March 2012 - Posts
Please, click here to read this article in pdf format: March 25 2012
During the past week, we think, we witnessed some interesting developments. In our previous letter, we had discussed what was the KreditAnstalt event of 1931. We saw a striking similarity with the current status quo because just like then, we now have sovereigns at the brink of default, whose creditors are other public institutions or countries, rather than private investors.
But there is more to it…
During the past week, we had Fed’s Chairman Ben Bernanke answering questions at the US Congress. It was there that Rep. Dan Burton (Indiana, 5th District) took Mr. Bernanke to task on the issue of the currency swaps the Fed has extended to the European Central Bank. On Thursday, we learned that the amount outstanding, which had reduced to $67BN, has remained there and increased a little bit. All this, in the face of a 7 ½ -month record low in US dollar funding costs for EU banks, given the 3-month cross currency swap basis reached 53bps below Euribor, on that same Thursday. The fact that the Fed currency swap lines are still in demand while the cost of US dollar funding keeps falling tells us that the EU financial system is segmented, with those who can access the market and those who cannot. But it also tells us that there is, paradoxically, an oversupply of US dollars, as we explain below.
R. Dan Burton then asked Mr. Bernanke how would the Fed recover the US dollars it loaned, should the Eurozone break. We made this point at “A View from the Trenches”, many, indeed many times before. You may see our latest letter on this issue at: http://sibileau.com/martin/2012/01/23/. Of course, Mr. Bernanke categorically played down the likelihood of such a scenario. He first lied to everyone saying that the debtor, the European Central Bank, does not finance governments. It was an insulting lie because not only does the ECB finance them indirectly via LTROs, but also explicitly and directly, through its Securities Market Programme, where more than EUR200BN are booked. Mr. Bernanke could not have and does not ignore this fact. Here is the link to the discussion: http://youtu.be/HzejoDbVXXs
On the other hand, we know that exactly this scenario, where the US had to bailout Europe, has already taken place in similar conditions. Back in 1931, when Austria defaulted leaving the gold standard, there was a generalized bank run (which the LTRO of last December prevented) and the United States had to establish a moratorium on the loans it had outstanding to Germany and to others. It was precisely this decision, that later pushed the United States to abandon the gold standard too, in 1932. Obviously, Americans understood that the amount of gold at the Fed, backing those claims now in moratorium, was not enough and they run against their banks as well. We found the video that shows President Hoover announcing the moratorium. It would have been so nice to have it handy to show to Mr. Bernanke before Congress: http://youtu.be/MFdTISc1KG0
Last week too, it was painful for those of us who still hold on to gold. Gold made interim lower lows at $1,628/oz on Thursday and bounced back to $1,665/oz on Friday afternoon. Is it still trading within range or is it consolidating to retake its bullish trend. We have our doubts, but the long term fundamentals support it. Let’s see…
One of the things that really caught our curiosity was to see the Euro appreciate since March 14th, with the simultaneous deterioration in sovereign credit risk. Since then, the sovereign spreads of Portugal, Spain, Italy and even Germany have been increasing. Should we not be looking at a weaker Euro in light of this? Why would we see the Euro flirting with a $1.33 level?
That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.
There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. This is the scenario that R. Dan Burton was proposing to Mr. Bernanke. Again, if this logic is correct, that scenario is not a tail risk, but the base risk.
How do we escape this circularity? With the ECB embarking in plain, good old Quantitative Easing. The collateralization of liquidity lines forces the EU to work within a context similar to that of the gold standard, where liquidity has to be backed by a commodity! In fact, if on the margin the supply of liquidity will only grow from collateralization, the EU would be better off under the gold standard, because gold at least, does not entail any credit risk!!!!Lowering interest rates, weakening collateral rules or extending maturities will not solve this problem.
If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU. These reasons make us feel comfortable holding gold.
We run out of time here, and we wished we had had the opportunity to discuss the fragile situation in two relevant countries: India and Canada. We will in our next letter.
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 18 2012
We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…
Title No.1: “The market proved us wrong”
Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!
We have no doubts that the plunge in gold on February 29th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:
The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.
The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.
As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…
Title No. 2: “Financial repression, Stage 1”
Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously. It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:
“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945
The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…
Title No. 3: “Remember the KreditAnstalt”
Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.
The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.
In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21st. The countries that held sterling pounds as foreign reserves suffered heavy losses.
Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.
The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.
Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.
In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…
Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…
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.
On Friday, out of the office and away from the screens (we are currently visiting the US capital), we were spared the enormous volatility in gold. Gold tried to break through the lows made since a public institution liquidated bullion on Februrary 29th but closed making a higher high (since the sell-off, of course). This, in light of a jobs report taken mildly positively by the market and the drop in the Euro post Greek debt swap, is encouraging to gold bulls (not bugs, but bulls) like us.
The Greek resolution of their debt exchange, with its credit default swap triggered, was a real slap in the face to anyone who was educated under the mainstream portfolio theory, where the existence of a risk-free asset is cornerstone. (We don’t belong to that group of thinking, because we have always recognized that implicitly, modern portfolio theory rests on the Walrasian (refer: http://en.wikipedia.org/wiki/L%C3%A9on_Walras) view of general equilibrium and in the world of central banking, where banks lend multiple times other people’s real savings, general equilibrium theory looks like Ptolemy’s geocentric model of astronomy. But then again, Ptolemy’s model survived centuries and while it lasted, those who dared to challenge it were threatened with death and hell. We want to survive, which is why we are gold bulls, but not gold bugs J).
Indeed, the Greek debt developments, together with monetary policy in the European Union, are writing a new chapter in the history of financial crises. But first things first, we must say that those who seek to compare the situation in Greece with that in Argentina in 2001 are misled, very. When Argentina defaulted, the price of 1 USD rose from 1 peso to above 4 pesos. It was the devaluation that brought subsequent growth, not the default itself. Devaluation has so far been absent in Greece and as we wrote before, it can last as long as the Greek people are willing to put up with the austerity measures being imposed upon them by the EU Council.
Our next step is to recognize that from now on, if you are a holder of sovereign debt, you risk being deeply subordinated by a supranational institution (like the European Central Bank) and, on top of counterparty risk, you will suffer from a high degree of uncertainty related to the usefulness of credit default swaps you may own. Along the same path, you will have learned that whatever holdings you had in unsecured bank debt will also be deeply subordinated to the collateral taken by the European Central Bank to keep your borrower (i.e. the banks) solvent via long-term refinancing operations. You will also have found out that this collateral too, can be created out of thin air, as banks (as in the case of Italy) may obtain government guarantees on their debt issuance, post it at the central bank’s window and receive new, freshly printed Euros!
Capital is therefore flowing out of the European Union and the flow is set to increase, perhaps exponentially. Nobody should be surprised by the fall of the Euro last Friday. Where does that leave the European private sector? Those big conglomerates able to issue bonds in other currencies (mostly in USD) will be able to borrow. The small businesses who depended on the EU capital markets will struggle. The lesson here is that to defend their currency, the European Monetary Union has destroyed their capital markets. And we do not know which one will be easier to rebuild. If run uncontested, the European Union will end like an emerging market of the ‘80s, where foreign funding is needed to support private investments. In light of this, what are the chances that the Fed will raise real interest rates? Very slim we think, for if they are actually raised, currency swaps to the Eurozone will be needed, and that may not be politically sustainable at that time.
After this debt exchange, the public sector (ECB, IMF, etc) will be the majority owner of the debt of the public sector in Greece, and in the future, in the rest of the European Union. The way out of this mess can only be debt monetization.
We want to end with another comment on something that we think the markets may have not paid enough attention to. China is reported to start extending loans to other nations (Brazil, India, Russia) in their own currency. We are witnessing the start of a “reserves war”, where the supremacy of the US dollar will be challenged on the margin. We know so far that above 90% of the US Treasury’s issuance in long-term debt has been purchased by the Fed, while Russia and China have been selling it. What if the loans in Renmimbis from China are funded with the sale of stock in US Treasuries owned by the People’s Bank of China? What if the sale by a public institution of gold at the fixing on February 29th was a warning to the other public institutions that are accumulating gold as reserves? What if that warning had been guessed by the Bank of Israel, influencing their decision to allocate up to 10% of their reserves in US equities, rather than in gold?
What if we are wrong? What if we are right? Should gold at $1,714/oz not look cheap? Should 30-yr US Treasuries not be a good short?
Martin Sibileau
Please, click here to read this article in pdf format: March 5 2012
Let’s start by confirming that we remain long-term bullish of gold, near-term neutral of stocks (and long-term bearish of stocks), bullish of corporate credit risk, neutral of sovereign risk (European and US). We are neutral on the EURUSD (but if we had to make only one trade and hold on to it, we would be bearish) and surprised by the latest performance of the Canadian dollar (happily surprised, of course, as we are long of this currency).
It is a widespread rumor by now that the huge sell off at theLondonfixing on Wednesday February 29th was not driven by Bernanke’s comments before the US Congress, but by plain manipulation, likely from a non-private seller. We, having seen no reaction in 30-yr Treasuries, decided to buy the dip, for we think that in this context one can only buy and hold gold, sitting tight in the face of all this volatility, or risking to lose one’s position in the bull trend.
Someone asked us why, if we were such believers in gold, did not buy stocks of mining companies. To answer this, we will have to first understand why we buy gold. It is not because of anything intrinsic to gold. We don’t care that we cannot eat gold or that it doesn’t give you a dividend. You cannot eat US Federal Reserve notes either and these, rather than give you a dividend…depreciate.
We have to understand that one of the services rendered by money, namely the storage of value, is no longer attached to fiat currencies. And the world needs that service. There is demand for a reserve asset and gold can address it. Is it the only asset fit for that? No! The only thing we care is that in the long run, the demand for that service will keep increasing and at the margin, even competing with other assets, gold will get a bid. It is that simple.
Now, we can dig a bit deeper and ask ourselves what are the causes and implications of witnessing fiat currencies lose their demand as a reserve asset. The causes are clear to all of us, but not the implications. The one least understood is the distortion in relative prices caused by the intervention of central banks. We write more about it below but for now, think of this: In the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?
I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place. We can intuit when it is going to happen, but will only be lucky in actually calling it. However, with gold, it is different. Hence, our buy and hold approach. We’ve seen it before: When decadence arrives with inflation, people want to own the product, not the producer. We want to own gold, not miners.
And some have brought to our attention that by doing so, we lose the leverage provided by stocks. We disagree and think that the price action in mining stocks speaks for itself. Besides, should one want to lever the bet in gold, the only thing required is to borrow and buy more gold. It is more efficient: One knows ex-ante the leverage one wants and will end up with!
Now, let’s address the distortions generated lately by central banks (We will focus on the Fed and the European Central Bank, but we could also write about the intervention of the Japanese Yen and the scary fall in Yuan deposits in China, that is forcing a steady cut in reserve requirements over there. But these are underlying, long term problems. We will have to deal with them later). When the Fed provided the currency swap at 50bps to the European Central Bank in December, US dollars that were needed to fund EU banks, all of a sudden, were no longer needed. We are speaking here of more than $90billion. This is no small change! Also in the December and a few days ago, we had two 3-yr refinancing operations by the European Central Bank. In all, more than a trillion Euros were printed to, among other things, repay previous funding, some of which was in US dollars too. As you see, suddenly, the providers of US dollar funding saw themselves with a lot of cash in their hands.
They could not offer cheaper funding to EU banks or sovereigns because a) the Euro funds from the central bank are against collateral, which deeply subordinated USD unsecured debt, and b) the latest decision by the ISDA, which considers the swap of Greek bonds with the ECB not to trigger a credit event, further guarantees the subordination of private sovereign debt holders going forward.
What did they do? They poured the money into equities, corporate bonds, commodities. But in the Eurozone, the banks that now count with cheap Euro financing, will not take risks. If they take risks, it will be in the form of sovereign risk, buying sovereign bonds. They have been doing this since January and will continue to do so. All this means that the private sector in the Eurozone will remain affected by a credit crunch, unless…..well, unless those who were previously providing US dollar funding to EU banks now use their excess balances to fund EU corporates. This, we think, is going to be the case as USD denominated debt (Yankee issuance) will be increasingly issued by EU corporates. This is why we said at the beginning that we are bullish of corporate credit risk. We make this more visual in the chart below:
The problem with this new situation is that eventually, we shall see a wave of EU corporates defaulting: Compared to US corporates, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries). However, the hunger for yield these last two central bank interventions has generated is pushing US financials to chase riskier assets and high yield EU corporates look today like sweet, low hanging fruit ready to be picked. Who’s going to be in the way??? Nobody, as this is an election year and nobody ruins parties in election years!
But, if that wave of defaults occurred…who would be bailing out theUSinstitutions that financed the EU corporates? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.
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.