Please, click here to read this article in pdf format: february-8-2010

During the weekend, we did a fair bit of reading and, among other things, watched an interview Mr. Martin Redrado (now ex-President of the Banco Central de la República Argentina) gave. It was an unusually interesting interview to watch (the interview was in Spanish and can be replayed at: http://www.tn.com.ar/2010/02/04/politica/02133330.html . We will refer to his comments made from minute 10:30 to 11:42). As you may know, Mr. Redrado gained public attention after he refused to hand over $6.6Bn in reserves of the Banco Central to the Argentina’s Treasury, to service upcoming debt maturities. Mr. Redrado had to eventually resign. In the interview, Mr. Redrado was asked why he thought the Treasury should not use the so called “excess reserves” of the Central Bank, if the amount of reserves is higher than the monetary base in pesos (which the reserves back)? Mr. Redrado answered that the question denoted a misunderstanding and gave an historical example: In 1989, at the time Argentina had hyperinflation, the amount of reserves was actually higher than the amount of “currency in circulation”. Redrado continued to point that the relevant metric a Central Bank should follow is not “Demand for currency”, but the  potential demand for currency. He explained that under the institutional uncertainty Argentines face, they may not renew term deposits at maturity (a component of M2). As these term deposits mature, they become demand deposits, which people then convert into USD. Therefore, the Banco Central has to maintain an optimal level of reserves that will guarantee enough supply, to a potential demand of USD . Term deposits must not be ignored. Therefore, according to Mr. Redrado, Argentina has no such a thing as “excess reserves”. (Here, the concept of currency is tricky. Argentines demand USD as a reserve currency, while they demand pesos as a transaction currency).

Why do I take you precious time to tell you this? Why should you care about this story, if you live in the developed world?

Last Friday,  Mr. Jeffrey Rosenberg, Bank of America’s Credit Strategist wrote an interpretation on the current crisis that the so-called Euro zone peripherals face (i.e. Greece, Italy, Portugal and Spain; “Default (even a sovereign one) is a liquidity event” in “US Fixed Income Situation”, Fixed Income Strategy, February 5th, 2010, Bank of America). According to Mr. Rosenberg, there is no currency crisis. As these peripherals have their debt denominated in Euros,”… this crisis is a long term “solvency” crisis precipitating a short term liquidity crisis…”. Therefore, this is not a typical sovereign currency crisis (not your father’s crisis), with investors fleeing the countries financial markets, and all we need is “liquidity support”.

What does Mr. Rosenberg mean by liquidity? He shows us two tables. In Table 2, we see “Fundamentals behind solvency concern”. Which ones are these? Fiscal Deficit as % of GDP, GDP, Sovereign debt (in $ and in % of GDP) and the required adjustment, as a % of GDP. In Table 3, there is a display of liquidity needs of the Eurozone. The metrics are (for each member country, in Euro) 2010 bond maturities, Rolling short term debt, Fiscal deficits and total financing needed. From this point of view, the natural conclusion is to obtain the scale of the liquidity support required.

After having heard Mr. Redrado, I could not help smiling at Mr. Rosenberg’s naiveness. Every currency crisis, absolutely every one of them, is the consequence of the assessment made by its holders, that their currency no longer can serve both to transact and to act as an asset to save. The currency can no longer be used to save. Why? The reason is always institutional. It doesn’t matter what the trade or fiscal deficits are (the USD is the best example) or what a government’s financing need is. At the heart of a currency crisis you have a crisis of confidence in the government. The currency holders ask themselves: “Will we be “taxed” for holding pesos, or Euros?” The extreme case of Argentina is a good example. Note that if the Central Bank’s reserves belong to a government’s Treasury, changing pesos for another currency constitutes an act of fiscal rebellion!

In conclusion, in my view, the Eurozone peripherals are not facing a liquidity crisis. The issue is far more serious. The whole European Union is facing an institutional crisis. Will the Eurozone behave as a Confederation or as a Union? Under our perspective, the cost for the Eurozone of not standing up to the circumstance and showing a firm resolution, will be far, far more expensive than the product of the existing government financing needs times a higher cost of borrowing, as Mr. Rosenberg wants us to believe. The European Central Bank must not believe for a second that what is at stake is a “short term liquidity problem of peripherals”. Paraphrasing Mr. Redrado’s wise comments, the European Central Bank must understand that in these peripherals there is also a potential demand for a reserve currency that will be triggered violently without notice, if the Eurozone acts as a Confederation, rather than a Union. In this case, liquidity support lines will be useless and will only delay a horrible end. What does the Eurozone need? A unified bond market.

Martin Sibileau

Please, click here to read this article in pdf format: february-5-20101
Below, we attach the same chart shown yesterday (Source: Bloomberg) on the IBEX (Spanish stocks), with banks’ share prices at yesterday’s close (i.e. updated). As days go by, our earlier comments sound more and more prophetic. By now, it should be obvious to everyone that the dam is broken, that the bears are out to do more damage but also….that this problem has a solution. That solution is more quantitative easing, by the European Central Bank. Will we see it? No! Will it be there? Yes. Mr. Trichet & Co. are currently trying to find a way to simultaneously rescue the Euro (and its financial system) and to save face. We know he can’t get both, but we are optimistic that the ongoing situation has a solution. It will still get uglier before it gets better, but such is human nature and our duty is to profit from any circumstance as much as we can.

The damage has been mainly driven by valuations in financials. So far, and this is our personal view, the fact that the Euro is still not the main reserve currency, is saving the day for the rest of the world. Liquidity costs for the world’s reserve currency, the USD, have not reacted accordingly. If this sovereign risk contagion (from public sector to financials) had happened in the US, things would be different. We should keep this very much in mind, which is why I believe both the price of gold and the Canadian dollar (in USD) are still holding relatively within their upward trend, although the challenge rises by the hour. But we must also keep it in mind because when the finest hour arrives for the US, a steeper yield curve will push us to review our default rate assumptions.

As well, it seems as if the market (still) shared our view on the temporary nature of this problem, and that there is light at the end of the tunnel. That light is the explicit recognition by monetary authorities worldwide, but especially in Europe, that inflation will be the only way to make the debt burden bearable. When that recognition is finally made, we will be buyers of gold, commodities and commodity currencies. Perhaps the recognition comes sooner rather than later. In the meantime, we see central banks holding their policy rates at record lows, like the European Central Bank did yesterday. That’s a good sign, but it is not enough. Perhaps we need an explicit commitment, like the one the Bank of Canada made last year, to calm animal spirits. However, the time to only play monetary policy is gone. None of this will work, anywhere, if a commitment of the same weight is not done on the fiscal front too.

Martin Sibileau

Please, click here to read this article in pdf format: february-4-2010

In the previous letter, I framed my review of 2010 in three stages. The bottom line is that I am bearish, and expect the bearishness to progress. The progress will be marked by the lack of credit expansion, caused by central banks unwinding quantitative easing policies or by governments limiting the credit expansion, through regulation. Without this lifeline, the onus is on fundamentals. So far, they don’t seem to surprise nor disappoint. I think there is merit in my intuition, proved perhaps by the fact that both the Reserve Bank of Australia and the Norges Bank took a break from rising policy rates this week.

In this context of stagnation, monetary authorities will be increasingly pressed to leave the status quo unchanged. However, in the case of Europe , the situation may be different. As the fiscal situation deteriorates seemingly faster than previously thought, the European Central Bank will have to take an holistic approach to the problem. As I mentioned on December 17th (www.sibileau.com/martin/2009/12/17), I expect the path of least resistance to be the abuse of the private placement market (bank debt) to finance peripherals’ deficits (i.e. Greece , Portugal , Spain , Italy , Ireland ). This will guarantee that the European Central Bank will be forced to extend liquidity to the affected financial institutions, providing a hidden subsidy. This is clearly bearish of the Euro. The chart below is very ominous in this respect. It shows the IBEX (Spain) stock index, which is approx. 11% off its January peak (Source: Bloomberg). Yesterday, the weakness was noticeable, driven by financials (bank stocks). This is the worst kind of weakness you can see and a bull market will never rise from it.

Yesterday, the markets surprised me. Stocks and fixed income sold off, while credit remained flat. Credit, it is true, is undergoing a lot of technicals, which make the picture blurry. However, on average, the market sought liquidity, for the sake of liquidity given the steepening of the US yield curve (2y10y by 3.8 bps, to 282.2 bps). The USD strengthened, while I believe the strength in oil was merely a bounce within a bearish trend. If I am correct, not even the upcoming G7 meeting (where neither China , India or Russia will be present) will be able to coordinate the required global exit strategy. On this basis, I see an increasingly bigger role for gold as a reserve asset (not currency). But we will still have to see a lot more water running under the bridge, before gold shows us the way. All along, the social backdrop will grow uglier, as unemployment will remain high.

How to trade with this outlook? Keep it liquid, and keep it simple, when you short the stock market or play the curve in European sovereign credit. As I previously said, I don’t see volatility waning in 2010, given the global fiscal front, which means that complex trades can get killed by tail risk, courtesy of liquidity preference behavior.

Martin Sibileau

Please, click here to read this article in pdf format:february-2-2010

When Maynard Keynes wrote the already famous sentence: “…And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…”, he was clearly considering “time” as a magnitude in his analysis.
It takes time to increase output and it takes time for prices to rise, reacting to such increase. The rise in prices and the speed of the output increase have to be matched by the nominal interest rate referred above. This is why Keynes also wrote, in the same paragraph: “…prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…” (The General Theory of Employment, Interest and Money”, Ch 13, S. III). Briefly, Keynes’ idea was to coordinate monetary policy to debase a currency taking advantage of productivity slack (i.e. the shapes of the physical supply functions) and unemployment (i.e. the liability of the wage-unit to rise in terms of money).

Since the start of 2010, it seems that of all sudden, central bankers have forgotten this idea, while at the same time, governments attack banks with higher reserve requirements and capitalization ratios. Banks are not to blame for the shocks. Shocks are produced by central banks, which determine the money supply function, but I guess somebody has to be blamed.

With the above in mind, I thought of 3 phases that may unfold in 2010. In all of them, the challenge of matching monetary policy to productivity is omnipresent. This framework suggests a long-term bullish view of gold and commodity based currencies, and a definite path to inflation by 2011, when it is most likely that the real tightening will take place.
These phases are presented in the chart below, which I think is self-explanatory. In the next letter, I will nevertheless elaborate more on this framework. In terms of timing, the only certainty we may have is that we will need to wait another quarter to see earnings disappointing.

Martin Sibileau

Please, click here to read this article in pdf format: february-1-2010

We enter February and nothing is what used to be. Keep this in mind because you will hear, read and watch hundreds of market gurus tell you that this “correction” represents a buying (of stocks, risk) opportunity. We are deductive at “A View from the Trenches” and deduction demands that we rationalize our view. Here we go:

When at the end of 2009 I expressed some optimism for 2010 (refer: http://sibileau.com/martin/2009/12/16/, “Thinking about 2010) I did so with caveats (…”I (…) ask myself what assumptions are behind this logical thread. The first one is the assumption of “stability” in benchmark, sovereign rates, with independent central banks”…). As well, even though I was optimistic, I disagreed with the mainstream view that volatility would be muted in 2010 (“…with the Euro zone falling into pieces, and with creditor countries in Asia exacerbating the USD peg. This is barely a picture of muted volatility and higher valuations…I am confident we will see effective policy action on all of these fronts. But, muted volatility? I don’t think so”…). The chart at the bottom (source: Bloomberg) shows the VIX index. It is cruelly clear that volatility in 2010 is still relevant.

As 2010 commenced with a rally, I thought over and over how I could rationalize the market action. I structured my view in two letters, on Jan 20th and 21st (refer: “Two dimensions”, Part I: http://sibileau.com/martin/2010/01/20/two-dimensions-part-i and Part II: http://sibileau.com/martin/2010/01/21/two-dimensions-part-ii/ ). Briefly, I think that in 2010 we see two juxtaposed forces: the non-neutrality of money and time or lack thereof, for the structural changes that different currency areas require.

But when on January 22nd I said : “…the market proved me wrong. If by the close of today we see the S&P500 not at 1,120pts, then I hope that you are as liquid as possible entering the next week…”, I wrote purely on a technical basis (I appreciate the wisdom of one of Gartman’s trading rules: “Think like a fundamentalist; trade like a technician”). I turned 100% liquid that same day and also made it clear that I was still not bearish, but neutral. I had to understand the new fundamentals…

To understand the new fundamentals, we can still use the two dimensional framework proposed earlier. Time has won over the non-neutrality of money, not based on its own merit, but because the non-neutrality of money was killed as China, the US and now India attacked the distribution chain (banks) of the credit expansion process, in the last two weeks. Time will also continue to win because the main assumption of stability mentioned above, relying on steady sovereign risk and independent central banks, is also dead. Europe is leading the destruction of stability in sovereign risk, while Argentina has already killed its central bank. Mexico follows, having announced its intention to repay a $47BN credit line to the IMF, with central bank’s reserves. And although the European Central Bank still remains fairly independent, such independence will prove illusory. Greece, Portugal, Spain and Italy will deceive the North and make the posthumous case for Max Weber (http://en.wikipedia.org/wiki/Max_Weber ). Our thoughts on Greece have been fairly laid out, and I stick to my initial script (refer: http://sibileau.com/martin/2009/12/17/ ).

With this backdrop, without monetary policy coordination, our Thesis No. 2 on gold (refer: www.sibileau.com/martin/2009/04/21), resurfaces. Gold has a chance. Tomorrow, I will write more on this chance, which requires further elaboration on how the macro picture has changed. But the bottom line is that now I am bearish. In the next letters, I will seek to provide structure to the bearish (and “beta”) trade.

Martin Sibileau