A View from the Trenches, August 9th, 2011: "The beginning of the end"
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
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