Please, click here to read this article in pdf format: january-26-2011
This is a week during which the global markets’ tectonic plates are shifting, and the shift is not too quiet. Our letter today will sound more like a monologue rather than a well laid-out explanation of what we think is occurring. The reason is simple: We are uncertain. We can however throw a few suggestions to understand the recent and potentially future action.
To begin, we think that the lower commodity prices we are testing this week are driven by the developments in Europe, rather than in the USA or China. Here, we see ourselves far from the common view that blames profit-taking or the possibility of higher rates in China for the drop in prices. We were one of the first to suggest, back in November 24th and 29th that the European Union’s efforts were being underestimated, while the US slept on the cushion provided by the new deficit monetization program of $600BN. Precisely yesterday, two months later, an event of historical proportions took place: The first truly “European” bond issuance was born under the European Financial Stability Facility (EFSF). Take a look (you may also save the image. Perhaps one day it will be of historical interest. Source: Bloomberg):
Here are a few comments: With this 5-yr EUR5BN bond at a 2.75% coupon, sovereign EU peripheral credit default swaps traded wider, and we understand that investors have shifted away from EU sovereign risk to EU corporate. We also understand that regardless of this reaction, and even in light of the horrible GDP release in the UK, more than EUR45BN were chasing this auction, with approximately 38% of the demand coming from Asia. Coincidentally yesterday, the US Treasury was scheduled to auction $35bn in 5s. The bid-cover ratio for US treasuries had been declining, with foreign investor allocation falling from 36% in the Sep/10 to 15% in December. But with the positive expectations set on fiscal policy (i.e. State of the Union speech), the was awarded at 0.650%, with no surprises.
Now, as a friend wrote to us today, it is clear that the Fed is not buying Treasuries to keep rates low long enough to sustain a recovery in the US private sector. That recovery is already taking place in spite of the Fed. The Fed is simply financing the US fiscal deficit. Yesterday’s EFSF issuance was guaranteed on a pro-rata basis by the EU members, but the demand came from the private sector and if the European Central Bank buys sovereign debt, it sterilizes it. In other words, in Europe, after a year, we are faced with a central bank subsidizing the financial sector with liquidity lines. But governments are slowly cutting spending and have proved that they have access to the markets. The problem with the EU, as we pointed out, was institutional. Yesterday’s issuance was an “institutional” innovation may allow Greece, whose debt is rated as junk, to avoid default. The missing piece for the EU now is to prove investors that during this year, EU periphery banks will be able to survive without liquidity lines. If they do so, the EUR should trade towards $1.50, all else equal, in our view.
If the Euro strengthens, that void that had been filled by gold as a reserve of value, will shrink. As the Euro strengthens too, relative prices within the EU will have to adjust, slowing activity temporarily, for core Europe will be saving for the periphery. That, all else equal, should temporarily affect the bull run in commodities. But if we are correct, how can we explain gold falling in value in USD terms? We can see it happening in Euros, but why does it also happen in USD?
When we say “all else equal”, we assume a state of affairs where China survives another year without addressing its imbalances, that the US shows (although painfully) to the world that it is serious about its fiscal deficit and that the municipal debt space is not challenged.
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-21-20111
We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key assumptions for 2011 that we presented in our last letter are weak at best…Well….think again.
Has anything happened this week that may challenge the assumption of further consolidation in Europe? No. In fact, we have heard and read many times about Spain’s resolution to inject more capital to its savings banks (i.e. “cajas”) and Ireland may end up paying a lower interest rate on the bailout fund. In the US, the weekly jobless claims data showed that at least, they did not increase. Anecdotally also, the S&P National AMT-Free Municipal Bond Index has withstood the sell-off in risk. Existing home sales data also surprised with a stronger than expected rise. The Philly Fed manufacturing survey remained strong, and leading economic also provided positive news. However too, a weak TIPS auction shadowed the UST market.
Ah, but of course, it seems that the main concern comes from China. Apparently, given the last release of activity data, China is growing even in the face of incipient inflation (officially gauged at around 5%) and investors fear that an interest rate increase is on the works…Who spread this rumor? Why was it spread coincidentally with China’s Jintao visit to the US? We have no idea. Has China not been increasing interest rates unsuccessfully? Yes, they have. Has China not just manipulated the cost of capital (i.e. rates) but also its quantity via increases in the reserve ratio requirements (RRR)? Yes, they have.
Any basic textbook of macroeconomics will teach us that when a country decides to fix the value of its currency, it loses control over interest rates. At least the “real” interest rates…The same applies to credit controls. History shows they have always, always failed. Why would China ignore these facts? Because they have nothing to lose with trying. Because they seek to delay the inevitable. However, today we want to show that these manipulations can actually have the opposite effect, if they are abused. For instance, let’s take their policy of increasing RRR to the extreme. Below, we show the balance sheets of the People’s Bank of China (PBOC) and the Yuan banking system, in a very stylized way. On the asset side of the PBOC’s balance sheet, we find mostly US Treasuries backing the Yuan. On the liabilities’ side, banks’ reserves. On the asset side of the banks’ balance sheet, we find reserves and interest-bearing assets (loans). On the liabilities’ side, deposits and their net worth.
We have divided the process of taking the reserves requirement ratio to 100%, in three stages. In the second one we can see that as loans mature, their net issuance decreases, to boost reserves. We assume here that the process is neutral: Higher funding costs have no effect on defaults and the banks’ aggregate net worth does not need to change. The overall impact is simply a change in the composition of the banks’ asset side of their balance sheet.
As aggregate leverage decreases to the extreme, as we can see in stage 3, the PBOC is simply left with US sovereign debt fully backing reserves. Effectively, all deposits have been invested in these securities. The financial savings of the Chinese people have been coercively “loaned” to the US sovereign. With this extreme example, you start to realize the folly of this monetary policy.
Implicitly, once leverage is taken out of the picture, the PBOC is irrelevant. Legally, it continues to serve as a lender of last resort, but China is left entirely at the mercy of the US Treasury. As the US approaches default, the value of its debt will collapse…and so will the value of the deposits of Chinese citizens! The irony here is that a run against China’s financial system would not be triggered by an internal development. Nevertheless, if the PBOC had to bail out a financial institution in this context (by extending loans and/or decreasing reserve requirements), the increase in money supply would be felt much more than if there was leverage. For on the margin, the new quantity of Yuan being printed by the PBOC would truly stand out.
Therefore, the Yuan would depreciate and it would do so at the worst time, exactly when the world would need a strong reserve currency. The contagion from the US to the rest of the world would be widespread and more violently than necessary.
How would the rest of the world sort this out? Gold would have to fill the void, which is why the recent weakness represents an opportunity to 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: january-17-2011
After almost a month, the most part of which we spent traveling in Argentina, we resume our publication with the first letter of 2011. A few weeks into the year and we don’t see but the continuation of themes we singled out at the end of 2010.
More than a month ago, on December 14th, we wrote that: “…given the latest increase in yields, as of last week, we have in our personal portfolio moved a bit away from commodities, in favour of US stocks. Do we think that the rally in commodities is overdone? No, we simply think that (and specially in the case of gold) the macro situation, which includes the unstable inflation picture out of China, points towards a bit of caution in owning gold, which may underperform relative to US stocks. However, as the fiscal view in the US deteriorates in 2011, we believe that the rise in yields that began post QE2 announcement will crystallize into a more clearer run against the sovereign and its currency. That will be the time when we will add to gold aggressively. But that time lies in the future…”. In hindsight, we were right to shift away from gold into US stocks (long 2x Nasdaq, more specifically) and in early January, we decided to further reduce our position in gold (do less of that which doesn’t work, to do more of that which does!).
To the risk of sounding like a broken record, we will repeat the 2010 themes that we think will further develop this year:
-Further consolidation of the European Union:
In 2010, we were the first to openly say that the EU’s problem was of an institutional nature (see: “An institutional perspective on the Euro”, February 10th, 2010). While everyone discussed Greece’s weakness in terms of solvency, we challenged the mainstream view with our perspective. Nowadays, everyone on the street is discussing the federalization of Europe.
On this point too, on November 24th, we changed our view. Until then, we had thought that Germany’s leadership would not be able to stand fully behind the EU. But on the 23rd, we had happened to read a Bloomberg report that had taken Ms. Merkel out of context. Ms. Merkel had been reported saying that the situation (i.e. of EU) was “extraordinarily serious” and the market began to sell the Euro, in full herd-like behaviour. As we happen to speak German and were surprised by the herd reaction, we went to the source (video link below) and concluded that for an unknown reason, Ms. Merkel’s speech had been fully misinterpreted. That was when we changed our view on the Euro, from bearish to neutral, for it became clear to us then, that Germany would move the EU in full force away from dissolution towards a proto-federal framework. We offer here again the speech (summarized) that changed our view: Click here
Where does this leave us? The European Central Bank has been buying and will continue to buy sovereign debt. But unlike the Fed, the ECB has not yet monetized it. Until now, that debt has been sterilized by issuing ECB debt, driving Euro liquidity rates higher than USD ones, thereby contributing to put a floor to the Euro (for an explanation of this process, see our letter of May 13th and December 2nd ) . In other words, the ECB still has a lot of firepower to save the monetary union and although they are now showing themselves as anti-inflationary, a good sell-off of sovereign or Euro-bank debt will change their minds quickly. In the meantime, the clock will be ticking for the Fed, which brings us to our next point:
-Further deterioration of US risk:
It is now very clear that after the extension of tax cuts in December, the US has not done anything yet to address its fiscal situation (see: “Europe is proving it…what about the US?”, November 29th, 2010). The tipping point on this issue, we think will prove to be a wave of failed auctions in municipal/state debt. This is beginning to show its ugly head, as we saw last week with the debt auction of the Port Authority of New York and New Jersey. Everybody in Wall Street will tell you this is not a serious problem. Everybody will downplay it. We understand why. What we have trouble understanding is how the only ETF we know to short municipal debt is actually “down”, in the last month!!! (ticker: NYSE:SMB) If any reader understands it, please, we welcome your feedback.
Now, as we wrote on December 6th: “…We think that monetizing state or municipal debt would be counterproductive for the Fed, because the market would realize that the issuers all depend on the same purchaser, and the market would level down, following the proverbial path of least resistance. The reasoning would be this: Muni debt, just like Federal debt, depends on the Fed = Muni investors leave and those in the Treasury market trigger an arbitrage, whereby they seek higher yield for the same risk. Therefore, the yields in Treasuries and Munis would converge (i.e. higher Treasury yields), forcing the Fed to buy even more Treasuries (i.e. QE3). This would all create more inflation, hurting municipal and state revenue in the process, as the stagflation grows…”
This outlook make us think gold is still to make higher highs in 2011 in spite of the temporary pullback we’re seeing now. Would this be consistent with higher stock prices? Yes, as long as a true sovereign crisis does not unfold. Such crisis is not our base case.
-Further price controls in China:
We think that China will continue to sustain its peg to the USD by enforcing even stricter price/quantity controls. This is a key assumption, for it means that the US Treasury market, particularly if the US shows at least a weak recovery, will keep a buyer. Will reserve requirements keep increasing? They will. Will credit controls pop out of nowhere? They will. Will the Chinese people seek to invest in gold or any other asset that serves them as an escape valve? They will. Please, note that we do not say this situation is sustainable. We just say it can remain another year without being solved.
What does this all mean?
If the three key assumptions play out, in 2011 we should see high volatility but higher stock prices worldwide, the Euro not making lower lows (i.e. not falling below 1.18USD), higher commodity prices and higher CAD/AUD/NZD dollars, higher interest rates, slow growth and steady unemployment.
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 have followed and continue to follow with utmost interest the political career of US Congressman Ron Paul. We sympathize with Mr. Paul’s cause for sound money, but he and his political life reminds us of Cicero in the face of Rome’s final days as a Republic. Mr. Paul may be remembered by historians of the United States, just as Cicero is remembered by historians of Rome. There is however a small but relevant difference between Cicero and Congressman Paul: Cicero took sides. Cicero, in the end, sided with Octavivs. Yes, Octavivs betrayed Cicero, but Cicero, also saw that neutrality was a sterile path.
Congressman Paul is not taking sides. Having been repeatedly asked lately what his plan is as the new chairman of the Financial Services Subcommittee on Domestic Monetary Policy, with Congressional oversight of the Federal Reserve, Mr. Paul replied that he would simply seek to allow gold or any other asset to compete as legal tender with the US dollar (in addition to audit the Fed, that is). We understand the noble intention behind this, but we can’t support it. We have no idea as to what the real chance is for this innocent proposition to be enacted. But we can say that this plan will only have the unintended consequence of creating unnecessary discredit to the Austrian economics tradition. Why? Because it is no plan! No, we are not advocating to plan monetary policy. That is also very un-Austrian. We are simply noting that to “end the Fed”, a plan is required.
A simple example (among many others that this short space doesn’t allow us to elaborate on) should help visualize our point. If gold has a chance as an alternative asset, in simultaneous competition with the US dollar, it will only be natural that we witness once more Gresham’s law at play. Gresham’s law, simply put, states that bad money displaces good money out of circulation. In a leveraged system like the one we live in, this means that market participants would arbitrage the system. They would simply borrow in US dollars and save in gold . To some degree, this is starting to slowly occur, but today the speed of this change is driven by the deterioration of the paper money, not by the quality of gold as legal tender. However, if gold was allowed to compete, this process would take place faster. This would quickly lead to the bankruptcy of the entire financial system, as we know it , for the cost of borrowing would increase exponentially, in real terms (i.e. in gold). But, if Mr. Paul does not end the Fed, as long as this institution survives, it will be forced to provide liquidity to the financial institutions, creating hyperinflation along the way.
What is the problem with hyperinflation? That those who still earned wages in paper money would see their income (and possibly their wealth too) destroyed. Please, note the following:
1.-Fiscal deficits, as long as the government does not bail out banks, would have NOTHING to do with this hyperinflation Mr. Paul’s plan would bring.
2.-The Fed would create hyperinflation by providing liquidity, not bailing out banks as in 2008, when it bought defaulted liabilities. In fact, as inflation spikes, it would be extraordinary to see defaults in paper money (i.e. bad loans), for the cost of paying off US denominated debts would decrease along with the higher rate of inflation
The only way to prevent hyperinflation would be to create fiscal surpluses and use them to buy gold to back the US dollar, for the Fed to be able to compete against gold-backed notes. Now, if you think the public and the financial lobby would allow monetary developments to get to this stage, you really are an optimistic in life. In the process, Mr. Paul and the rest of the Austrian movement would be blamed for creating inflation and making the poor poorer.
Given the impossibility to save the Fed, the next stage, which would see the Tea Party ousted from Congress for decades, would be to unwind the Fed. And the United States would have a multitude of unregulated banks issuing gold-backed notes, lending more than they have in deposit. It would only be a matter of time, until the next Ponzi scheme is uncovered and by then, given the absence of a lender of last resort, the public would seek to solve the problem with regulation. Someone would remind Americans of the good old times when there was a lender of last resort and the United States was the global power, and we would see central banking back in place.
We can’t let that happen, Mr. Paul. We need a plan to unwind the Fed without creating hyperinflation. The good news is that it is technically possible.
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.
This is our last letter of the year. Briefly, we want to go over the main themes that we leave with:
To have structure, we will classify the themes according to their respective currency zones. Starting with the US, we must say we’re impressed by the level of optimism expressed in the many research notes we’ve read in the past week. The outlook for 2011 is too good and shared by too many, which is a recipe for deception. Most of it is based on the fact that from a fundamental perspective, 2011 will “suffer” from a negative net issuance in almost every credit/fixed income class, exacerbated by the Fed’s announced purchase of $600BN in Treasuries. This shortage in net issuance is to us the main theme, the basis of an expected asset reflation trade. Do we agree with this view? No! This view is not dynamic. This view assumes market participants will be comfortable once the negative net issuance is over and we enter 2012. This could never occur, because once the force behind the reflation weakens, the pain will be even less tolerable and a new source of price inflation will be sought.
For the European Monetary Union, next year will be quite the test. We differ with those who see indecision in European politicians to take the next step towards a fiscal union. But we fear more the idiocy or lack of understanding by politicians, of certain economic fundamentals. To tell sovereign debt investors they will be subordinated to supranational debt (i.e. European Financial Stability Facility), to threaten those they call speculators but provide liquidity to the market, will only take the pricing of future badly needed issuances to unsustainable levels, seriously jeopardizing any chance of survival.
In the meantime, in 2011, we think the UK will keep playing its Keynesian game of debasing real wages (i.e. inflation) and cutting fiscal spending, as long as investors allow it. The UK has an enviable sovereign debt maturity profile (i.e. long-term skewed), where the benefits of a small inflation surpass the political costs of frugality….for now…
We see China’s oligarchy further condemning the masses to coerced saving, by increasing the segmentation of its capital markets. Hong Kong will profit, while mainland Chinese labour will foot the bill, continuing to work at suppressed wages for the party to continue in the West. How do you segment capital markets? You disrupt the credit multiplier raising the reserve requirement ratios, forcing exporters to clear payments in Hong Kong, taxing capital inflows, raising the exit costs for foreign capital. All in the name of a pegged Yuan. Can this last another year? We think it can.
Finally, Emerging markets and the “other dollars” will walk the tight rope, as they try to keep their economies open and at the same time, seek to prevent the import of inflation from Helicopter Ben. This, as David Hume back in 1752 wrote, is futile. It’s a losing proposition. In the case of Canada, we would not be surprised if the Bank of Canada abuses its repurchase agreements or the if Canadian Home Mortgage Corp., on behalf of the export lobby, injects liquidity in the market by repurchasing mortgages. All this to keep the Canadian dollar from going beyond parity. It will be sad, but it will happen.
We want to thank everyone for accompanying us on our second year and wish you all a great 2011!
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: december-17-2010
This week we have been a bit confused with the market action. Although we believe that the recent increase in yields is due to higher output expectations, which drive a reallocation in portfolios out of fixed income and into equities (i.e. expected to provide higher returns adjusted for risk), we think that the recent price action has not been so clear to prove us right.
As the charts below show (source: Bloomberg, five last), the downward trend in the long-end (30-yr) is clear. However, that was not the case for the S&P500 in the past five trading sessions.
Gold and commodities also plunged this week (charts not shown). What is this telling us? Most have suggested this drop was caused by a stronger US dollar. Are we seeing the glass half empty here? The Euro, in spite of all the bad news out of Ireland and Spain (ratings outlook reviewed by Moody’s) has not moved below 1.32. The Canadian dollar, in spite of all the weakness in commodities, has only been trading around parity with the USD. Where is the USD strength, we ask?
On August 18th, we wrote the following:
“…those who still see a double dip in the horizon base their forecast on a double dip in the US housing market. Yet, when stocks rise, the resources and materials sector seem to lead and most monetary policy is specifically addressed towards the housing market. Why not base the double dip on a sovereign crisis in the US? Did the government not assume private sector’s liabilities last year? And if indeed the double dip is finally triggered by a sovereign crisis, why not bet on the sure thing? Why bet on precious metals rather than short Treasuries? The collapse of the Treasuries market looks more certain than the rise in the price of gold. The collapse of Treasuries will precede and fuel the rally in gold and gold shall only rally if it rallies against all currencies, we think. But first, capital must flee from government debt and only then, among other alternatives, it can choose to go to gold…“
The market action we have seen so far, sort of fits with the above prediction. Sort of, because stocks and the Euro have been trading within a range…Will this continue? Was this simply the effect of illiquidity close to Christmas? Was it profit taking?
We note that, if following the price action vs. the prediction above, we concluded that we are at the initial stages of a sovereign (i.e. US) and currency crisis, we would be using inductive reasoning…and we despise induction at “A View from the Trenches”. Therefore, we still stick to the portfolio reallocation theory, until we see evidence of stocks and oil falling out of their respective recent trading bands.
However, the US hasn’t even drafted a plan to seriously cut its fiscal deficit, while at the same time keeps doing everything possible to scare capital out of its borders. Latest data show a relevant outflow of foreign money from municipal and federal US debt (refer: Bank of America’s “Situation Room” report, December 15th, 2010).
In the meantime, as we pointed out on November 29th, Europe is taking slow but steady steps to consolidate its monetary union…
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:december-14-2010
We think a quick recap of the market action in the last days is warranted today. On November 29th, we made the point that the European Union was showing willingness, commitment to overcome their structural (i.e. institutional) weaknesses as well as fiscal imbalances. We added that the US, in comparison, had done nothing to address its internal and escalating problems.
Later, on December 2nd, we pointed at some “signs” that were telling us a developing story: a Euribor-OIS spread that had not exploded even in the face of Ireland’s stress, strength in the price of oil, activity and prices picking up in the US. So far, the Euro has gained about 4 cents vs. the USD, since we wrote on November 29th, oil has risen another $10/bbl and a rally in risky assets, though not too strong, has unfolded, rising yields. This rise in yields moved us to discuss in our last letter, whether a stronger US dollar was conceivable. We didn’t think so…
However, given the latest increase in yields, as of last week, we have in our personal portfolio moved a bit away from commodities, in favour of US stocks. Do we think that the rally in commodities is overdone? No, we simply think that (and specially in the case of gold) the macro situation, which includes the unstable inflation picture out of China, points towards a bit of caution in owning gold, which may underperform relative to US stocks. However, as the fiscal view in the US deteriorates in 2011, we believe that the rise in yields that began post QE2 announcement will crystallize into a more clearer run against the sovereign and its currency. That will be the time when we will add to gold aggressively. But that time lies in the future.
Now, as we approach the end of the year, we expect activity to wind down. However, there are certain themes that will continue to gravitate, themes that like a drifting iceberg, look not so big at first sight, but hide a lot under the water. They will definitely be a source of volatility in 2011 and we must be ready to understand their implications. Today, we will single out a few, situated in different geographies, but all political in nature.
Starting with the US, we are concerned about the latest publicity Congressman Ron Paul is gaining on his recent appointment to chair the House Domestic Monetary Policy Subcommittee, overseeing the Fed. As we wrote before, Mr. Paul has not disclosed any alternative to the Fed and has so far only advocated freedom for gold to compete with the US dollar. All this rhetoric against fiat money will end up firing back, we fear, if the only celebrity politician the Austrian school has, does not profit from this unique opportunity to lay out a credible plan for “the way out”. Why would this be one of the themes of 2011? Because it will impact the degree of liberty the Fed will have, as 2011 progresses and the fiscal collapse of the US is exposed naked.
The counterparty to this US theme is the inflation theme in China. It is nothing else but “the other side of the same coin”. It is also political in nature, because something that could have naturally been resolved following a simple macroeconomics textbook is artificially prolonged by a political class seeking to keep a status quo based on a horrible savings rate coerced upon the Chinese working class. The volatility caused by this theme will continue to be expressed in the uncertainty regarding interest rates and credit supply disruptions (i.e. higher reserve requirements) in the Chinese market, affecting commodities.
Another 2011 theme will be the institutionalization of a proto federal structure within the European Union, supporting a unified debt market. We think the EU may end up surprising too many here in 2011. Will there be other runs against peripheral debt and banks? Of course, and it will be exactly those runs that will ensure, in our view, a cohesion to force the next step for the Union.
Lastly, in Canada, we have missed a great opportunity in the past two years to become a leading financial hub. We have also done nothing to ensure a stronger economic growth and everything to facilitate a future deleveraging crisis. The Bank of Canada is to blame here, with its irresponsible lax policy towards credit and currency. It is sad to read how Governor Carney yesterday warned Canadians of their high debt levels, which he himself misled them to take. It reminds us of that scene in the Devil’s Advocate, when Al Pacino, the Devil, tells us how God sets the rules in opposition:…”Look, but don’t touch! Touch, but don’t taste! Taste, but don’t swallow!”. Mr. Carney tells us the same: Have low rates, but don’t get into a lot of debt! If you get into debt, don’t use it to consume! But if you have to consume, do so with caution!…It would be funny, if it wasn’t sad…
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: december-10-2010
This wasn’t a good week for us. We began it in bed, sick, trying at the same time to figure out what was happening in the markets, caught in the midst of a sell-off in Treasuries and stronger US dollar. But, could we be heading towards a stronger USD?
To begin, let’s say that the USD action was triggered by the possibility of seeing the Bush tax cuts extended. There are no details yet but some have ventured to quantify the cost of this by US$200-300bn in increased fiscal deficit in 2011 (refer: “New US fiscal plan rattles the bond market”, Bank of America’s Rates Research, December 8th, 2010) . Loyal to our Austrian school approach, we have no idea nor are interested in venturing what the actual cost will be either in absolute or relative (i.e. % of GDP) terms. As good Austrians, we don’t care about the determination of balances, but about coordination, speculation, also known as human action.
On that note, we understand that all else equal, there will be a higher need by the US government to access the capital markets to finance the revenue that could be collected, if the tax cuts are not extended. We will assume, to be in line with the market’s expectation, that the tax cuts will finally be extended.
Over the past days we have heard and read all sorts of comments on the implications of this. Vox populi dixit that this fiscal move will generate “growth” (Note to the readers: The word “growth” here is used with the meaning assigned by the masses, when they refer to consumption. But growth, indeed, is nothing else than higher productivity). Given this higher “growth”, the propensity by Helicopter Ben to print more money will decrease, on the margin, strengthening the US dollar. The other popular variation to this reasoning is that Helicopter Ben may not need to print less money but he may start rising rates earlier than what had been priced by the bond market. Hence, the sell off in the long end of the Treasuries’ curve that we witnessed this week (i.e. higher rates, lower prices).
In our view, this reasoning is flawed at best, and idiotic at worst. Not only that: We are angered to hear it coming from people that we know are smart enough not to believe in it. Why? Because it assumes that the US will continue to run a growing fiscal deficit undisturbed, without the need for the Fed to monetize the increased debt levels. Yes, we believe that lower tax rates generate higher fiscal revenue, but only when accompanied by other good policies. However, note that by extending the tax cuts there would be no lower tax rates. There would only be a continuation of the existing ones, in cohabitation with a growing fiscal deficit. If at current deficit levels Helicopter Ben had to pull out QE2…what do you think will be his reaction if the deficit increases? How can the US dollar be stronger then? Because Treasuries’ yields increase?
US yields no longer, in our view, reflect anything. They are being completely manipulated, curve wide, by the Fed. So, when Treasuries sell off, we don’t seek to explain them in terms of changes in expectations vis-à-vis future FOMC’s decisions. We are simple: If the market sells, all we care is that it disagrees with the Fed’s manipulation. If it buys, it agrees. We think we don’t need to look any further than that, given the obscene level of manipulation, which begins with the Fed’s purchases and ends with the absurd regulation called Basel III and its risk weightings scale, which assigns zero risk to sovereign debt.
To be fair, the only time we witnessed a stronger currency and a sovereign bond sell off was in 1995, in Argentina, at the time of the Tequila’s shock (i.e. the Mexican’s debt crisis). However, back then Argentina’s rates jumped under a convertibility system, which meant that the Argentine peso was 100% backed by FX reserves, being totally isolated from the fiscal side of the equation. The situation in the USA is hardly similar to that one. Those who bought the peso back then were wise to do so.
Lastly, a potential source of US dollar strength (or gold weakness) may be provided by the appointment of Congressman Ron Paul, to chair the House Domestic Monetary Policy Subcommittee, overseeing the Fed. We read yesterday’s Bloomberg’s report on a survey that found most American’s wanting to rein in or abolish the Fed. We wish Mr. Paul well on his new role and believe he fully deserves that place. But we also fear that his actions may end up being counterproductive. Mr. Paul or the Tea Party may wish to end the Fed, but they have no alternative plan, let alone clarity on how to unwind it. We will elaborate further on this in future letters.
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: december-6-2010
When last Friday gold jumped to $1,400s/oz post announcement of the employment data in the US, we were not surprised at all. What surprised us was the strength in oil and other commodities. Had we not seen it coming? Of course we did, for we have been forecasting stagflation since early 2009, as those who have followed us know. However, we stood in awe on the reaction. Late on Friday, we did some research to get a sense of what others’ thoughts were on this and we came across Peter Schiff’s comments on gold, in his “Schiff report”, suggesting that we are now, for the first time, perhaps witnessing the beginning of a bubble in gold…Why now? Mr. Schiff’s criteria lies in the performance between gold stocks and gold, and last week we saw a much stronger performance in gold stocks.
Last week ended therefore with a few expectations. From the European Union, markets expect either an increasing role from the ECB as lender of last resort and potentially a bigger bailout fund, as it is clear that the Union itself is being challenged. With respect to the ECB’s role in particular, it is obvious that liquidity programs and sovereign bond purchases must continue, either directly or indirectly, from banks. What the ECB is trying to keep is the sterilization of those purchases, but we think that sooner rather than later, that will not be possible. This is consistent with our fundamental change of opinion from November 24th, when we anticipated that the market had underestimated the EU’s intentions. The Euro shorts ended the week on tears…
In terms of a bigger bailout, well… that will depend on the negotiations among core Europe and the periphery. But the important thing here is that the option has been mentioned for the first time.
We repeat: we think we are witnessing the very transformation of the EU into a proto-federal institution. This would not be the first time something of the sort happens. Political unification is always taking place somewhere in the world, although not at the scale and degree of diversity that the EU confronts.
As an analogy, we offer the case of Argentina. When Spain under and after Napoleon’s rule could no longer hold its possessions in America, Argentina fragmented into a group of territories in complete anarchy. Some of these territories quickly became independent countries, like Bolivia, Uruguay and Paraguay. But the rest of them, which later would become provinces, actually forced Buenos Aires to join a Union, which first was known as the Provincias Unidas del Rio de la Plata and later, simply Argentina. Why do we bring this up today? Because we think it is interesting to see how different this case was from what we see in Europe today. It would seem that today, it is core Europe that is interested in sustaining the Union, rather than the periphery…Why? Because they seek to force their currency (i.e. credit) on them. If the Union used gold as currency, that is to say, if there was no central, monopolic paper currency, perhaps we would see in Europe the same dynamics that we saw in the territories of Argentina in the nineteenth century: The periphery, not the core, would seek the unification.
What does this all mean? It means simply that for the unification to further in Europe, the core will have to compromise on monetary policy, while the periphery will need to do the same with their fiscal policy. It also means a weaker Euro and a long-term bid on gold.
Having said this, we now turn to the US. On Friday too, we read a few articles and listened to media comments that speculated on the possibility that the Fed buy not just Treasuries (i.e. federal debt) but also state and municipal debt. We have no idea whether they will or not, but we can advance the following analysis, if they end up doing so.
We think that monetizing state or municipal debt would be counterproductive for the Fed, because the market would realize that the issuers all depend on the same purchaser, and the market would level down, following the proverbial path of least resistance. The reasoning would be this: Muni debt, just like Federal debt, depends on the Fed = Muni investors leave and those in the Treasury market trigger an arbitrage, whereby they seek higher yield for the same risk. Therefore, the yields in Treasuries and Munis would converge (i.e. higher Treasury yields), forcing the Fed to buy even more Treasuries (i.e. QE3). This would all create more inflation, hurting municipal and state revenue in the process, as the stagflation grows.
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: december-2-2010
Again, most of the action this week has been driven by speculation on the future of the European Union. Let’s begin today by repeating what we left with a week ago, when we changed our view, radically, on the survival of the Euro:
“…We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place…” (www.sibileau.com/martin/2010/11/24 )
In the past days, we have been contacted by readers asking for our view on the situation in Europe. We answered, consistent with the writing above, that the key here is the European Central Bank. We said we agreed with Mr. Trichet’s comment yesterday, in that we also thought the markets were underestimating the determination and capability of the Central Bank. A bit of this has been corrected yesterday, and some analysts have gone on record calling yesterday’s action a typical dead bounce cat. We wouldn’t be so sure about it…
If you think about it, the European Central Bank has not yet engaged into what we know as quantitative easing. Yes, it has bought sovereign debt directly or indirectly by purchasing bank debt guaranteed by the sovereign (i.e. Greece) but these purchases, unlike the case of Helicopter Ben, have been all sterilized through its Securities Market Program facility, which up to last week had the equivalent of EUR66BN in term deposits from the banks, as the chart below shows:
As you can see from the chart above, if the European Central Bank (ECB) simply let the term deposits expire, liquidity would be injected into the system, without the need to buy more government debt. If the problem is the government debt itself, because a sovereign refinancing is in the way, the ECB can always buy the issue, depreciating the Euro.
Before we move on, please note that the mechanism shown above may or not, in the short term, trigger a depreciation in the Euro, ceteris paribus. It will depend on the resulting rates spread with the USD. However, the depreciation is inevitable in the long term.
Now, we must not lose perspective of the fact that the European crisis, although fiscal and institutional in nature, carries the leverage created by its weak financial system, which is weak because the EU lacks a unified bond market. This brews an arbitrage between peripheral banks and core banks whereby depositors in a peripheral bank shift their deposits to a core bank (i.e. Deutsche Bank), precipitating what we saw in Ireland.
This therefore begs the question of whether the European Central Bank did not stand up to its responsibility, as lender of last resort, in Ireland. Personally, had we been in government there, we would have asked ourselves what benefit would be derived from remaining within the EU monetary union, if the issuer of the currency (i.e. the ECB) does not act as lender of last resort and allows deposits to leave our jurisdiction. After all, if the country needs to put their pension funds and tax revenue on the line to support its financial system…why the hell would it need Mr. Trichet’s authority over their monetary matters? But then again, what do we know? It’s a done deal and the we all want to focus on the next in line…right?
So, what’s next? As we hinted in our last letter, we are more concerned about the US fiscal situation than that of Europe. We think the ECB will this time use its ammunition to prevent a run against Portugal and Spain and that it will be difficult to fight it. Of course, one can never underestimate the idiocy of policymakers, as when they introduced the idea of making senior bondholders of bank debt…well, not so senior…You certainly want to avoid this sort of language in the midst of a currency/financial crisis.
But in the US, we understand a bipartisan revision of spending is underway. We ignore how far it can go but the fact that it is taking place is a sign to us of what may be coming next. Below, we mention other “interesting signs”:
-Credit spreads of gold mining companies (i.e. Barrick Gold, Newmont Mining) are trading at lower levels than financials (excluding Canadian banks) and within the range of Germany’s
-The Euribor-OIS spread, after all the stress of recent weeks, remains reasonably low
-The price of oil remains impressively above $80/bbl
-Activity and prices (not just asset prices) in the US are picking up, in line with the price of gold
-The curves of Euro sovereign spreads are pricing the issuance of AAA debt under the European Financial Stabilization Facility
And there is more…but for now, these are enough to tell us that a major proto-federal institutionalization is underway in Europe, while in the US it will be difficult if not impossible to revert an upcoming explicit inflation.
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: november-29-2010
We start the week with three main themes, plus the absence of one. Indeed, yesterday the EU/IMF disclosed the “85 Milliarden Euro Rettungspaket für Irland”. So far, this is to the best of our understanding, what has been agreed to:
-In terms of sources, das Paket will consist of EUR17.5BN contributed by Ireland + EUR22.5BN contributed by the IMF + EUR22.5BN contributed by the European Financial Stabilisation Mechanism + EUR17.7BN by the European Financial Stability Facility + EUR3.8BN in bilateral loans from the UK + EUR1BN in bilateral loans fra Sverige og Danmark.
We note that the sources of the EUR17.5BN Irish support will be Irish Treasury (yes, I know…) and the National Pension Reserve Fund (no different than what Kirchner did in Argentina a few years ago, when the private pension funds were nationalized and put to good use financing the federal fiscal deficit).
-In terms of uses, das Paket will assign EUR10BN to capitalize Irish banks, EU50BN to cover budget financing needs and EUR25BN as contingent banking support. And here is where things get rather interesting…After Kanzler Merkel would threaten with haircuts on senior bank debt holders, European finance leaders yesterday had to commit to a plan, post-2013 (i.e. when temporary crisis facilities expire) that would treat writeoffs only on a “case-by-case” basis (as reported by Bloomberg), addressing “collective action clauses”. In our view, although this offers a bit of calm to investors, the “technical” damage has been done and it will be difficult to repair, unless there is now an explicit rejection by the EU finance ministers on the issue. They don’t want that? Fine, Mr. Market will eventually force their hands. Just sit tight and watch… What’s next now? Portugal?
The second theme that will impact this week’s action, and perhaps more to come, is the situation in the Yellow Sea, between the Koreas. The recent mediation by China to hold discussions among the Koreas, Russia, the US and Japan smells to a set-up to us, to buy more time for North Korea. It raises the question too, of whether this would have all not been planned before hand. Now, if South Korea rejects the invitation, it will look bad on them. If they don’t, nothing will come out of it, except that the dictatorship to the north will have won time. This could have been a great opportunity for China to demonstrate they are politically up to their pretension to be a global superpower. Because nothing will be solved, in our view, Asian stocks will be capped on their potential to the upside and the price of gold will keep a premium.
The third theme in our view is the expectation, after Black Friday, that consumer spending is slowly recovering and that this will be a force behind a “trend to rally”. Certainly, the recently announced $600BN monetization of federal debt by the Fed (also known as Quantitative Easing II) will also keep a bid on asset prices.
Lastly, another theme is actually the lack thereof, that we may see more clear if and once the public becomes comfortable with the situation in the EU: Namely, the lack of an exit strategy in the US. See, since the beginning of this year, the EU has been working towards gaining trust. Let’s recap:
First, nobody thought they would pull out a spending cuts program. But so they did! We now have spending cuts from Ireland, UK to Greece. Yes, citizens protested big time, but the cuts are here to stay. Yes, they are not enough, but there is always more to cut and privatizations have not even been discussed yet. What about spending cuts in the US?
Later, nobody believed the EU would really pull out a package for Greece. Yet, they rescued Greece and now Ireland. They even worked out a mechanism to address future crisis and most importantly they put deadlines to them: 2013. What did the US do on its municipal and state debt problem? So far, the municipal bond market suffered a huge outflow of money two weeks ago and Wall Street is making every effort to downplay the issue, as we expect of course, from those who make money distributing this debt.
Finally, the European Central Bank stated that their government purchase bonds would be sterilized. Nobody believed them (we included) and nevertheless, they did so issuing their own debt (EUR65.8BN at Nov 24th) and without driving rates to expensive levels. What has the Fed done? This is all brewing USD weakness in our opinion and it won’t be long till we see it bursting.
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.
Click here to read this article in pdf format: november-24-2010
We usually publish on Mondays, but this time, we wanted to see things play out before coming back. We stand therefore by our forecast published back in September, when most saw the European Financial Stability Facility as a source of strength for the Euro, while we publicly disagreed: We saw this facility as a the key that would trigger chaos within the Union. The chart below (source: Bloomberg) redeems us: the Euro fell by four cents vs. the USD, since the Irish requested access to the facility.
In our last letter, we suggested that the best way to understand the ongoing action within the EU is to use a “game theory” approach, of a non-cooperative nature, we should add. We put forth three main players: Ireland, Rest of peripherals and Core Europe. Now that the bailout for Ireland is news, a new dynamics unfolded. Early yesterday, Bloomberg reported German Chancellor Angela Merkel declaring that the prospect of serial European bailouts was “exceptionally serious”. However, we listened to the speech ourselves (Click here to watch it ) and believe the press may have taken Ms. Merkel out of context, which implies that the markets may have overreacted but also, that there is more in hand here .
Now that Ireland seems to have gotten away with its corporate tax structure, other “participants” in line (i.e. Portugal) have learned something: Time is on their side. Why? Because marginally, once a country’s sovereign yield shoots up and becomes the next in line, the marginal pain is bigger for Core Europe. When Greece’s bubble went bust, Ireland felt the pain, Core Europe barely felt it. When Ireland’s bubble goes bust, Portugal feels the pain and Core Europe begins to take notice. By the time Portugal’s bubble goes bust, the pain for Spain will be felt and Core Europe will be very uncomfortable, since France or Italy will be the next in line and Germany simply can’t afford this.
Therefore, the sooner Core Europe deals with Portugal, the cheaper it will be to cut the pain. How does Core Europe force Portugal to come to terms? By pushing their sovereign yields higher than the policy makers of the first-in-line countries expected. How? By going on record, like Ms. Merkel did yesterday, saying that the situation is exceptionally serious. That way, Portugal’s credit risk jumps 35bps to 490bps threatening with a margin increase at LCH Clearnet. This move leaves the first-in-line country unable to raise capital and asking for help to the EU and European Central Bank (sooner, rather than later! This is the point!). To us, this makes sense…Otherwise, why would someone as serious as Ms. Merkel say what she said with such a brutal sincerity? When are politicians sincere?
Where does this all leave us? It leaves us with a change in our view: We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place. However, if they succeed, it may well have again a chance to become the world’s reserve currency, if the US doesn’t correct their monetary mistakes. Why? Because the only way to succeed is through a dramatic institutional change, a true federal pan-European structure. In the meantime, the opportunity to become a reserve asset grows for gold by the day, because the risks of failure are just too big to be ignored.
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: november-18-2010
A quick note to finish the week…We think we are entering a new stage in the dynamics of the Eurozone, and that the ongoing negotiation between Ireland and the European Union as well as the weakness in the Euro prove that the comment we made on September 9th was appropriate. We wrote:
“…Another interesting perspective is that which finds strength in the Euro, from the fact that peripheral countries can now access the European Financial Stability Facility, which is now effectively operational. We actually see it the other way: Precisely because the weak countries will access this facility, the break of the European Monetary Union will be accelerated, as the rich countries are faced with true costs; costs which until now were being piled under the big rug (the balance sheet) of the ECB…” (www.sibileau.com/martin/2010/09/09 )
Since November 4th, the Euro has embarked on a very defined downward trend. Counter intuitively, this should not occur. Ireland does not need to access the market before June 2011 and if it required funding, the European Union is ready to sign the cheque. Therefore, what is behind the weakness?
To understand this issue and our previous comment, we need to see first that Europe has first and above all an institutional problem. Secondly, one can use the Game Theory approach. We are not well versed in this approach. We studied the theory while as undergraduate students and thanks to the extraordinary advancement of mathematics, we know it has evolved tremendously since John von Neumann and Oskar Morgenstern first published in 1944 the famous “Theory of Games and Economic Behavior”. We are very reluctant to use formal approaches to human action but we think the particular negotiations that are currently taking place can be easily analyzed under this method. Here are what we think can be premises:
1.-Ireland’s financial position, just like any other peripherals, deteriorates with the passage of time. However, as it does not require funding until June 2011, its position vs. time is stronger than that of Portugal or Spain (i.e. the first “derivative” of loss vs. time is lower for Ireland. But not the second. By 2011, everyone is on the same leveled field ).
2.-Ireland knows (1) above (i.e. has perfect information) and uses this upper hand to better negotiate the terms of the inevitable bailout. However, if it waits too long, the advantage is lost.
3.-Portugal, Spain and Italy know (i.e. have imperfect information) that once Ireland gets help via the EFSF, spaces will fill quickly. There isn’t simply enough room for everyone. The EFSF cannot be but for exceptions. Otherwise, there is no catch! An EFSF for everyone can simply not be AAA rated: A bank that lends with leverage cannot honor all deposits at once. Furthermore, keep in mind that there are no defined pan-European taxes supporting draws under the EFSF, but a promise from each respective EU member to get those funds somehow (Another important aspect here is that the IMF is contributing an additional 50% , which a friend and reader pointed to us is simply another important source of debt monetization).
Therefore, once Ireland draws under the EFSF, a race will start by Portugal, Spain and Italy to win the next seat, to be the next in line to draw, before the window closes. Be ready. All kinds of tricks and influences will be played at this point.
4.-Core EU members (i.e. Germany, France, Netherlands) know that the puck must stop somewhere, before their own solvency is compromised. If it is compromised, the only way out is a blanket, wide monetization of government debt by the European Central Bank, a massive currency crisis, assuming the EU monetary union doesn’t break. What are they doing about it? Ms. Merkel has been pushing to for the creation of a debt crisis mechanism, in which an “orderly” bankruptcy is carried out and whereby sovereign bondholders take a haircut. This is simply a wrong and absurd idea, which if implemented, it will only accelerate the demise of the monetary union. On this note, we think it is worth reading UBS Tommy Leung’s recent comments (UBS EU Credit Stategy – Daily Morning Walk, November 16th, 2010: “A glaring contradiction”) where he reflects upon this issue. Mr. Leung observes that this mechanism would discriminate between sovereign debt issued prior and after 2013, effectively creating a two-tiered EU sovereign debt market. This actually goes against the natural solution for Europe, which is a unified bond market! In this scenario, bonds issued prior to 2013 would be structurally senior to those issued from 2013 on. Mr. Leung further asks how would this be consistent under Basel III, where banks holding these bonds assign a zero risk-weight to them. Clearly, if a restructuring mechanism is considered, the possibility of default cannot be ignored. Mr. Leung leaves the topic here, but we don’t. If default cannot be ignored, the arbitrage within the EU financial system will be immediate, with depositors shifting their savings from the banks holding the subordinated bonds to those holding the senior bonds. This can only deteriorate the balance sheet of the European Central Bank.
Where does all this leaves us? What can core EU members do? Nothing! Absolutely nothing. What will they do? Force more fiscal discipline on the other peripheral countries. But as we saw in point 3, once Ireland access the EFSF, these countries will have a strong incentive to fill in the last seat available. In other words, they will seek to show they can’t survive without it.
The US cannot react to this, as it is too concerned with its own problems. The latest performance of municipal debt is very telling in this respect. How can China react? By holding lower amounts of Euros as reserves and shifting that allocation to gold, slowly but steadily.
Lastly, we want to bring collective attention to the recent pressure the Fed is facing. Not only is there internal dissent regarding QE2, but also on Tuesday, as everyone must know by now, an open letter to the Fed was published by the Wall Street Journal, criticizing this latest move. Now, at our desk, we always have Bloomberg TV turned on and yesterday we noted how guest after guest was asked by different news anchors whether the Fed should not reconsider its dual mandate. Once an answer was given, the Bloomberg anchors replied asking whether Mr. Bernanke would likely resign on such change, noting that this is a possibility, given the new Republican majority in Congress. Are we thinking too much here? Were we watching a press op unfold or was this pure coincidence?
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: november-16-2010
We are writing with hesitation this morning. For the first time in a long time, we feel at a loss in terms of markets’ near term direction. We want to believe that the trend in asset inflation is alive and healthy and that what took place on Thursday-Friday, was simply a correction, following last week’s increase in margin for silver contracts (discussed in our previous letter of Nov 11th). But there are simply too many things going on, which are proving powerful enough to temporarily halt asset inflation.
-Ireland
We have dealt extensively here on the institutional problem of the European Union. Ireland represents only one more variation of it, just like Greece did earlier in May. Yes, Ireland’s problem differs from Greece’s in that the source of the increase in the fiscal deficit is a once-and-for-all loss (i.e. bailout) on mortgages. In this respect, it would appear more similar to the US in 2009 than to Greece in 2010. But the problem is always the same: The government can increase its deficit, but cannot monetize it on its own. It needs the complicity of the rest of the Union members. So far, they say they’re in!
Our view: One can never underestimate idiocy. Ireland has now the support of the EU but refuses to accept it, undermining everyone else’s efforts. Why? Because there is a general feeling that independence will be lost. First, they floated the idea of making senior bondholders of the affected financials lose their seniority in a bail-in scenario. It didn’t go far. Now, they pretend they can wait for they are pre-funded for 2011. But the problem is that other EU peripheral members are not in that situation and the refusal to face the problem infects the entire EU bond space. We think there is no alternative but to monetize the financials losses using the European Financial Stability Facility. This means that the EFSF, a Luxembourg-registered company owned by euro area member states, will issue AAA debt to fund the Irish government. With the proceeds, the Irish government “should” buy the distressed assets of its insolvent banks (i.e. it should not capitalize the banks, but buy their assets outright). This transfer would tighten credit spreads on the banks and widen it on Ireland’s sovereign risk. Thus, how will Ireland cope with it going forward? In 2011, if necessary, it will sell its debt to the European Central Bank, further debasing the Euro. Should this not be long-term supportive of commodities? Of course it should!
-US Sovereign risk
We were one of the first to note this early on November 9th. Now, it is vox populi. On November 9th we wrote:
“…we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis…”
The US yield curve continues to steepen. The ProShares UltraShort 20+ Year Treasury ETF (ticker: TBT), for instance, is +17.5%, since the last FOMC announcement, on November 3rd. And this gain has been forged on stocks rallying or selling off, on the USD rallying or selling off. The trend appears to be firm. Not only that: Since last Friday too, the US federal debt market is also “crowding out” the municipal debt market. Flows into municipal bond funds seem to have be slowing at fast and furious pace, according to a report from Bank of America’s Municipal team, published yesterday. Yesterday too, 10 Yr AAA Muni rate closed at 2.75% (+11bps) heavy supply.
Our view: We see the municipal/state financial situation impacting on the value of the USD as we see peripherals debt in the EU impacting the Euro. On top of this, the Fed is facing political pressure from the Republican party to not proceed with the announced QE2, while no real action plan has been counter offered to address the ever growing fiscal deficit. Here, the path of least resistance is easier to visualize. Ben Bernanke has told us he has no shame monetizing deficits. The currency crisis of the United States has simply begun, in our opinion. Should this not be long-term supportive of commodities? Of course it should!
-China and other net creditor markets
China and the rest of the emerging markets insist on sustaining their activity on the back of a cheap currency, pegged to the USD. If the USD itself is debased, they will have to do the same with their currencies. Therefore, they must confront inflation. But since they did not witness a deleveraging a l’Americaine in the past years, inflation picks up easily there. What are they doing? Anything to stem the inflow of capital to their currency zones: Taxes on capital inflows, increase in reserve requirements for banks (i.e. lower credit multiplier), increase in interest rates…
Our view: Any textbook on macroeconomics will explicitly tell you this is absurd. When a country controls its foreign exchange, it loses control over interest rates and prices. In the short term, these markets can use all the tricks available to them. This shows how dictatorial they are, for there is a lobby group in control denying the working masses the benefits of their hard work. These emerging markets are condemned to remain emergent and anyone telling you the opposite is simply blind to the fact that economic growth is ultimately the result of only a strict respect for private property. The inflation tax is anything but that and in the long term, these markets are bound to lose their competitiveness caused by this distortion in the relative price of capital. Should this not be long-term supportive of commodities? Of course it should, because their supply will decrease, relative to their demand, as real wages fall in these markets and labour and capital to produce them becomes scarce.
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: november-11-2010
Since our last letter, commodities (excluding oil) have sold off. The developments out of Ireland have impacted the Euro, as we discussed earlier and, in addition on Tuesday, the CME announced at close that deposits and margins on silver contracts and hedge positions would be raised. These two factors have temporarily affected liquidity on risky assets.
The first one, Ireland, has obviously an important spillover potential, as the banking system is technically insolvent and, if bailed out, will require either Irish taxpayers or EU taxpayers to foot the bill. If it isn’t bailed out, it will then affect the capital of other financial institutions within the EU mostly, with Irish exposure. On that note, sovereign credit spreads of Peripheral EU jumped yesterday and the situation is understandably affecting the Euro. The chart below (source: Bloomberg) is very telling. Since it peaked on November 4th, the Euro has embarked on a very well defined downward trend.
This trend is draining liquidity from the market, although not to worrying levels, for the Euribor-OIS spread is still low, at 26.4bps. Some may argue that it is due to the intervention of the European Central Bank…which is true and may continue, producing an “orderly” fall of the Euro, in spite of wider sovereign spreads. Of great help is the fact that the Irish government does not require to access the capital markets before 2011. All this is what, in our view, is preventing gold from resuming its upward trend, to prove once more that it is on its way to become the world’s de facto reserve asset.
Having said this, we want to return to a point we made on Tuesday, when we wrote that:
“…we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis…”
Yes, the yield curve steepened since Nov 3rd, but the chart below (source: Bloomberg) should also be visual enough to raise concern over the wisdom of the Fed’s recent decision. As long as the money being “printed” by the Fed causes a shift from Treasuries (long-end mostly) to cash, without lifting commodities or stocks, we will be in the proverbial liquidity trap and the USD will be far from a crisis. But as soon as the massive unwind of pre-QE2 positions and short USD/long EUR positions (which we think are causing the confusion) is over, we will see the weakness in the long-end of Treasuries as the seed of a materially higher price of gold and the beginning of the US currency crisis.
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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