Today, we think it would be important to leave the analysis of the latest news aside (including the negotiations on Greece’s debt) and instead, to present a theoretical framework that may allow us to understand the ongoing rally and what may develop during 2012 and beyond. There is nothing more practical than a good theory and a good theory is indeed what we are looking for this morning.

Let’s first examine what we are witnessing today, namely the financing by the Fed and the European Central Bank (“ECB”), of the Eurozone financial system. Below, we describe how it works and we carry the analysis to the extreme. We like challenging models to their extreme implications, because this aprioristic deductive exercise forces us to identify what mainstream economists, many months later than us, usually end up calling “tail risks”.

In step 1 above, we see the first pillar of the EU financial system bailout: The Fed extending US dollar swaps to the ECB, at below market rates. As can be seen, these swaps are an asset of the Fed and a liability to the ECB, which receives US dollars in exchange. With these US dollars, as we explained on December 12th, the Fed avoids a liquidation of US denominated assets by EU banks and the resulting increase in the cost of US dollar funding as well as in counterparty risk, for US financial institutions. These swaps can therefore be seen as vendor financing in favor of US banks, at the expense of American taxpayers and anyone who invests their savings in US dollars (i.e. US banks, via the Fed, provide cheap financing to their trading counterparties, all paid for by a devaluation in the purchasing power of the US dollar. On this matter, please refer our comments on September 12^th, 2011).

However, the extension of USD swaps is not enough to save the status quo. The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB, as shown on step 2. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits. That is shown, as step 3.

On step 3 too, we see that these funds keep open the window for depositors in weak banks to continue the liquidation of their deposits, in exchange of fresh cash. On the other hand, once the governments sell their bonds to the banks, they distribute the Euros issued by the ECB across the Eurozone.

Finally, on step 4, we see the conversion of these Euros by EU depositors and corporations, into US dollars (or Swiss Francs or gold), as a way to protect their savings from the unsustainable status quo: They know that the EU fiscal deficits will remain alive and have uncertainty on the future of the monetary system. Who provides them with the window of opportunity to exchange their Euros for US dollars? Ultimately, the Fed, with the provision of cheap US dollars to the ECB, via swaps.

This circular process, in extremis, brings us to the final line in the graph above, where we show the balance sheets of the Fed, the ECB, the EU banks and the EU depositors & Non-financials. The Fed will own US swaps against which US dollars will have been printed. Yes, printed! This had occurred in the 1920’s and 1930’s, but at least back then, those US dollars were somehow backed by gold reserves. Today, that’s no longer the case. Who will have the US dollars owed to the Fed? Not the EU banks nor the ECB, but the EU depositors & Non-financials! In summary, the people of the Eurozone!

In extremis too, the balance sheet of the ECB will look like that of a middle man. As assets, it will carry long-term refinancings. As liabilities, it will have the US swaps, that it extended to the EU banks. These EU banks however used the euros to buy sovereign debt, which is now their asset, and owe euros (i.e. LTROs) to the ECB. This is a very unstable situation, because if the fiscal situation of the Euro zone does not improve, these sovereign bonds in possession by the EU banks will remain driving capital losses.

This analytical framework leaves us with questions:

If the Fed ends up being the creditor of the EU depositors and corporations…how will it ever get its money back? What will be needed to repatriate these US dollars? We think there are only two ways to solve this problem. The best case and least likely is to see an improvement in the fiscal situation of the Euro zone. If deficits were stabilized or even reduced, the sovereign bonds held by the EU banks would drive capital gains, euros would flow back again to the EU banks in the periphery and US dollars would have to be sold in exchange, to buy these Euros. The EU banks would be then in a position to both return the LTROs and the US dollars to the ECB. The worst case occurs if the Fed implements an exit strategy, raising US dollar interest rates and US dollars flow back to the US. This is also not likely, at least in the short-to-near term, in our view. This would require, a priori, a strong economic recovery.

Another interesting question is related to the Euros in circulation, supplied by the LTROs: What happened to them? In extremis, we see that the EU depositors and Non-financials first took these Euros from the EU banks and later exchanged them for US dollars. Were they taken out of circulation? No, but the velocity of circulation increased, from the ECB to the banks, to the people, and back to the ECB. This is consistent with the monetization of sovereign debt and a context of high inflation. Once again, we note that this analysis is in extremis…For now, we can see it as a natural logical consequence. To mainstream analysts, this is a “tail risk”. The reader is of course free to take a view on this matter.

Please, note that this analysis implies the survival of the Eurozone with the liquidation of sovereign debts via inflation.

Is this status quo sustainable? If not, what will accelerate its demise? How will gold and the rest of the risky asset spectrum behave? Below, we present a flow chart, where we seek to summarize this process.

As we can see, as backdrop to the process described above, the Euro zone today is crowding out private investments, given the high cost of sovereign debt. In addition, it has and continues to implement higher tax rates and further interventionism and financial repression. With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unadressed. All these factors only contribute to prolong the recession and a high unemployment rate.

The flow chart is clear: As long as the people of the EU put up with this situation and the EU Council, chaired by Mr. Herman Van Rompuy effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain. If people revolt and the EU breaks up or if the Fed is no longer politically strong enough to force these swaps, the status quo will collapse.

Contrary to popular belief, this status quo is based on the “coupling” and not “decoupling” of the Fed with the ECB. This coupling relaxes correlations, because the US dollars sent by the Fed to the ECB were printed and nobody in the US feels the immediate pain. Hence, we have the rally in stocks and gold, without any correction in the US Treasuries market.

Whenever the political sustainability of the EU is challenged, we will see a run for liquidity. And 2012 will have many of these panic situations, affecting any late longs in gold or stocks.

Finally, when the “decoupling” takes place, the US dollar can only remain strong if the fiscal situation of the US permits. But we fear that the Fed will embark on interest rate targeting. This is a story for another letter…

The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo.

Martin Sibileau

This is our first letter of 2012. The year started with a mini rally that every analyst out there attributes to something called “decoupling”. Why? Because the strength in asset inflation, although global in nature, is particularly more solid in the US.

The oddity appears to be higher asset prices, in spite of a weaker Euro, in a Eurozone whose main problems remain unsolved. Correlations are breaking! say analysts, at every opportunity they have to speak to the media.

We want to start the year tackling this issue, which we feel is very important to understand. Without mincing words, we will say that the concept of “decoupling” is completely wrong and if followed, it will lead to wrong conclusions and horrible investment decisions.

The fall in asset prices during the last quarter of 2011 was triggered by a run for liquidity, typical of fiat currency systems or systems with leverage. Euro zone banks had to sell USD denominated assets to raise liquidity, lifting the price of the USD and putting pressure on the rest of the risk asset spectrum. This was addressed in November, when the Fed confirmed its commitment to continue extending USD swaps to other central banks, at a reduced price of 50bps. At “A View from the Trenches”, not only have we dealt extensively with the mechanics and implications of currency swaps but also, we believe we would not be mistaken if we said that we were the first and only ones to point to its relevance, way before anyone else in the market. For instance, in February 2010 (almost two years ago!), we warned:

“…that France did the same (in the 1920s) that we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment…” (refer: www.sibileau.com/martin/2010/02/26 )

How relevant was this action taken in November? The chart below (source: Bloomberg) shows us how the price of the 3-month EURUSD swap reverted after November 30^th:

How consequential was the amount of swaps extended by the Fed? The next chart (source: Bloomberg)gives some perspective, showing what the Fed extended in 2008, vs. what occurred last November:

The spike is certainly visible. Back in 2008, the deleveraging was just starting, so it would seem unlikely to us to see those levels again. However, we must not underestimate the magnitudes seen in November and the sovereign problem ahead, particularly if it threatens to break the Euro zone. In light of all this, it is clear to us (and not to the rest, apparently) that rather than a decoupling, we are seeing a huge coupling. In fact, we are witnessing the mother of all couplings! As we explained on December 12^th, the Fed is bailing out the European Central Bank, because without US dollars, the run for liquidity in Europe would result in a general run against the ECB. But since December, the ECB is now also financing on a 3-yr basis, the liquidity, in Euros, of the Eurozone banks. There is plenty of speculation as to what the Euro zone banks do with that money but we think it is safe to say that at least, they are not forced to liquidate assets. On the accounting analysis of the 3-yr financing, we found a very interesting article, by Izabella Kaminska, at FT Alphaville, named “The curious case of ECB deposits”.

In summary, the mother of all couplings consists in linking the balance sheet of Euro zone banks indirectly with the Fed: The Euro zone banks get cheap liquidity from the ECB in Euros, supported by the US dollars provided by the Fed to the ECB. Asset are not sold now and in fact, they could actually be purchased later, if the sovereign crisis in Europe was to be addressed.

What does this all mean? Well, as we explained on December 12^th, this printing of billions of US dollars by the Fed to back the ECB means that Americans need not to save any extra, to bail out Europe. This is what puzzles mainstream economists, who refer to this “oddity” as a “break in correlations”. The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps. Such a sell off would bring down the price of every single asset vs. the US dollar.

Now that we have clarified this point, we must ask ourselves how this should impact gold. On this point, we must say we are now in uncharted waters. Yes, the swaps are nothing new, but the context in which they unfold is. With this in mind, we think that the rhythm in 2012 will be marked the evolution of the fiscal situation in the Euro zone. On Friday, we saw a massive downgrade in sovereign risk by S&P that was fairly priced in by the market. Going forward, further deterioration or default surprises will accelerate the pressure on Euro banks, which in turn will force the Fed to become more coupled and to print more US dollars. We think that in this context the volatility and the bull trend in gold should both increase.

Why would we not also want to buy stocks? Because we follow the view of Friedrich Von Hayek: We believe that this process is also affecting relative prices everywhere and when relative prices are distorted, in the long term, production falls and we end with a higher amount of money in circulation, available to purchase a smaller amount of goods. Inflation, in the long term, always bankrupts producers and benefits the holder of products. If you don’t believe us, ask gold miners how they feel about the performance of their stocks vs. that of gold bullion.

Martin Sibileau

Please, click here to read this article in pdf format:december-22-2011

In the absence of further meaningful events, this will probably be our last letter of the year. Reflecting on our main macro thesis, things have played out the way we thought they would. Not from the beginning of 2011, but from the beginning of 2010. That’s right, already back in 2010 (refer for instance our letter from May 3^rd 2010: www.sibileau.com/martin/2010/05/03 ) we envisaged a scenario exactly like the one we’re facing today. Back then we wrote:

“….It has become clear and public that European sovereign debt is being and will continue to be bought by European banks backed by the ECB, making the sovereign risk contagion back to the financial system a done deal. Therefore, how safe are those who bought sovereign credit default swaps (“cds”) from banks that are now exposed by the sovereigns?…We have mentioned this ignored side of sovereign cds in previous letters (for instance, refer: www.sibileau.com/martin/2010/03/01 ). How this issue is not discussed while every regulator in the world is still looking for ways to reduce systemic risk is beyond our understanding.

If sovereign jump-to-default risk increased, the ECB would most likely monetize sovereign debt (actually, the ECB is already doing it), further devaluing the Euro. But as long as no sovereign defaults, things will be under control. However, if a Eurozone sovereign ended in a credit event triggering the cds contract…How bad would the run for liquidity to the USD be? CDS contracts on European sovereigns trade in USD.

How much would counterparty risk (=risk between the banks that traded the cds) jump? Is the size of outstanding sovereign debt and that of the cds net notial useful to assess the impact? We think not and we guess that anyone downplaying this issue based on the size of Greece’s cds net notional outstanding doesn’t understand the leveraged nature of capital markets. Are Greece’s funding needs in 2010 not minimal compared to the impact they are causing?

The next question is whether gold would rally or fall. To answer it, we have to speculate on whether the Fed would or not extend currency swaps to the ECB to avoid the collapse of the Euro. The Fed did so in Sep/Oct-08, upon the Lehman event, and we believe the Fed would so again, which brings us to the another point… What is riskier?:

a) To have the Fed extend currency swaps to the ECB to provide liquidity to the financial system for clearing purposes (as in post-Lehman) or…..

b) to have the Fed extend currency swaps to the ECB, as a ultimate back-up on liquidity on sovereign debt?

In the first scenario, should gold not sell? (It did). In the second, should gold not rally, as a sovereign default causes the collapse of the Euro (our base case assumption here)? Would American taxpayers ever get their monies back if the Fed extended those swaps to the ECB under the second scenario?…”

What we did not anticipate is that it was possible to start in scenario (a) above, and as we think will occur during 2012, transition to scenario (b). It may now be possible that these scenarios be not mutually exclusive, as we imagined then 19 months ago, but linked with one preceding the other.

Recapping the year, we should say we had a bit of cautious optimism, back in January, when we thought there would be agreement to use the EFSF to purchase sovereign debt in the secondary market. In perspective, we realize that the refusal to go this path by Germany in March, marked the death sentence of the Euro as we know it.

The debt ceiling negotiations in the US, including its sovereign risk downgrade by S&P, and the latest drop in reserve requirements in China are symbolic of what we will see in 2012.

The view from the rest of the world is also murky. In 2011, we witnessed the fall of dictatorships in the Arab world, without any clarity on what will follow. The same applies to North Korea. South America is divided into a right-leaning block (Chile, Perú, Colombia) and a left-leaning one (Venezuela, Ecuador, Bolivia, Argentina), with Brazil still trying to figure out which way it will go. We believe it will go left. It’s the path of least resistance.

Overall, there has been disintegration in global trade, with the irony of a convergence in risk, between the developed and the emerging world. The first are being downgraded, while the second have been upgraded.

What next?

We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy. In Europe, that may mean not just the fall of the Euro but also of the European Union. In the US, the rise of Ron Paul and if not him, his ideas, may create a serious schism in the Republican Party, in favour of Obama’s re-election. In China, the rebellion should proceed at a slower pace, but steady nonetheless, as prices increase.

Back to a shorter term view, as the reader is already aware, yesterday the long term (3 year) refinancing operation resulted in almost Eur489 billion being borrowed by 523 banks. A lot has been said and written. All we want to add here today is this: We must keep in mind that all this does is to prevent the further sale of assets (sovereign) by Euro banks. Nothing else. If sovereign ratings are further downgraded, the respective losses will still have an impact. If fiscal deficits persist in the Eurozone, the value of the sovereign debt will fall and will still have an impact. If investors are further affected by the Greek situation, the value of sovereign debt will fall and will still have an impact. As you see, the substance of the problem remains alive. All eyes will be on the Fed, which will have no alternative but to remain financing the rest of the world via currency swaps.

This situation however leaves us with uncertainty and uncertainty breeds volatility. Gold and the rest of the risky assets will have a hard time.

We wish you all a prosperous 2012!

All the best,

Martin Sibileau

Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

Martin Sibileau

Click here to read this article in pdf format: december-5-2011

Today we want to write a few comments on the news last week, of the IMF receiving loans from central banks from the Eurozone, to buy EU sovereign debt. We certainly don’t know if this will work out or not and by the amounts that were speculated (EUR200BN or more). But there is merit to make a few observations at this point:

1.-We think the most interesting detail here, to which we believe little attention was paid, is that it will “apparently” be national central banks and not the ECB, that will lend the funds to the IMF, to purchase sovereign debt (“apparently” being the operative word here). Why do you think this would be relevant? It would not, if you were not considering an eventual break up of the Eurozone. But if that scenario plays out, the clearing of sovereign debt will be much easier. In other words: this way of monetizing sovereign debt eventually allows an orderly dissolution of the Eurozone.

2.-As usual, it will be interesting to see whether the funds are used to buy in the primary market (i.e. direct funding of governments) or in the secondary market (i.e. funding to bondholders). We suspect that given the limitations in size and the level of yields the Euro zone is facing, the funds will be exclusively used in the primary market. This has a negative impact on the pricing discovery process. We may see a funding stress on the existing bondholders, impacting the USD funding market and eventually leading to USD swaps at cero cost from the Fed. In summary, we would see more “inelasticity” from the markets (refer our last letter), with apparently sustainable high yields in sovereign debt. These situations very often lead to frustrated policymakers, who see no alternative but to increase the level of financial repression.

3.-If the IMF buys debt from governments, and the banks who hold past issues of government debt face funding problems, we assume the banks will still need liquidity lines from the ECB. Should we not see a transfer of these liquidity lines to national central banks? Which banks would benefit? Which ones would lose?

4.- What will occur with the sovereign debt that the ECB has already purchased since May 2010, through the Securities Markets Program? Will it also be transferred to national central banks?

5.- Will points 3 and 4 be contemplated in the next EU summits, when fiscal integration is discussed? How would the markets take the news, if they actually are?

Needless to say, lending printed money to the IMF to buy sovereign debt is to simply leverage the problem, without addressing its root. While every analyst dismissed the Greek problem at the beginning of 2010, saying that it was only a liquidity issue, we were the first and perhaps only ones to go on record saying that the Eurozone did not face a liquidity or solvency problem, but an institutional problem (See our letter from February 8^th and 10^th, 2010: www.sibileau.com/martin/2010/02/08 and www.sibileau.com/martin/2010/02/10)

On February 10^th, we wrote: “…As investors, what should we interpret as a catalyst, as a defining moment?  Here’s our view: If the IMF has to intervene, the European Union will definitely be a Confederation. This is unfortunately the path of least resistance. This is the easiest and less painful path.  If the IMF is engaged, the Euro will no longer be considered an alternative global reserve currency and the bid that there was under such belief will no longer be there. We shall be sellers of Euros under this scenario. This is the worst-case scenario, for if the EU citizens lose purchasing power, the global recovery will become a long-term dream. Note that we don’t care about Debt/GDP ratios or other metrics. The relevant issue here is that on the margin, the Euro would no longer offer more safety than other strong, healthy currencies. In fact, its complex institutional framework would be a burden, compared to other ones, simpler to understand…”

What could save the Euro? A real fiscal integration. By this we mean a structure where a EU wide federal tax is charged to all the Eurozone citizens, to allow transfers to countries in trouble. If this worked, this federal institution could issue its own bonds, Eurobonds, that would later be swapped to the IMF, in exchange for the national sovereign bonds that the IMF would purchase. This is the only way to save the Euro, and we think it is already too late to implement.

Martin Sibileau