Please, click here to read this article in pdf format: september-30-2009

Below, I show two charts (source: Bloomberg). On the left, we can see the 3-mo Libor – Overnight Index Swap spread. As we repeated countless times, in the past, we were confident that the rally in stocks and credit was going to continue as long as we saw this spread compress. We followed it from its 83+bps level at the end of April to its 2009 low of 10.29bps, reached on September 18th. Since then, the trend has been unequivocally from the lower left to the upper right. On the 22nd, we turned neutral on equities. To the right, we can see the change in the US yield curve, from Sep 21 to date. It is visibly flatter.

Are we witnessing a retreat, a flight-to-safety? The USD index (DXY), which indicates the general international value of the USD has risen from 76.42 to 77.08. It is not much, but it is a signal and since September 18th, the DXY seems to be very correlated with the 3-mo Libor – OIS spread. I do not want to make straightforward conclusions out of the 3-mo Libor – OIS spread, because there are excessively many parts moving around in the rates space lately, which diminish the predictive power of the trend. One of them, for instance, is the speculation (ref. Bank of America’s Global Rate Focus report, Sep 25/09) that in 2010, as part of its exit strategy, the Fed will need to take on $500BN in reverse repo transactions. This volume is too high, when compared with the average $219BN in Treasuries, Agency and MBS, which suggests a huge crowding out effect on Commercial Paper, out of which Libor is based. Thus, depending on how near and how violently the market forecasts the reversal move take place, the recent trend highlighted in the charts above may or may not continue. The impact on the equities and forex markets is noticeable. The impact on credit, not so much.

Corporate credit seems to be enjoying the benefit of some sort of inertia. The flow of cash out money funds and into credit has not stopped, as investors keep crowding the boat in search of whatever yield is left to take. I do not blame them. After all, that was the purpose of the quantitative easing policies. The hope that this flow of capital will trigger a wave of investments is perhaps a long way from materializing. However, the flow is the necessary condition. It is not a sufficient, but a necessary condition.

In conclusion, the trend in the 3-mo Libor – OIS spread, Treasuries, the value of the USD and, last but not least, the political changes taking place in Europe and the Middle East continue to make me comfortable with my position on the sidelines. If the aforementioned trends show continued strength, I will have no choice but to turn bearish…

Lastly, the Fed bought yesterday $3.BN in Treasuries (May/12- Nov/13 maturity range), leaving only $7BN to complete its $300BN purchase plan. It seems it was yesterday when I first wrote that I was convinced the Fed would upsize this program. Was it successful though?

A rare congruence of factors has taken place in the last 24 hours, allowing Treasuries to gain (flatter yield curve) the USD to weaken, and US stocks to gain a bit of what was lost last week. As I mentioned yesterday, there is a lot happening these days, a lot of moving parts at a very fast pace, which is shifting the tectonic plates rather swiftly.

To begin with, I have to side with the notion that the waves touching North America yesterday were generated out of Japan and Germany (i.e. Menkel’s victory) during the weekend, and augmented by the winds of the European Central Bank on Monday.

It’s true, the announcement of Xerox Corp. reaching an agreement to buy Affiliated Computer Services for $6.4BN and Abbott Laboratories’ plan to purchase Solvay SA did also add to the winds. From Japan, we seem to have had a short-cover move in the JPY/USD carry trade. I like this explanation. It makes sense in my view. It was suggested yesterday by UBS’ Rates Team.

The short-covering is a bullish trade on the Yen, positively affecting Treasuries. It might look like a flight-to-safety trade, but the fact that both Europe’s and North American indexes finished higher rejects this thesis. We should get confirmation of this if we see the yesterday’s rally extending to Asia in overnight trading.

Yesterday too, M. Trichet went public with Euro-bearish comments, in support of the USD. Among those, he said that “now is not the time to exit”, that “rates are appropriate” but above all, that “ a strong dollar is extremely important”. One has the sense that there is a lot of propaganda going on lately, as Bank of Canada’s Governor Carney also addressed the public (in Ottawa) to show once more his unease with a strong Canadian dollar.

These comments bring uncertainty and over the weekend, I could read a few different theories on the potential next moves in interest rates. This brings me to my point today. Yesterday, I briefly mentioned that Robert Mundell had suggested before a crowd in Hong Kong that the USD/EUR exchange rate should be fixed (http://www.bloomberg.com/apps/news?pid=20601083&sid=aczBO8TH0OpA).

The move towards a convertible  Euro would certainly evaporate the uncertainty we suffer these days. As soon as these comments hit the news, gold sold off last Thursday. I show the chart for the price of gold (in USD/oz, source: Bloomberg) for the last five trading sessions.

Can we say that Mr. Mundell’s comments triggered the big move to the downside on Thursday? I am never too sure but the timing is perfect. The sell off started between 8:48 and 8:57am, exactly coincident with the release of Mr. Mundell’s comments, at 8:53am. You decide. But the sell off would be consistent with a thesis held at “A View from the Trenches”, first proposed on April 21st: “…when there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset…” (www.sibileau.com/martin/2009/04/21 )

There is a lot to opine on this suggestion. But I can remember my days at the Universidad de Buenos Aires, when students and professors endlessly debated the wisdom of the USD/Argentine Peso convertibility. The main lesson was that under convertibility, central banks forfeit the right to act as lenders of last resort. This is the reason behind the Austrian School of Economics’ support of the gold standard. If central banks cannot provide liquidity in a crisis, the banking system will be conservative, because Banks will be on their own.

Thus, what is the conclusion one can make here? Would the Fed and the ECB give up their powers in the name of stability? It seems too far fetched to me. If these banks wanted to keep their powers, they would need a supra-national bank to back them. Can you imagine the IMF playing out this role? I can’t.

What is one to make out of this? If the idea is good but doesn’t seem feasible, the late sell off in gold should be seen as an opportunity…

Please, click here to read this article in pdf format:  september-28-2009

A week ago, we went on record with our neutral call on equities (see www.sibileau.com/martin/2009/09/22 ). The three points we made played out as anticipated: Lack of clarity on exit strategies, dispersion in (global) monetary answers and political instability increasing. By now, both the first and last points should be self-explanatory (see: www.sibileau.com/2009/09/23 ). The second point, the dispersion in the monetary policy answers is the one that worries me the most.  There will be an exit strategy and regardless of how difficult it may be to get clarity on it, eventually that clarity will come. There will be political instability, but it will only (for now at least) indirectly touch the markets. On Friday, for instance, the joint statement made by the US, UK and France at the G20 meeting on Iran lifted the price of crude from $65+ to $67 (statement released at 8:53am ET, the strength was sold with violence…).  However, the dispersion in monetary policies is an open-ended question. We don’t know how many countries may decide to abandon the coordination ship. We ignore what they will do if they abandon it, and we have no knowledge of the time when all this will happen.

But the process has started. It started with the United Kingdom. Last year, one thought it would be triggered by Iceland, or the Baltic nations dragging Sweden along, or Poland dragging Austria or Latin America dragging Spain. Today is the United Kingdom, and it is not hypothetical. It is a fact. The housing and banking problems have been rather serious there and although the UK has so far been in my opinion the most proactive and ingenious country in this crisis, the fact is that its currency is undergoing a speculative run. Moreover, it can get worse, because the market has heard from the Bank of England’s Governor Marvin King himself that interest rates there are likely to stay low for longer than anticipated. The Pound Sterling is therefore on its own. Perhaps that is a good thing, as it will prevent the growth of further imbalances. Ultimately, the answer relies on the side of fiscal policy. The situation with the Pound Sterling worries me not because the currency has depreciated against other currencies, but against gold, along a clear definite path. If gold becomes a visible refuge, the technical damage will have been done and the temptation to run against other currencies will grow exponentially.
In the late ‘20s, the situation with the UK was very similar. I dug into a few documents I had and found an interview The Economist held with Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ). It was published on June 1965, and entitled “The Role and the Rule of Gold.” The entire interview was reprinted in Jacques Rueff’s book “The Monetary Sin of the West”, MacMillan Co., New York, 1971, Part III. Its online version can be found at (www.mises.org/books/monetarysin.pdf ). I show below, a critical part of that interview, which I find contemporaneous:

The Economist: One of the countries that saw the biggest constriction imposed by the gold standard was, of course, Britain—which held no foreign exchange in its reserves. And, as we have always recognized, Britain at this time suffered precisely because of the harsh and inflexible disciplines of the gold standard, which you now want to restore

Jacques Rueff: Let me tell you that you touch a point on which I have quite a few personal recollections. In 1930, I was financial attaché in the French Embassy in London, and in that capacity, I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.

The Economist: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances that was in part responsible for the general collapse later on?

J.R. Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.

Please, click here to read this article in pdf format: september-24-2009

Yesterday we had the announcement of the FOMC decision. Nobody was surprised, the target range for the federal funds rate was left where it was, and the extension in (and slowing down of) the mortgage-backed securities and agency-debt purchases to March 2010 had been expected. However, the intraday volatility was still there.
At 10:30am, the Dept. of Energy released crude oil inventory data. The consensus had been for a decrease of 1.4mm barrels. Instead, inventories grew by 2.9mm. This immediately triggered a sell off in crude and the typical flight-to-safety trade that appreciates the USD. Oil thus lost 3+ dollars, as it fell from $71.65 to $68.35.
The healing process in credit continues, with issuances coming to market in full fashion. Another positive sign yesterday was the weekly MBA Mortgage Applications index: +12.8%, from previous -8.6%. The refinancing wave keeps strong, but I still hold firm to my neutral stance on equities. It is neither bearish nor bullish. I am just neutral, with cash on the sidelines, waiting for things to crystallize before I make my next move.  As I wrote yesterday, the political action generates a volatility that makes me uncomfortable.

To make my point more graphic, I am including this morning a chart (see below left, source: Bloomberg) showing the reaction in the Treasuries (white line) market to the Fed’s decision of letting things the way they are. You would think continuity deserves indifference, but that was not the case. In fact, the S&P500 plunged at close, closing -1.01% at 1,060.87pts.

Naturally, I read the typical macro reports on what happened yesterday. I was surprised to see a huge divergence of opinions. Therefore, mine will contribute to the confusion. For instance, according to some analysts, volatility decreased. In my view, volatility ended higher, touching the swaps (see chart above, right, showing the last 10 days for the 2-yr swap and compare to what happened yesterday) and agency markets, as investors have to reinterpret the outlook with very limited information. The outlook is also seen from different angles. Some think that the fact that the programs are coming to an end signal that we are better off. To me (yes, I know, I am always a bit negative!), one can interpret the situation as follows: The fact that the Bank of England last week insinuated the probability of having lower bank deposits rates and yesterday the Fed announced the extension of its agency-debt purchase program until March 31, 2010 means that:

1. – It’s true, liquidity triggered a recovery, otherwise central banks would have already stopped injecting liquidity,

2. The recovery is still not self-sustainable, otherwise we would not be insinuating lower bank deposit rates or purchase program extensions. Another proof of that is the lack of details on an exit strategy. In fact, Bank of Canada Governor Mark Carney said last Tuesday that “…That growth that we are seeing is largely the result of policy: monetary policy, fiscal policy, the measures to stabilize the financial system….We have a ways to go before we are really going to see true growth, self- sustaining private sector growth.”. Thus, I rest my case! (A confesion de parte, relevo de prueba!)

This fragility, this weakness, led in my view to profit taking in the last hour yesterday. Now, to be fair, we should ask ourselves what is it that we would like to see, to convince ourselves that the recovery is in fact self sustainable. An exit strategy by central banks? No, in fact, I believe that it will only come after there is proof of such sustainability. What then? Capital expenditures! I will believe in this recovery the day I start seeing issuances in the bond markets not to refinance bank debt or other short-term debt, not to finance equity purchases, but to fund plain, old-fashioned capital expenditures.

Please, click here to read this article in pdf format: september-23-2009

I want to start today’s comments reiterating my neutral call on equities. This is on equities only, not on credit. Credit is undergoing a different dynamics. Again, my call is different from that of the bears out there. I do not have a bearish call. My call is based on my uneasiness with the following issues:

1. – No clarity on exit strategies. As an update, Bloomberg reported yesterday afternoon that the Fed has started talks with dealers on using reverse repos. This program would increase the supply of Treasuries, in conjunction with a rising federal fiscal deficit in the US. Unless there demand picks up, interest rates will increase (Treasuries sold off), with a huge crowding out effect on other asset classes. There is also the logistical side of it, as the Fed could bypass the dealers and transact with money funds directly. There will be dislocations. On the other hand, if there is demand for the increased supply of Treasuries, it will be at the expense of equities. Therefore, the equity market faces a real challenge.

2. – Recent dispersion in monetary policy answers. We are in a global world and it is not enough to see good actions carried out by only some governments. The recent developments in the UK are flagging some cracks in the front. While the world is discussing exit strategies, last week the Bank of England’s Governor King said he was considering lowering the interest rate banks earn on deposits. The GBP sold off on the news and finished the week 3.2% lower vs. the Euro. What is worse, the sterling lost big time against gold. As we said on Monday, we don’t want to see gold become a reserve asset. But when it does, it will not be instantaneously against all currencies. No, it won’t. It will first start rising against a weak currency, and then it will spread like a cancer to the rest of the global currencies. Right now, we see the tumor in the GBP. Let’s hope it doesn’t spread.

3. – Political instability is increasing. One gets the sense that the world is rapidly fracturing into right and left again. We did not have that in 2008 and unity was critical to save us from a run against the financial system. That unity is not there anymore. On top of this, we face the developments in Iran. My feeling is that the world is misreading the problem here. As much as the market does not believe in inflation until it sees a jump in the CPI, I get the impression the market does not see a conflict in the Strait of Hormuz, until it happens. And when it happens, it will be too late.

Thus, please note that my call is not bearish based on fundamentals. The sell-off of 2008 and the rally of 2009 were never about fundamentals. It was, is and will be about liquidity. Liquidity has to spread via asset acquisitions carried out by Central Banks. When the asset mix changes, liquidity suffers, volatility increases, and I want to sit on the sidelines. Politics determines the asset mix. Politicians (I include central bankers under this category) arbitrarily decide what and when they will buy Treasuries, mortgages, bank’s capital, etc.
Lastly, I thought I would include a chart of the S&P500 (source: Bloomberg), since I started writing and measure it against my recommendations. My initial call on Mar 19/09 was bullish (“A View from the Trenches” was sent via email in those days) on the Treasury Purchase Program announcement. On June 3rd, I turned neutral and remained neutral until August 4th. The reasons behind can be reviewed at: www.sibileau.com/martin/2009/06/03 and www.sibileau.com/martin/2009/08/04 . As well, during this period, I wrote many times against those who believed the end was near. Yesterday, I turned neutral again.