Please, click here to read this article in pdf format: november-30-20091

Today’s letter is very brief and is the continuation of Friday’s, which at the same time, constitutes another good test of our Thesis No. 2 on gold, postulated on April 21st, 2009. Why is today’s letter so short? Because it has an attached chart that I think is worth more than a thousand words.  As we wrote on Friday, Dubai’s crisis is starting to look contained, delimited and unique by its political background. Of course, given the impact on financial institutions locally and in Europe mostly, one cannot ignore it. But, as we wrote too, according to our thesis, if central banks step in to coordinate action against potential contagion in the foreign exchange markets, gold loses its chances to become a reserve asset.
Thus, on Thursday night, the news that the Bank of Japan was considering intervention (according to some analysts it did not carry it fully out, to avoid adding confusion to the situation in Dubai), as the chart below shows, brought gold to its knees overnight, after it had held admirably well on Thursday. Also shown (at the bottom of chart), is the 3-month Libor – Overnight Index Swap spread, which a benchmark of the liquidity conditions in the USD market. On Friday, this spread opened almost unchanged. Thus, in Europe equity markets ended up correcting Thursday’s sell off and even as the S&P500 Index was down to 1,083 intraday, the VIX Index managed to contract intraday, closing at 24.74 or 5+% higher than Monday’s open. What is the conclusion? Well, I hope it will be obvious by now how much control central banks retain yet…

Martin Sibileau

Please, click here to read this article in pdf format: november-27-2009

With US markets closed yesterday, the level of liquidity was not normal in the face of the events/news out of Dubai. Equity markets elsewhere got the message (finally!) and the sell-off, which to my surprise had been absent yesterday, took place.

As I write these comments there is speculation on the motive Dubai may have had to request the standstill (until at least May 2010) in financing payments by property developer Nakheel and other member companies of Dubai World, which is the company’s state-owned parent.  The markets’ deception is due to Dubai’s recent announcement of $5BN raised in a fully subscribed transaction with two Abu Dhabi-owned banks. I prefer not to comment on rumors. Apparently, this situation unfolded because of some tension between Abu Dhabi and Dubai. Later in the day, the market began to discriminate between Dubai’s systemic risk and that of other Gulf nations.

At the big picture level, I think there are two interesting observations to make, related to two theses I have written about earlier.  Back on September 2nd, I wrote that:

“…emerging markets are the Achilles’ tendon… We can perfectly see a G-8 central bank coordinate assistance with another G-8 member, but investors are wondering who is going to pay the bill, if a fiscal problem unfolds in an emerging market. The IMF? Maybe, but given that history suggests otherwise, the onus is on policy makers…” (www.sibileau.com/2009/09/02 ).

This debt crisis seems to have certain unique characteristics, given the Emirates’ political dynamic. However, given that local banks were involved in the financing of the real estate delusions with people’s deposits, this is also another typical emerging market debt crisis. Therefore, policy makers in the developed world will be forced again to consider assistance mechanisms.

The second observation relates to our old thesis on gold. On September 3rd, I suggested that:

“…A run against an emerging market’s currency would not necessarily be supportive of the USD, if the same is triggered by a wave of defaults affecting the country’s financial system. It could potentially be supportive of gold, if the big guys (G-8 countries) don’t lend a timely hand...” (www.sibileau.com/martin/2009/09/03 )

Gold did not rally yesterday, but the USD did. Does this therefore mean that there will be a “timely hand”? (Our gold thesis reads as follows: “…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…”)

One is tempted to induce an answer. However, we are not inductive at “A View from the Trenches”. We follow the Austrian method, which is purely deductive. It is a fallacy to think that if A is true –>B is true, therefore, when B is true –>A is true.

Applied to this situation, it is wrong to conclude that: “If when there is global coordination (of central banks) gold doesn’t rally (=is not lucrative), therefore, when we see like yesterday that gold did not rally (= was not lucrative), global coordination is on the way”.

It is nevertheless a bit early to draw conclusions here because:

1. – Yesterday the US markets were closed (maybe this was precisely the reason behind the sudden announcement by Dubai),
2. – It is not yet clear what Dubai really intends to do.

Happy Thanksgiving to all the readers in the United States that follow “A View from the Trenches”. Even though this is a short week, what we witnessed yesterday makes it impressive, indeed.
Yesterday was full of macroeconomic data (overall positive, with new jobless claims in the US dropping below 500k), but two events really stole my interest.
Early in the morning, the news out of that Dubai announcing the restructuring of Dubai World, which is state-controlled, seemed that it would add more stress to the sovereign credit default swap market, after last week’s concern over the health of Greek banks. Dubai World was going to ask all providers of financing to Dubai World and Nakheel PJSC to standstill and extend maturities until May/10. With this press release, Dubai’s credit default swap widened 116bps to 434bps, but without impacting the sovereign market. Truly unbelievable, if you compare this to other past debt crisis in emerging markets.
The other (by now not so unbelievable) event is related to my last comment, on Tuesday, about my view on how the exit strategy by the Fed will play. The main point I made was that contrary to what many analysts predict, I believe the Fed will not target a level of excess reserves. In my view, it is more consistent with the policy developed so far to target a level of “excess supply of liquidity”. The problem here is how to define “excess supply”. Liquidity measurements have always been a concern, and perhaps deserve a special chapter in the theory of statistics rather than monetary theory. This problem is faced by every central bank. Therefore, we may not be able to measure the excess supply, but we can see its impact. This is similar to Heisenberg’s principle in Physics. For instance, yesterday we had the 7-yr Treasury notes auction, which took the total issuance during this short week to $118BN!!! It was a complete success, with the yield closing down -4bps and a flatter curve.
What does this have to do with excess supply of liquidity? The solid demand for this issuance did not affect at all the equity market. At all! Let me repeat this: Yesterday, we had the explicit insinuation of an upcoming sovereign default coming out of an emerging market, a successful auction of a US Treasury 7-yr issuance, an increase in equity prices and an increase in gold! Amazing! Who was the big loser? The US dollar!
This is an example of the impact of excess liquidity (as I write, Gold is trading at $1,194/oz.).  Below is a chart, showing the 30-yr Treasury (in white) and S&P500 Index(in orange)prices during the session yesterday (Source: Bloomberg). The change in dynamics after 1pm, when the auction results were announced is very, very clear. And both the 30-yr note and S&P500 Index rose in conjunction. Under “normal” conditions, a increase in bond prices (higher interest) rates, should have the opposite effect on equities. These are certainly not normal times…

 

Yesterday too, an interesting note on Quantitative Easing by Prof. Charles Goodhart, from the London School of Economics (Mr. Goodhart was also member of the Bank of England Policy Committee from 1997 to 2000), was published by Morgan Stanley (“The Global Monetary Analyst”, Nov. 25th). In it, Prof. Goodhart indirectly sides with the notion of excess supply, suggesting that “asset markets (…) determine the end of QE”. I fully agree.
Now, the important issue here is that if you want to be consistent all the way on this subject, excess supply is eliminated with asset sales, not necessarily with interest rate increases. Please, take a good note of this. If you target excess reserves, you can play with interest rates. If you target excess supply, you must sell assets in the balance sheet of central banks. It makes sense. When central banks buy assets, they inject liquidity that creates asset bubbles. To keep them muted, central banks must sell assets.
Will central banks sell assets? Not initially, but eventually. Why should we care about this? Because it should provide us with a good tool to assess when the bubbles will go bust. You can trade gold accordingly!

Please, click here to read this article in pdf format: november-24-20091

The widespread impression that the US deficit will continue set all non-money assets on a rally yesterday. Gold reached $1,174/oz. As we said many, many times over, it is as simple as that. Interestingly enough, with the 10am announcement on the 10.1% increase in the existing home sales (month-over-month), the market took profits in equity and gold.

Yesterday, I quoted comments from our April 28th letter (www.sibileau.com/martin/2009/04/28 “A Keynesian Perspective”) on Keynes approach to monetizing financial crisis like the one we are in. I thought it was interesting to see Keynes’ point here, because in my opinion, Keynes is Bernanke’s intellectual father.
Keynes thought that a readjustment of prices to a new level in the quantity of money was possible, without further unintended consequences (from Chapter 13, “General Theory of Employment, Interest and Money”, 1936). In his words:

“…Circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest…” (Have we not seen this happen in front of us over all of 2009?)

“…Whilst an increase in the volume of investment may be expected … to increase employment, this may not happen if the propensity to consume is falling off…” (Is this not what all economists keep telling us on the weakness of this recovery?)

“…If employment increases, 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..(…)…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…”

From this last paragraph, we learn that the exact price level at which prices would adjust would depend on productivity and unemployment rates. Please, remember that rates are a metric, which depend on time. Thus, timing was indirectly also accounted for. Of course, Keynes neglected the non-neutrality of money (i.e. fluctuations in the quantity of money do not affect all prices at the same time). Note that ignoring the non-neutrality of money is expensive, because if you do so, you miss on the rally we’ve been enjoying since March. But in the long term, it is true, there is an adjustment of prices to a new quantity of money, as long as your currency is not debased enough to push investors to massively dump it. In the case of a global crisis, Keynes correctly appreciated the value of monetary policy coordination to avoid a run against fiat money and proposed the creation of what later came to be the International Monetary Fund.

Where do I go with all this? Do I believe that there will not be an exit strategy after all? Not at all.

My view is that if Bernanke follows Keynes, the Fed will withdraw liquidity in the quantities that it sees in excess of demand (=excess supply). As long as it sees demand for a certain quantity of liquidity, that quantity will not be reduced and of course, further liquidity will not be provided. Let’s call this Thesis No. 3, which I will test going forward and will elaborate more on (i.e. how do we measure “excess supply”?)

This view significantly differs from the mainstream opinion, which holds that the Fed, once it starts unfolding its exit strategy, will seek to return the level of bank reserves, which are expected to rise to $1.35 trillion to the historical average of $10 billion (i.e. normal levels prior to the crisis; this strategy consists therefore in eliminating excess reserves). This would represent a significant reduction in liquidity.

The difference here between the Fed and a typical inflationist third-world country would be in that third-world countries not only do not withdraw liquidity but also keep providing it indefinitely.

What do we make of it? In the foreign exchange market, such scenario should continue the depreciation of the USD against gold and those currencies that do not import USD inflation. Which are the countries that do not import USD inflation? Those countries where their central banks do not accumulate either USD or securities from their financial institutions in the asset side of their balance sheets.

Although the past week did not seem to show a fair amount of important trading or direction, I think that it was a relevant week nevertheless. Monetary authorities and government have made it very clear, if there ever were any hesitations, that at least in the US the accommodating policies will stay in place for as long as needed. In addition to this, over the weekend, a major hurdle to the collectivization of the US health care infrastructure was removed.
The natural winning choice here seems to be gold. However, over the long term, it doesn’t seem right to me. Call it a hunch. Indeed, the world is struggling to come up with a reserve asset, on the prospect that the USD may fail to work as one. But, does anyone doubt for a moment that liquidity will eventually be drained out of the market? To be honest, I do. The issue is that what we call liquidity today, may only be so at a diminished value tomorrow. Let’s see…
Everything may seem a challenge these days, but Keynes foresaw decades ago the dilemma we currently have in front of us. We, at “A View from the Trenches”, also suggested this approach, in our letter of April 28th (www.sibileau.com/martin/2009/04/28 “A Keynesian Perspective”). In April, I quoted Chapter 13 of the General Theory, writing that:
“…Keynes says something rather ominous: “…if employment increases, 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…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…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…”. This strongly suggests that an exit strategy by the Fed may be counterproductive. Inflation may be high enough for us to need today’s increase in the quantity of money, to maintain the rate of interest at the end of this experiment”
The discussion above is more relevant after the events of last week. Strategists worldwide are writing research on how to hedge against upcoming inflation, the initial consequences in the credit markets (spread tightening in 2010 will continue) and the evolution of the global monetary system as the US may be too focused in trying to orchestrate a joint exit program with China only. Thus the degree of productivity increases (= strength of the recovery), which we check every quarter, as earnings are released, becomes critical. Unemployment, which so many an analyst sees as a burden for growth in consumption is, in my view and following Keynes’ comments, a plus. With a 10%+ unemployment rate (i.e. the liability of the wage-unit to rise in terms of money), prices will rise slower than otherwise. Thus, is there a role for gold? Unfortunately, even as this commodity will certainly continue to rise, unless something more fundamental takes place, gold has limited chances of becoming a true reserve asset. But this does not mean, at all, that gold’s chances to outperform in the near term are compromised.
Lastly, as I read the news last week, it seemed to me that we were closing on many questions that we had had since the beginning of the year. Will the Treasury be able to place its debt? Will the Fed indicate a path on rates? Will the US have a collective social health care system? Will there be enough demand for corporate credit? Will we see a clear inflationary reading in the Consumer Price Index? Will we see a clear trend in the reduction of unemployment claims?”
Thus, on this note, I think a comment about Method can be suggested. Thomas Bayes (London, 1701-1761) became posthumously famous thanks to his paper titled “An essay toward solving a problem in the Doctrine of Chances”, published in the Royal Society’s Philosophical Transactions, in 1764. Bayes had elaborated conditional probability, to be able to answer this question: “How can we infer underlying probability from observation”? (refer L. Mlodinow’s “The Drunkard’s Walk”, Ch. 6″).
It is very tempting, as questions become certainty, to infer what will happen in 2010. In the past weeks, I have read a lot of economic and financial research that is nothing else than inferences made on conditional probability (i.e. if the Fed leaves rates unchanged in 2010, what are the chances that investing in corporate credit outperforms investing in equity or gold?) But here’s the trick: In conditional probability, once you identify and quantify your sample space, you have to prune it, to adjust it for the conditions you already know. Can we do this in a global multi-currency world, where the unemployment rate that is assumed to delay consumption growth is not in the country that produces most of the goods sold worlwide? I think the answer is negative. But it is also negative because money is non-neutral, which means that it affects assets prices at different stages in an inflationary process and in different degrees. Therefore, I believe that we are not even able to work with a specific sample space, let alone prune it.