September 2011 - Posts
Click here to read this article in pdf format: september-27-2011
Since our last letter, we have witnessed (and perhaps are still witnessing) once more, the typical run for liquidity, when all asset classes tell us that diversification is a myth and that there is no place to hide but in the US dollar. Those who were long of gold (including ourselves) got a good lesson (in our case, a reminder) in asset management under central banking and hopefully too, got to appreciate the value of stop losses, like we did, which saved our day.
Let’s first begin by saying that from the perspective of the “real” economy, absolutely nothing has changed since September 12th. This sell off was indeed a déjà vu and we had, in previous letters, described a scenario like it. For instance, on February 2nd 2010, we proposed three phases in this downward cycle, shown in the chart below. Everything would seem to indicate that we are in what we called phase 2:
When are we going to enter phase 3? Before we address the question, let’s briefly comment on the announcement that triggered the recent sell off: the Fed’s so-called Operation Twist. By now, everybody knows that the Fed announced it will shift the composition of its assets, basically selling short-term Treasuries and using the proceeds to buy longer term Treasuries (this is a very, very basic description). In doing so, three things will occur.
Firstly, the yield curve should flatten, affecting negatively the profitability of credit investors (banks, insurance companies) that fund cheap in the short term market to lend long term, at higher spreads. If providing credit will be less profitable, credit supply will contract, affecting borrowers.
Secondly, by shifting the tenor of its assets to a longer term, the Fed will suffer huge losses, when interest rates finally rise forced upon this central bank by a massive repudiation of the US dollar (its liabilities). By then, how will the Fed be recapitalized? This point however will take a lot to materialize. But we nevertheless mention it here for the record. Peter Schiff in his blog described these first two (watch: http://youtu.be/BCYGVKBOcCo ) issues.
Thirdly, and to us this is perhaps the most important, Operation Twist contributes to confirm the stagflationary trend. For mainstream economists, this is difficult to see, because they ignore the role of the price system in the market process. Every mainstream analyst has told us in the past days that because the Fed is not expanding its liabilities, this move should not be inflationary. Let us tell you why, although this fact (i.e. no expansion of Fed’s liabilities) is correct, the conclusion is not.
Since the beginning of QE1, central banks and regulators have incrementally exercised financial repression on global markets. In doing so, they have deprived markets of the benefit of the price discovery mechanism through which they can efficiently allocate resources.
With the purchase of government bonds, whose yield are a benchmark rate, the benchmark rate has been manipulated to the point where, with rates practically at zero levels, markets no longer have a benchmark.
With the intervention in the banking system, markets no longer can easily price the solvency of banks and their capital needs.
With the intervention, during the waves of defaults, in the legal proceedings between creditors and borrowers, markets can no longer have a clear view on recovery values at default, or even seniority of credits. Will pension plans have priority over lenders? Will private investors in sovereign debt end up deeply subordinated?
Until last week, therefore, we had slowly lost our benchmark rates, the capacity to calculate losses/defaults, and understand the legal consequences of extending credit. Since last week, thanks to Operation Twist and a flatter yield curve, we will also lose a benchmark for the inter-temporal rate of exchange: The relative value of time will almost disappear. How can anyone make an educated investment decision in this context? He/she can’t, which brings us sad memories of our life during the hyperinflation years in Argentina. During those extreme years, we remember having seen stores closed because “they lacked prices”. Many stores would simply shut and leave a sign by the door that read: “Cerrado por falta de precios”. Indeed, given the acute movement in prices, store owners could not decide whether their sales would leave them with a profit or a loss, and would not open to the public!
There and then, this happened with consumption goods. Here and now, it is starting to occur first with investment goods. All parameters relevant to an investment decision are absent: the value of a risk-free asset, probabilities of default and cost of capital, institutional certainty and soon, the value of time. In this context, investments, and subsequently productivity and employment can only collapse.
Going back to our point on the inflationary impact of Operation Twist, if we understand now that this measure contributes to destroying investment, if the produce of the USA drops, even if the size of the Fed’s liabilities doesn’t increase, the amount of money stock vs. output will have still grown and the value of the US dollar will have to drop! This is why people call it stagflation! (Money stock = monetary base + fiduciary media, refer Figure 2 in “The causes of price inflation and Deflation: Fundamental Economic principles the deflationists have ignored”, by Laura F. Davidson at: http://libertarianpapers.org/articles/2011/lp-3-13.pdf )
Returning now to our previous question of “when are we going to enter phase 3?”, the answer is: We are not sure. In summary, if the Euro crisis finds a fiscal way out in which the European Central Bank (ECB) does not have to capitulate (and this includes the ECB lending to a bigger European Financial Stability Facility (EFSF)) we will not have phase 3, and gold will continue to sell off, in our opinion, at the expense of equities. If the ECB is made to capitulate because no fiscal solution is reached and the only way out is a weaker Euro, we will enter phase 3, with gold and equities rallying.
Lost in the mess of these negotiations, there remains the issue of what will happen in China with its current imbalances. We are starting to lose sleep on this one…
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: september-12-2011
Today’s comments will be brief. In fact, we will not seek to provide answers but to leave the reader with questions.
By now, everyone is surely aware of the decision by the Swiss National Bank to peg the Swiss Franc to the Euro, at 1.20. Effectively, the SNB would buy as many Euros as sold to them, at 1.20EUR/CHF.
On this news, Dennis Gartman, last week wrote that from now on, the policy of the SNB will be driven by that of the European Central Bank. We think that is not correct. Because the European Central Bank has no policy of its own. The ECB has its hands tied. As we wrote back in May 10th, 2010 , when we foresaw this:
“…We think that (…), the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, (…), 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 (…)? In the long run, the only way out for the ECB (…) is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy …”
Indeed, we think that with the peg, the supply of Swiss Francs will also be determined by “…the growth rate of the EU’s consolidated fiscal deficit…”.
Back then, on our next letter dated May 13th, 2010, we further discussed this point and added this graph, that now looks ominous:
The letter, titled “ECB Plan = The End of Paper Money?” already mentioned the importance of currency swaps extended by the Fed (seen in the chart above). We finished that letter noting that gold looked like a bargain at $1,240/oz. And just like we wrote about these swaps 16 months ago, last Monday we went on record stating that: “… AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER…”
With this in mind, we invite readers to think about this: If, in the face of upcoming US dollar funding problems for Eurozone banks, the Fed will commit to lend unlimited US dollars to the European Central Bank, to further sell them to Eurozone banks….WILL THE FED NOT BE EFFECTIVELY PEGGING THE US DOLLAR TO THE EURO? WILL THERE NOT BE AN UNOFFICIAL EQUILIBRIUM EXCHANGE RATE AT WHICH THE FUNDING MARKET IS CLEARED?
And if that is the case…What will differentiate the Fed from the Swiss National Bank? We think nothing!
After the German’s High Court ruling, where any institutional fix to the Eurozone problem, including Eurobonds will be legal but operationally unfeasible, the European Central Bank is the only savior and will have to monetize the consolidated fiscal deficit of the Eurozone. If the Fed, just like the Swiss National Bank, pegs its currency to the Euro, then the supply of US dollars will also be driven by “…the growth rate of the EU’s consolidated fiscal deficit…”.
We saw it coming . This scenario will eventually make the case for gold clearer and clearer. In the process, the banking system of the world will go bankrupt, nationalized and more concentrated, and financial repression will grow exponentially.
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: september-5-2011
In our last letter, we showed that our view from May 2010 is fully developing (We had stated that eventually money supply in the Eurozone would be determined by the growth in the zone’s fiscal deficits). Also, the contagion from the Eurozone to the USD zone is also growing, thanks to the EUR/USD currency swaps extended by the Fed to the European Central Bank. This contagion, we wrote, is nothing new, but had been highly criticized already in the early 1930’s by Jacques Rueff. We insist therefore that readers get a copy of Mr. Rueff ‘s “The Monetary Sin of the West”, published in 1972. An online version can be found at: www.mises.org/books/monetarysin.pdf . Too old? Perhaps, but remember: There is nothing more practical than a good theory!
If you have been following us vs. other analysis, you will notice that only recently, other analysts are beginning to pay attention to these FX swaps. Mainstream analysts refer to it as the “Fed’s USD backstop”, which is also appropriate. Why is this for us so relevant? Because thanks to this backstop, the world ends up being impacted similarly (“similarly” being the operative word here) to what we would see, if the Fed bailed out Eurozone banks. Is the Fed bailing out foreign banks providing this backstop? We see it that way, although the Fed will always deny it. But think of this simple question: What would happen to the weakest Eurozone banks that need to roll over USD funding, if that backstop wasn’t there? They would certainly be insolvent by now. However, the Fed doesn’t see it that way. What the Fed sees is the underlying counterparty risk. The Fed turns around the question to tell us that if the backstop was not there, the US banks would have funding problems, competing with Eurozone banks for funding.
To his credit, Dr. Ron Paul, was the only politician to see this far in advance, last year, when he questioned Mr. Daniel Tarullo, member of the Board of Governors of the Fed, on this point on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ).
Had we been in that session with Mr. Tarullo, we would have asked him what would the Fed do, if the dollars lent to the European Central Bank, forwarded to Eurozone banks, cannot be paid back because the assets these dollars funded are in default or generating substantial losses to the originating banks?
This is important because that is exactly what occurs during stagflation: Businesses go bankrupt. We know the answer: The Fed would do nothing, allowing these dollars, printed money, to remain overseas. This is why we say that the FX swap is effectively quantitative easing from the Fed on the Eurozone. We will go on record stating this: AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER.
Turning now to the Eurozone, it is completely clear now what we have been predicating time and time again, since February 8th, 2010: The zone faces an institutional crisis. Back then, it was only an institutional problem. The disastrous handling of the crisis by Euro politicians have made it now a real economic one and we think there is no way out here but dissolution in chaos. This again, shall be very bullish of gold and bearish of risk (unlike mainstream view, we distinguish gold from “risk” because to us, gold is money). Enough said. We could go on but we think that over the past letters we have been very clear and unfortunately, times will now accelerate and we will witness this problem evolve exponentially.
In China, it seems the People’s Bank has not been sterilizing its FX reserves purchases. However, to mitigate the corresponding inflationary impact, it has been relentlessly increasing the reserves requirement ratio of financial institutions, using the “credit multiplier” channel. According to Bank of America’s Rates and FX Research team (“Global Rates and FX Weekly”, August 26th, 2011), by September 2010 the level of USD reserves had reached $3.4 trillion (CNY21.8 trillion) , while the People’s Bank’s debt had decreased from CNY4.4 trillion to CNY2.7 trillion. The gap between the FX reserves (i.e. assets) and the debt (liabilities) was covered by the increase in reserve requirements (i.e. liabilities too: Remember that the banks’ reserves in a central bank are an asset to the banks and a liability to the central bank).
Why did China’s central bank choose to hike reserves rather than issue debt to mitigate the impact of its USD purchases? It was simply cheaper, apparently, which means that if the trend continues two things will become evident: 1) the profitability of China’s banking system will be hurt, and 2) the US Treasury will find it harder to place its debt.
On the first point, the central bank may be forced to increase the interest rate on the reserves, dragging banks to depend on it, increasing the cost of eventually appreciating the Yuan (i.e. exit strategy). On the second point, the Fed will be forced to step in, should China merely stop accumulating reserves. We may add that as the first point becomes more relevant, the cost of eventual defaults will be way higher. Both issues are very bullish of gold and bearish of risk, too.
After all these considerations, we are really surprised to hear mainstream analysts say that another recession (as if the last one had ended) would be a so-called Black Swan event (i.e. a rare event). How so? We would argue that the opposite is true: In this context, avoiding a double dip is actually the Black Swan event!
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.