Last week marked an important step in the history of this crisis. We had started the week calling our readers’ collective attention towards the consolidation that gold had witnessed on Friday, April 1st, and wrote that: “… we think higher highs are soon to come…”. Well,…the higher highs came and we fear, they came to stay.
If we had to define in one sentence the action last week and that which is to develop in the future, we would say it in actually one word, not even a sentence. That word is “stagflation”. We truly believed stagflation would present itself to us later this year or even next year. However, we think it is here now. This leaves us on the contrarian side, because almost everyone we read, hear or watch is telling us that “growth” (a misnomer used by mainstream economists, including those at the helm of the Fed, to refer to a higher GDP) will be high in 2011 and that the Fed will be forced to raise rates in 2012.
Before we go any further, let’s define “stagflation”. The easiest way is to refer to Wikipedia, where we are told that: “In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. It raises a dilemma for economic policy since actions designed to lower inflation may worsen economic growth and vice versa.” The description of stagflation is further elaborated and given within its historical context.
Ludwig von Mises, in Chapter XX (“ Interest, Credit Expansion and the Trade Cycle”), of his magnum opus “Human Action” writes that: “…It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption…” (p. 549, 4th Edition, 1963). And we think this is key to understand stagflation.
Why do we fear that we may be facing stagflation?
If you have been following energy stocks lately, particularly those in the TSX Energy Index, you will have noticed that as oil (West-Texas Intermediate) approached and passed $110/bbl, this group of stocks, collectively, did not make higher highs. Yes, on Thursday and Friday, their valuations improved, but oil closed above $113/bl after hours and these stocks have not really impressed us. In “normal conditions”, this should not have happened. The highs in this group were made when chaos unfolded in Egypt, at the beginning of the year. Now that the anarchy in the Middle East is to stay and oil prices are making higher highs every week, we should see energy stocks strongly outperforming. But this is not the case. Capital is not going to that sector as the price of oil should signal. This can only mean that in the future, with a lower stock of capital to produce oil, we will see higher oil prices. This can only point towards stagflation.
The same can be said even about gold mining shares and, in general, stocks collectively, as an asset class. Capital is being consumed! On the lending side of things, we don’t see anything but refinancings to take advantage of low interest rates, while they last, and to extend maturities. We, personally (not objectively) believe we are not seeing the same level of M&A that most market participants were expecting at this stage of the so-called “recovery”.
On the other hand, we still have big, unresolved macro issues:
-European Union:
We have, for a long time already, written that last week’s decision by the European Central Bank to raise rates is a big mistake. Since a year ago, we have been very clear on this: The survival of the Euro depends on its flexibility, and by this we mean, its ability to go lower, to depreciate. Right now, the opposite is taking place and it is only a matter of time until we see the political consequences of this move. We have patience.
-US fiscal deficit/QE2:
Last week’s debate on the US budget was a complete embarrassment and has exposed the challenges the Fed will face, if it really means to undertake an exit strategy.
-Inflation in EMs
Finally, we cannot expect high inflation to be confined to Emerging markets only. Most of these nations have sought to keep their currencies from appreciating against the US dollar, thereby increasing their supply and with it, inflation. These nations are net exporters. If wages in them increase, the developing world that imports their goods will see its purchasing power suffer.
Most likely, we are not telling anything new here, but we think it is good to remind ourselves of these issues, within the current context. Therefore, to dream of a Fed raising rates because of a “recovery” is to ignore important flags like a stock market that lags commodity prices, a worsening situation in Europe and the US, as well as a-soon-to-come impact from the emerging markets.
Of course, by the time the prices of imported goods will affect developed nations, mainstream economists will seek to convince us that the inflation is of a structural nature, because central banks in developed nations cannot influence prices in emerging markets. But our readers will know that that is a fallacy at best, and a lie at worst. The only structural thing about it all will have been the quantitative easing of central banks in the developed world.
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: april-4-2011
We don’t trade upon technicals but we take note of them. On Friday, we think gold went through an important test. After the announcement, at 8:30am, that the US unemployment rate had fallen to 8.8% (the lowest for the past two years), gold sold off to $1,415/oz. This fall came after having briefly touched $1,440/oz the day earlier. We were disappointed, because the markets in our view, had misinterpreted the new information. Relative prices on Friday morning seemed to reflect this line of reasoning: The lower unemployment rate, given the “stable” inflation rate, will push the Fed to hike rates sooner rather than later. Why? Because it would seem that the so-called stimulus of QE2 is working. If it is working, the Fed can now focus on fighting inflation.
What is wrong with this view? In our opinion, it is simply absurd. The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold.
By the end of the session, gold had bounced back from $1,415/oz (making a higher low, vs. the previous of $1,409) and consolidating around $1,430/oz. We don’t trade upon technicals, but we certainly took note of this consolidation and we think higher highs are soon to come.
Continuing our analysis of the Fed, we applaud the result of Bloomberg and News Corp.’s Fox News Network LLC lawsuit against the Fed for records under the Freedom of Information Act. The US Supreme Court rejected the Fed’s attempt to block the disclosure of records related to its discount window operations. The release of this information showed how the Fed made significant loans to overseas banks, that is, banks outside the US currency zone.
At “A View from the Trenches” we have repeatedly discussed the role that these loans, including cross-currency swaps, have in magnifying global leverage. The first to point at cross currency swaps between central banks as a potential transmission channel for global imbalances, was M. Jacques Rueff, who blamed them for the “…long duration of the substantial credit inflation that preceded the 1929 crisis in the United States (our note: under the gold-exchange standard)”. M. Rueff, who was Financial Attachée in the French Embassy in London, made this opinion public for the first time on a letter dated Oct 1st, 1931, to France’s Prime Minister (J. Rueff, “The Monetary Sin of the West”, 1971).
These loans and cross currency swaps are the “leverage of the leverage”, so to speak. With them, other central banks give up their sovereignty and the Fed effectively becomes the world’s lender of last resort. For instance, when the Fed loans US dollars to a German bank, as it did, the European Central Bank can no longer act as lender of last resort, should the German bank default on its obligations with the Fed. But, would this in reality occur? Of course not! If the German bank was not able to repay its US dollar denominated loans, the Fed would simply roll over the liquidity line. This is a very troubling scenario because the Fed in fact expands the supply of US dollars worldwide (global leverage), without any counterbalancing reduction of credit in the US currency zone.
In our view, these “global” discount window operations are the necessary (but not sufficient) step towards the collapse of fiat money. If we are ever going to see the end of fiat money, it will be thanks to global loans from the Fed. Without them, other central banks will always retain their sovereignty and become alternatives to the US dollar. But with them, once the loans are out and a wave of defaults is triggered, the Fed becomes the easy prey for the collective gold longs. This of course, is ironic, because Ron Paul, who wants to end the Fed and is chairman of the House subcommittee overseeing the Fed, will seek to stop such loans and swaps from being offered. We, on the other hand, would follow Napoléon’s advice, when he said: “N’interrompez jamais un ennemi qui est en train de faire une erreur” (Never interrupt an enemy, when he is making a mistake).
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-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.
In our last letter, we wrote that we were finding the market action inconsistent and that we wanted to walk to the sidelines. Well, we wanted, but the market didn’t let us, for we had to get back to stocks and gold, given the strength shown, albeit with less leverage. We were wrong about the move, but not on the view, we think.
As we had mentioned, we were and are concerned about the strength of the Euro, which yesterday made it all the way back to 1.38 USD. At “A view from the Trenches“, back in May 2010, we were the first to say that the Euro crisis was not a solvency, but an institutional crisis, and furthermore, that the survival of the Euro would require flexibility. We have no alternative but to reproduce what we published on May 6th, 2010, just before the bailout package was announced. Back then, this was considered a contrarian view! In hindsight, it still looks ominous:
“…There is a line of reasoning that compares the current sovereign events with the credit events of 2008 (i.e. Bear Stearns, Lehman, refer “European Credit Compass”, UBS, April 30, 2010 report). We could not disagree more. Bear and Lehman were investment banks, funding on a very short-term basis, highly leveraged and were big counterparties in many markets.
Sovereigns on the other hand are not counterparties and the troubled assets, the sovereign debt, have the European Central Bank as counterparty! The fact that the Euro is devaluing on a daily basis shows that this counterparty is working fine, for it is monetizing sovereign debt. Monetizing sovereign debt is the same as paying par on leveraged debt. The ECB, as counterparty, honors the contract and when it does, it adds liquidity. Hence, the excess supply of Euros and its consequent drop in price.
In fact, we should be concerned if the Euro appreciated!!! For this would mean that the ECB, as counterparty, would not be there to pay par on the sovereign debt! That’s why we find comical that some Euro politicians like Mr. Axel Weber openly defend a strong Euro. The survival of the Euro as a currency, ironically, lies on its flexibility to be devalued!…”
Having said this, we want to bring collective attention to the fact that Greece’s sovereign credit default swap ended February 110bps wider, with an inverted term structure (5-yr at 946bps). In light of what we just quoted, this makes perfect sense to us. There is a hawkish message coming out of the ECB, pushing the markets to price in an earlier interest rate hike, while liquidity has been drained from the system. In summary, this has lifted the Euro. But what we want to leave the reader with today is that the Eurozone is in fact weaker because of that. The result of this policy will be the inevitable default or restructuring of peripheral debt, which is why gold, unlike in 2010, is rallying with and not in spite of the stronger Euro. Mark our words here: Should the ECB and the EU council support this trend after the meetings on March 3rd and 11th, without the explicit support of the European Financial Stability Facility, we will see a massive run against the financial system in Greece. Maybe not in 2011, but likely in 2012.
The other concern we have these days is the situation in China (no, not in the Middle East, but because of the Middle East). As country after country in the Middle East brings down its dictatorship and we read that China is using repression against dissent, we wonder how long can the status quo remain there. Should inflation pick up, we think the fall of the status quo in China will be inminent. And then? So far, we can only ask questions, acknowledging that sometimes, the questions asked are more valuable than the answers guessed.
If inflation brought China’s dictatorship down, the manipulation of the fixed exchange system as we know, would no longer be feasible. This means that the accumulation of US Treasuries by the People’s Bank of China would be seriously challenged, bringing about a revaluation of the Yuan. Would that be recessive for China? And if so, would it not impact the real estate bubble in that nation? Would it lift or bring down the price of commodities? Would it be chaotic enough to push gold to obscene highs? Or would the international community have enough foresight to work an orderly exit? Would the existing onshore/offshore financial structure, with Hong Kong as accomplice be a blessing in stopping the contagion to the rest of the world?
Is it too early to ask these questions? If it is, can there be another catalyst that may trigger a civil uprising?
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: february-25-2011
It’s the end of the month and the animal spirits nervously want to take profits on a good February. Before we start today’s letter, we want to clarify our view with respect to the impact of the developments in the Middle East on the price of oil. When we wrote that: “…A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil…” we were clearly speaking of the long-term, on the assumption that chaos is followed by democratic (At least formally) governments. That time is far, far away and right now, we have chaos. But if democracy is established in the Middle East in the 2010’s, just like it was in Latin America in the ‘80s, we expect the OPEC to slowly become irrelevant, as the new political class of those countries desperately depletes any source of cash it can lay its hands on to win votes.
Yesterday, was a day full of inconsistencies, in our view. Gold had been testing the $1,418/oz level by the time the weekly jobless claims print was released at 8:30am. Post the announcement, which was bullish (22k less, to 391k), weakness in gold began. This was the first inconsistency, for a stronger job market means to us, all other things equal, a higher probability of seeing a pick-up in CPI (consumer price index) earlier. Yet, the release must have been interpreted as bullish for stocks and a reallocation trade could have been triggered.
The other nonsense we heard and read was that the S&P/TSX Global Gold Index sold off with oil. This is simply not true. The index opened the session selling off, even with the price of WTI above $99/bl. This weakness in mining stocks was immediately followed by weakness in energy stocks (here, we refer to the S&P TSX 60 Capped Energy Index). It was early in the day and both gold and oil were stable. Yet, their “derivatives” were on the downside. While stocks and credit were deciding which way to go, the confusion was enough to push us out to the sidelines, after a great February. And that proved wise, for the rest is history…
What triggered this sell-off? If anything, the developments out of Libya would suggest a higher price for oil, as we understand that it represents a loss at over 1 to 1.2 million barrels/day. We also don’t think the sell-off would have been driven by a liquidity stress, for nothing of the sort was reflected in the credit or rate markets, in our view. We think the explanation lies in the strength of the Euro.
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.
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: february-22-2011
During the last two weeks, we think that three self-evident macro-themes began to develop. We can even venture to add that these themes may stay with us longer than at this is imaginable. Let us explain…
Theme 1: Capital leaves the Middle East
Since the upheaval in Tunisia and the fall of Mubarak in Egypt, political uncertainty defines the Middle East. It is difficult at this time to speculate on how this will impact the price of oil in the long term but one thing we are sure of: Capital is and will continue to leave the region. We can simply post what seems to us a self-evident axiom: Capital that was funding energy exploration and production in the region will be looking for a safer place, likely in the energy sector in North America. Part of the capital that was in the form of liquid savings will likely be invested in gold. We have been trading this theme profitably since the start of February. On February 7th, we said that :
“…With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions…”
Theme 2: Capital inflows are discouraged by Emerging Markets
At the same time, the monetary experiment of the Fed is causing enormous pain in emerging markets (EMs) where the ruling lobby groups in the export industries had managed to keep the USD pegged. The mandate to keep a stable USD has pushed central banks to expand the money supply in their respective local currencies, triggering inflation. From now on, to avoid a spiraling situation, these markets will seek to discourage capital inflows. They will tax the inflows, cut the credit expansion via higher reserve requirements or simply force exporters to clear their transactions offshore, as is the case in China, favouring Hong Kong. At “A View from the Trenches” we had anticipated this more than a year ago, when on January 21st, 2010, we wrote:
“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”
Therefore, the self-evident theme here is that capital should start flowing back to the developed world. Flows that went to EM stocks should now be redirected to stocks in developed markets. Flows that went to corporate EM bonds/loans, should now be redirected to corporate bonds/loans in developed markets. This, together with the QE2 bid, should provide a strong support, in our view, to the recent rallies we saw in stocks in North America, particularly in the energy sector. A disclosure here: “A View from the Trenches” does not count with the data to back these assumptions. But as we say, they seem self-evident to us.
Theme 3: Inflation can no longer be denied
The last theme is our usual theme: Inflation. On our first letter, on April 14th, 2009 (almost two years ago), we put a chart that very visually explained an inflationary process. We said it was myopic to only believe inflation could be managed tracking a CPI (consumer price index) print. We reproduce the graph below:
Only now, politicians are admitting levels of 3-5% in CPI. This means that real inflation, as they should be measuring is at least 8-10%. This is for sure what we personally witness. This fact and the ongoing disagreements within the G-20 are very supportive of gold and commodities. Patience will be well rewarded.
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: february-16-2011
Perhaps the most relevant factor shaping the action this week is the absence of a significant, market moving event. Investors seem to just be marking time. Every major decision is being postponed by policy makers and the drift higher in stocks is simply following the quantitative easing of central banks. In the US, this easing is explicit. In the rest of the world, it is not.
What decisions are being postponed? Some of them had been put off with anticipation, like the reform of government sponsored mortgages in the USA or the gridlock in the US Congress regarding the budget, or the rate hikes in Canada, to favour a lobby group. Other decisions are more uncertain. The first one, which we have discussed at length in previous letters, is related to the future of the European Financial Stability Facility. The second is the monetary policy of China itself, which of course, is not anticipated to change, but is “fine tuned” in small shocks.
Let’s profit therefore from this relative calm to think of a relevant issue: The unwinding of quantitative easing policies. Why would we want to discuss this issue today? Because there is no doubt in our mind (in fact, there never was, as our very first letter attests) that worse times are to come, shaped by the unfair touch of inflation.
Just as we wrote last week that the idea of a structural aspect to inflation will soon resuscitate, we came across two research notes published by Morgan Stanley’s Global Economics Team (see: “The inflation merry-go round“, of January 26th and February 9th). In these notes, it is suggested that to keep inflation within limits, coordination among central banks is required. The underlying point here is that inflation may be managed. To a certain extent, it may be true. However, when we look at it from a practical point of view, the real solution would be a world where only flexible exchange rate regimes exist. That way, if Helicopter Ben feels like printing $600bn to finance Barak’s social justice agenda, the dollar suffers a violent and swift currency crisis. That, in our view, is the only solution to global inflation, and it is anything but coordination. It’s monetary freedom!
We are not surprised to read this nonsense which, if left to run its own course, will inevitably lead to international summits where a global reserve currency, possibly managed by the IMF, will be debated. We are not only anticipating, but preparing ourselves for it, by being long of gold in our personal account.
The final solution to the problem, we think, will depend on how central banks manage the asset side of their balance sheets. Currently, those which are engaged in the business of “quantitative easing”, are steadily increasing their holdings of sovereign debt. How can they get rid of it without impacting interest rates? We think an innovative approach would be to exchange that sovereign debt for non-financial assets (real estate, infrastructure assets able to collect tolls, etc.) of the respective governments, along the lines of a massive privatization of governments’ assets….only to transfer their ownership to an independent central bank. The second step would be to gradually auction those non-financial assets to the public, withdrawing liquidity in the process.
What would be the advantage of this? First, it would preempt the market from speculating on bond sales or any other exit strategy that would bring higher yields. Secondly, when governments sell their non-financial assets, they simultaneously reduce deficits and improve their credit profile, bringing rates lower. At the same time, as the sovereign debt increases in price, financial institutions that hold it can see a capital gain. Lastly, the later auction of these assets would bring foreign direct investment, strengthening the currency and without crowding out other financial assets.
We recognize this proposal sounds creative, but if central banks were creative boosting their assets, they will need to be creative to reduce them when the time comes. In the meantime, we think any other solution would be suboptimal, with global coordination an impossible.
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: february-11-2011
Just after our last letter on Monday, when we wrote that “…out of China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March…” we were surprised by a 25bps increase. The fact that the increase took place during their holiday was also part of the message. But for the rest of the week, the markets chose to ignore it, with a lot of resilience.
Since our last comments, a few things appear to have changed. As time goes by, it is more apparent that the political situation in the EU is far from being conciliatory. The decision on the proceeds from EFSF funds has not been postponed. Simply, there is no agreement on whether to use them to finance ongoing deficits, to buy back sovereign debt from banks or to buy it from the European Central Bank, let alone on its final size. In the meantime, yesterday we saw that a 5-year bond sold by Portugal on Monday was being tossed off the proverbial cliff in the early hours (it widened from 360 bp to 420 bp), forcing the ECB to intervene.
The other issue that gets murkier by the day is the future of EU bank debt. On February 7th, Morgan Stanley’s Investment Grade Credit team published a note (under “European Banks”) titled: “Senior Debt: The path to all or nothing”, which for obvious reasons we cannot reproduce here, but which we highly recommend. In summary, funding difficulties are the path of least resistance, unless the EFSF funds are wisely put to use.
With all this in mind, one can hardly see a risk to the upside in the markets. However, the markets seem to shrug off any bad news, sell rates and support commodities. Jobless claims in the US continue their downward trend and all signs point to a “recovery”.
Should we be bearish or bullish? Neither, we think, is the answer. In our view, we are in a context, globally, of “passive money”. We wrote about this idea on Nov. 1st, 2010, when we said:
“Nobody seems yet to be aware of the “dynamic” nature of the problem. As we wrote before, macroeconomic theory should not be about real income determination, but about coordination. We are not concerned with determining how many bps the 10-yr Treasury yield will tighten if $100BN rather than $500BN are purchased by the Fed. What concerns us is that the market will progressively adapt to the new “rate of money supply”.
The developed world is still not used to the idea of “passive money”. Passive money is a relatively foreign concept to most contemporary economists, but its research began as a consequence of the problems Latin America faced in the ‘60s and ‘70s, when monetary policy turned accommodative, responsive to the unemployment rate. The concept of passive money was, in our view, the foundation to what was later called the “structural” explanation of inflation or the notion of “structural inflation”…(…)…We think the review of this concept is worth understanding, because we have no reason to doubt the Fed is taking the path of passive money (i.e. labour standard) and other central banks will have to soon follow. Gold, therefore, is bound to go higher…”
If, as we advised back in November, you reviewed and understood this concept, it will be clear that no matter how Ben Bernanke spins it, we are only seeing the beginning of the inflation story. Much has been and is being said on “food inflation”, being blamed upon demographics, weather, income differentials between the developed and emerging markets, etc. It will not be long until brilliant mainstream economists begin attaching the adjective “structural” to the noun “inflation” and price controls pop up everywhere. But it will be increasingly clear that the only structural thing is that central banks will be financing structural fiscal deficits.
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: february-7-2011
We start this week with what we ended the last one. In our view, the two main concerns or sources of volatility that remain from last week are the situation in Egypt and the uncertainty over the future scope of the EU’s European Financial Stability Facility (EFSF). The picture out of the US or the UK is decidedly one of inflation, monetary expansion with all the known consequences. Out of China, we expect no news on rates or credit manipulation (i.e. reserve requirement ratios) until March (the PBoC recently conducted Rmb300 bn of reverse repos).
With regards to the political situation out of Egypt, we know as much as anyone else: Nothing! But here’s what we think, and which we understand may not be shared by many: A shift towards democracy in Egypt and the rest of the Middle East is bearish for oil. Regardless of who inherits power in the area, the new political class will need revenue to appease public employees and the people in general. Without the ability to coerce, the new leaders will need to buy peace and will not care a whit about the origin of their much needed funding. This means that the OPEC will slowly become irrelevant, as member countries need to place their produce with urgency, at any price. Along this same rationale, we should not worry about the Suez Canal. Every ruling party in Egypt needs it open to profit from the toll.
So far, we are at the very early stages of a more general transition in the Middle East. On this basis, we preferred not to trade last week’s increase in the price of oil. Instead, we chose to be net long of Canadian energy stocks, with the belief that capital within the energy sector will leave the Middle East, looking for safer jurisdictions.
We now want to turn the readers’ collective attention back to the European Union. If you’ve been following us, you will know by now that we have been bullish of the Euro. During the past week, uncertainty grew around the final shape that the EU will give to the EFSF. On Wednesday, Bloomberg reported that “Germans” were ruling out bond buybacks. This was a scenario that we had analyzed in detail in past letters and it was a scenario that made a lot of sense to us. Upon seeing this title, which unfortunately moved markets, we thoroughly read the article and found that the title had been horribly misleading. In the end, the EU leaders met on Friday only to postpone any fundamental decision around the EFSF, until March.
However, we understand that some speculate that the EFSF could buy sovereign debt currently being held by the European Central Bank (ECB). We really ignore what the final decision will be but warn readers that such a scenario (EFSF sourcing sov debt from the ECB) is different from the one we analyzed two letters ago. In fact, the outcome would be radically opposite to what we expect, if the EFSF bought sovereign debt from EU banks. Here’s why, in summary:
To buy sovereign debt, the EFSF must raise funds, Euros, in the market. This takes liquidity from the financial system. If the liquidity is then used to buy assets (i.e. sov bonds) from the ECB, these Euros will be taken out of circulation (i.e. assets and liabilities of the ECB will decrease). Therefore, not only will the EU witness a crowding out of private in favor of public credit. On top of it, the amounts of Euros in circulation will drop, raising rates. This would not occur if the EFSF bought the sov bonds from the EU banks (see our letter of Jan 28th). Under both scenarios, the Euro strengthens. However, if liquidity drops because the ECB sells its bonds, the exercise is recessive, affecting the profitability of banks and the competitiveness of those countries the EFSF was set up to help. Should this occur, we think the possibilities of a successful monetary union in the EU would be seriously challenged, and we would use the initial strength in the Euro to quietly shift to a very liquid USD denominated portfolio. Remember that EU sovereign credit default swaps are denominated in USDs…
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: february-2-2011
Some quick comments for the mid-week, following up on our thesis that should the EFSF be used to purchase outstanding sovereign peripheral debt, the Euro would strengthen and possibly steal market share to gold within the reserve currency market.
To begin with, in the past 48hrs, this scenario has been gaining weight with the consensus expecting a resolution on this in March. The common sense question, a question we’ve been approached by readers is whether the scenario is already priced in. We think there is still room for this view to crystallize, taking the Euro over the $1.40 level and bank credit spreads materially tighter. The obvious risk here is that the banking sector may not heal if Euro politicians overshoot on their wish to effectively convert banks’ senior bondholders into contributors contingent capital. But…how can they not overshoot? The mere suggestion of this folly is enough to hurt. The other risk is that a stronger Euro and continuous fiscal cost-cutting affect aggregate demand, questioning the sustainability of the status quo (= the avoidance of a restructuring). But we want to leave you with this: Regardless of what takes place, the ECB is by far way more capable of handling this mess than the Fed is, simply because the European Central Bank has not used any ammunition yet. Until now, they have been sterilizing their purchases of sovereign debt. Remember, this is a beauty contest and all they need is to just look a little bit better than the competition.
With regards to the exposition we gave in our last letter, we received questions from readers asking if we assumed that the EFSF would purchase government debt at par or at market prices. We think at neither. By definition, if market prices were “clearing prices” that excess supply of debt would not be sitting on the asset side of the banks’ balance sheets. For consistency, if the ECB currently applies haircuts to the debt, the EFSF will also not pay par. The uncertainty around pricing, as well as quantity and source is what is delaying, in our view, this transaction.
Now, in our last letter too, we concluded that if the Euro strengthened, it would only be natural to see gold weaken. Since yesterday, after the announcement that the ISM’s factory index last month rose to 60.8 (the fastest pace in more than six years), the negative correlation between the Euro and gold broke, as the chart below shows (source: Bloomberg; price of gold in $/oz on white line), and both rallied. This was a very bullish signal and we took due note. Does this mean that the competition between the two candidates for the world’s reserve currency will disappear? We don’t think so. This is just a truce. Problems are being postponed. In the meantime, carpe diem! Enjoy the ride. (Lastly, we have not dealt with the situation in the Middle East, but we will write our thoughts on it later. So far, we faded the rally in oil and instead traded the view that on the margin, capital will leave the energy sector in the Middle East for a safer place in Canada. To date, the market is telling us we were right 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: january-28-2011
We were as surprised as many others when the lows of $1325/oz were taken yesterday and gold made it all the way down to $1,310/oz, after the previous post-FOMC rally. We were the more surprised to see this drop without major movements in rates or anything else that would have explained the “testing” of the gold-as-reserve-currency thesis.
So…what was that? We began our last letter saying that “…we think that the lower commodity prices we are testing this week are driven by the developments in Europe…”. We will try to explain ourselves better this time. Since last year, but specifically since early January of 2011, politicians and central bankers in the European Union have been hinting at the possibility of using the funds raised by the European Financial Stability Facility to repurchase outstanding sovereign debt of peripheral EU governments, rather than to finance such governments’ deficits.
Today, we want to examine what this repurchase transaction means in terms of macroeconomic variables, but we anticipate the following: A higher Euro, possibly a lower price of gold and a higher valuation in Euro bank stocks. There are many risks to this view, but we believe that the mere possibility of this transaction can move markets. In fact, we think that the late weakness in gold, strength in Euro and Euro bank stocks is driven by this speculation. Let’s see why:
In the figure below, we show the aggregate balance sheet of EU peripheral governments (“EU Sovs”), the European Central Bank (“ECB”), Euro-zone banks (“EU Banks”) and the European Financial Stability Facility, a special-purpose vehicle (“EFSF”) that issues Aaa/AAA debt guaranteed collectively by all the EU-zone members:
In step 1 above, the EFSF issues EFSF bonds, at a yield lower than that at which the EU sovs would be able to. The EFSF increases its liabilities in exchange of Euros, provided by the EU Banks. The EU Banks keep the EFSF bonds as assets. In step 2, the EFSF uses the Euros to purchase Sov Bonds held as assets by the EU banks. In the end, as shown on step 3, the EFSF holds Sov bonds as assets, matched by EFSF Bonds. The EU Banks effectively exchanged Sov Bonds for EFSF bonds, of higher rating, at no cost. They keep the same amount of Euros they had before the exercise. Therefore, the EU Banks have had a capital gain. Do we think that this is what has been driving the outperformance of Euro bank stocks lately? Interestingly enough, the MSCI Europe Financials Sector Index Fund (ticker: EUFN) has risen on significant volume since January 10th, when the possibility of carrying out sov debt purchases with the EFSF began to be taken seriously. Below, we show the corresponding chart (source: Bloomberg):
Was this a coincidence on the back of “good earnings”? How would EU leaders, who take pleasure in blaming greedy bankers for this crisis, explain this transfer of wealth, from the EU taxpayers to the EU Banks shareholders?
But this is not all. As the EFSF buys this outstanding debt, if the purchases surpass the 2011 net issuance of EU sovs, the supply of EU sov bonds falls, and their price rises. This is a virtuous cycle through which EU sovs are able to raise funds at lower yields, the debt remaining in the asset side of the EU banks’ balance sheets appreciates and the EFSF vehicle produces a capital gain (the value of the assets, EU sov bonds increases, while their liabilities remain unchanged):
Now, as you can see from steps 1 to 3 above, until here, the European Central Bank has not been involved, which means that their options are open….Open to what?, you may ask…
As we explained on May 13th of 2010, since the European Central Bank got itself fully involved in the bailout of peripherals, it has been buying and holding EU sov bonds (EUR77BN at Jan 26th) and sterilizing these purchases via the so-called Securities Market Program.
Now, the virtuous cycle by which EU sov bonds rise in value also affects the balance sheet of the ECB, producing a capital gain. As the supply of EU sov bonds in circulation decreases with the EFSF purchases, the ECB can, but may choose not to, sell back the EU sov bonds it had bought to the banks, returning their supply to the previous “equilibrium” amount:
As we show in step 4 below, if the ECB did sell the EU sov bonds it holds, the respective amount of Euros raised by the sale would be taken out of circulation (i.e. there would be a decrease in the liabilities of the ECB):
Why would the ECB want to sell back to the market the sovereign debt it bought? Simply put, to fight upcoming inflation. If they could “pull this one”, they would be simultaneously avoiding the default of EU peripheral debt, decreasing the yields the EU zone pays, strengthening their financial system and stabilizing prices.
Now, if this scenario took place and the Euro strengthened, on the margin, the demand for gold as an alternative reserve asset would necessarily have to fall. Have we not exactly seen a drop in gold with the strengthening of the Euro, also since January 10th? The chart below (source: Bloomberg, Euro shown in orange, gold in white) shows our point. It also shows how in the summer of 2010 too, when the ECB proved the solvency of the EU financial system, gold suffered a major correction. This would explain why gold in January has been falling without major increases in yields:
How sure are we that the scenario we just described can take place? We are not, but we are inclined to believe that it may happen. It has its costs though, for as the Euro strengthens, the competitiveness of the Euro zone falls in the short-term, affecting employment both in core Europe, which will have to pay the bill, and in peripheral Europe, where cost cutting will have to continue, to rein fiscal deficits. Remember that this is only provisory, for as step 5 shows below, in the end, the Euro banks end up holding both EU sov bonds and EFSF bonds. If the risk of these is seen to increase as the Euro strengthens, the ECB will be under a lot of political pressure.
Are we too late to trade this thesis? We don’t think so, because investors in EU bank bonds still see a relevant political risk in the conversion of senior debt to contingent capital. This explains why credit spreads in EU financials have only tightened little, underperforming stocks. But once clarity is gained on this issue and on a positive note, the trade (long Euro, long EU banks stocks/credit, short gold) could find another leg upwards.
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.
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