do that, and receive Euros instead.” And we were, I must say, weak enough to comply with this request and not ask for dollars. The fact that I had such important U.S. dollar deposits in Frankfurt shows that we did not use this right to ask for U.S. dollars. 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 2009 and 2010. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.”…”
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: august-9-2011
Where do we start after two weeks of absence? Let’s start by first acknowledging how utterly wrong we were to leave gold before the debt ceiling debate. Our analysis was binomial and reality proved that most times, grays are the norm, and in many shades, while “black and white” are a mental construction.
For the record, we wrote: “…What is the reason for our position? If prior to August 2nd we have a deal regarding the debt ceiling in the US, gold in our opinion would have to correct, given the reduction in jump to default risk. If we do not have a deal and we face a downgrade or default on US sovereign debt, we think that the world will face a serious run for US dollar liquidity. This, as counterintuitive as it sounds, would appreciate the US dollar, for as long as it takes the Fed to intervene, launching a forced QE3 (debt monetization), whereby downgraded/defaulted debt is purchased.”
What went wrong? Right after the last-minute agreement to lift the ceiling, weakness came from Europe and it was a weakness that was addressed by the monetary authority (European Central Bank, ECB) through its Securities Markets Program. We will have more to say more about this program in a moment. Had we not seen it coming? Yes, but not so fast! On the other hand, the downgrade was only partial (one in three ratings agencies), and has not yet triggered the reaction it deserves, let alone the one we had expected, had the downgrade forced the selling of Treasuries/Agency debt by money market funds and financial institutions. In hindsight, would we make the same “mistake? Of course, we would! We were managing risk and the first duty we have in this game is to survive.
To finish our thoughts on gold, we must say that after S&P downgraded the sovereign debt of the US, when yesterday morning we saw gold trading only $10/oz above the previous top last week (i.e. $1,684/oz), we had no alternative but to buy it. We could not believe what a bargain it was. Was gold expensive last week at $1,684/oz, after having reached an agreement over the debt ceiling? Yes, we think. Was gold cheap at only $1,694/oz on Monday morning after the downgrade of US sov debt, the ECB’s announcement that it would buy core Europe’s sovereign debt, the belief that France will be downgraded, the repricing of the whole credit spectrum and a Fed that may have no alternative but to monetize government debt? Absolutely! The new set of information changes the whole story! We will mince no words here: The dam is broken and there is really no way to hold the fury back. The forces that will be unleashed here will surpass what anyone of us can imagine and the end game is a world’s reserve currency backed by gold. Within a fractionary reserve system? Unfortunately we think so, but backed by gold!
Now, in terms of the political situation in the US, which is what appears to be the main driver behind S&P’s downgrade, we think the US has a structural/institutional problem, which goes beyond political parties. Effectively, Mr. Obama last week faced what under a parliamentary system is known as a “vote of non-confidence”. Under such system, proper to the Commonwealth, when a Prime Minister cannot have his/her budget approved, elections are called and citizens actually vote for or against it, reelecting or not the official party. That is quite an advantage, which the Presidential system lacks. The President of the United States has received a vote of non-confidence and yet, he will hold power until the end of 2012.
Meanwhile, in Europe, on Monday we learned that Germany voiced its opposition to fiscal integration of the Eurozone, leaving all the weight on the shoulders of the ECB. The ECB can not do much and what is doing is simply futile, but truly supportive of gold. Let’s see (what we are about to discuss is radically different from the EFSF purchase of sovereign debt that back in January, we thought was a good move):
In the figure below, we can see that under the Securities Market Program, the ECB in step 1, creates money ex-nihilo and buys sovereign debt held by Eurozone banks. Immediately after, in step 2, the ECB sterilizes that increase in the supply of money by issuing short-term debt, which takes out of circulation the Euros that were previously printed.
In the end, in step 3, we see that the Eurozone banks hold short-term debt of the ECB, while the liabilities of the ECB are backed by Euro sovereign debt.
What is important here? What we don’t see!!! Let’s go in detail:
1. Yes, the supply of money has not been increased, but at the same time, the credit multiplier has not been touched. Eurozone banks, which were previously defacto insolvent, count with the same firepower to continue the expansion or maintenance of credit within the Eurozone. The bigger they are, the harder they will fall!
2.- The liabilities of the Eurozone banks may and actually are denominated in USD. If the sovereign debt the ECB holds further deteriorates (a capital loss to the ECB), so should the credit of the ECB, its short-term debt, which is backed by the sovereign bonds. But if that is the case, there will be a mismatch between the assets the Eurozone banks have and the liabilities they have assumed.
3.-If the mismatch just described widens, the ECB will be helpless. In as much as the same involves US dollar liabilites, the Fed would be forced to extend a currency swap to the ECB to support the Euro financial system. When and if this occurs, the cancer will have spread, metastasising into the two main reserve currencies of the world.
In light of this, yes, we think gold was cheap on Monday. Has gold gone up too fast too much? Yes. It will not be an easy ride.
We have not had the time to further deal with the consequences of the US debt downgrade or to examine how the creditor countries (Asia, Latin America) can react to this chaos. But we think the Eurozone is currently the main driver of the current crisis, ahead of the US fiscal situation.
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.