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

Below is the first chart that I included on my first letter, back on April 14th (refer: www.sibileau.com/martin/2009/04/14 , “Remembering Harberler: The price level may be a misleading guide for monetary policy”). I think this chart says it all. Back in April, the spill over from the Treasuries and Agency debt/Mortgages markets was just beginning. As I foresaw, quantitative easing policies worldwide lifted commodities, taking oil to $80+/bbl and gold to $1,226/oz, and stocks, with for instance, the S&P500 reaching 1,120 yesterday.

Further, in the spring, we heard economists all along say that the markets were overvalued, that a second dip was on its way. All along, I stuck to my thoroughly explained thesis. I also thoroughly explained why the mainstream theses (i.e. David Rosenberg’s:” Reversible rally or reflexive rebound?” Bank of America’s Morning Call Note, April 20th, 2009) was wrong (For instance, also refer to my critic on Krugman’s view: “Why should we see lower lows in stocks and wider wides in credit?”, www.sibileau.com/martin/2009/05/19 ).

Entering 2010, we will reach stage no.4 shown below, where we should see an increase in prices for capital goods and raw materials, as well as the price of the companies that supply them. The tap feeding the waterfall will have shut for the most part, but the spillover effects from tighter spreads in credit will keep feeding a rally in stocks, along with M&A deals, increasing the leverage of companies. As the text for stage no. 4 reads, we will tell ourselves that companies cannot justify their investment levels, and we will not be able to come to terms with P/E ratios.  This will only be the beginning of mankind’s greatest illusion or economic delusion. It won’t be nice, because along the way, the head of sovereign defaults will raise its ugly head. Get ready, but in the meantime, profit from the spillover effect. On this, please refer to my letters earlier this month.

Finally yet importantly, I would like to wish everyone a healthy and prosperous 2010. It has been a pleasure writing “A View from the Trenches” and exchanging intellectually challenging correspondence with many readers. This is the final letter of 2009. “A View from the Trenches” will be published again on January 4th, 2010.

Martin Sibileau

Please, click here to read this article in pdf format: december-22-2009

Before we go on to discuss the latest development, I invite you to refer back to my letter from May 26th, 2009 (www.sibileau.com/martin/2009/05/26 , “A short description of the process”). In that letter, I laid out the main drivers of the adjustment process, after the monetary expansion. Given the market action in December, I think it is worth reviewing these comments.

Apart from the international coordination in monetary policies and globalization of production chains, there really isn’t anything new that a good macroeconomics book will not tell you. We witnessed a full transfer of private deficits to the balance sheet of governments. On top of that, governments were already running their own deficits and now, with the assumption of liabilities from the private sector and the fall in revenue, they will have to either reduce spending or increase taxes. And they will of course increase taxes. They will tax us to death: They will tax more of your income flows, they will tax your savings flows and your wealth no matter where you store it. And should citizens of the world decide to store it in gold….they will see it confiscated by their governments. The sooner this happens, the faster we will be better off. It is like a vomit… you feel much better after it and there is no point in delaying it.

In the meantime, the government that is best equipped to handle its deficits is of course the US government, because of the international reserve status of its liabilities, in which its debt is also denominated. The market is now discriminating sovereign risk and sees the US as the lesser of all evils. It buys USD accordingly not because it loves USD, but because it hates Euros and gold, the two alternatives.

The cycle where US yields are to rise within a steepening move kicked off, and in full force. Some analysts disagree with me, and believe that the fall we witnessed yesterday in the 30-yr Treasury (dropping to 96+ from 99) is explained by the illiquidity proper to this short week. It is true, volume in Treasuries yesterday was below average (73%) but you would have to be naive to miss the trend triggered since the end of November. As well, in corporate credit, we saw the CDX IG13 Index (tracks the credit default swaps of a pool of 125 liquid North American investment grade companies) compress to 85.5bps, from the 90+ we had only a week ago.

Within a steady low-interest-rate environment and ongoing quantitative easing policies, higher sovereign yields and lower corporate credit spreads will be positive of USD equities and negative for gold. As you can see below (Source: Bloomberg), I have included today two charts. To the left, we have crude oil, in 2008, when it began to fall until it reached $32/bbl. To the right, we have gold, in USD/oz. The two charts look very similar and give me horribly ominous feeling on gold.

Martin Sibileau

Please, click here to read this article in pdf format: december-18-2009

The world seems to have radically changed in the past sessions and it is important not to lose track of the fundamental logic that was behind the action in 2009 and will possibly be in 2010. Briefly, in 2007/8 we had “liquidity issues” in an overleveraged world that had misallocated resources into real estate. The issues were eventually “taken care of” by the intervention of central banks. Damage was nevertheless caused, in my view, due to a delayed the intervention, with the political transition from the Bush Administration to the Obama Administration (or more precisely from H. Paulson to T. Geithner). After that delay, the quantitative easing programs gained full speed and we won the rally of 2009.

In the face of Greece’s downgrade and the surprise of the US labor market stats yesterday (jobless claims at 480k vs. consensus of 465k), why will liquidity be an issue again? What makes you think that this time the situation will be different? Political struggles within the Euro zone?

The Fed reiterated only a day ago (and for the 100th time) that it intends to leave the Fed funds rate at a low level for an extended period. Perhaps that clarity was lacking with respect to the European Central Bank but now, after the mess in the so-called peripherals (Ireland, Portgual, Spain, Italy, Greece), we may have clarity sooner rather than later.
Therefore, it is starting to be evident (at least to me) the Fed and the European Central Bank would (or should) maintain an accommodative approach, also in 2011. However, according to our Thesis No. 2 on gold, under such coordination, gold should underperform (see: www.sibileau.com/martin/2009/04/21 ). On December 7th (see: www.sibileau.com/martin/2009/12/07 , “Gold is put to the test”) I wrote about this and so far, the market is telling me I am right. However, I want to wait until January to reach a conclusion and I sincerely hope I am wrong on this one…

On the other hand, if the monetary accommodation takes place, risky assets should continue rallying, which would suggest that December 2009 might, in hindsight, look like a buying opportunity months from now. But the move in the USD was very violent and very strong, and it certainly takes a leap of faith to focus on the big picture for 2010 and to stick to the logics of liquidity (low rates) and non-neutrality of monetary and credit expansions.

I want to be constructive. Following the scientific method of empirical falsification (http://en.wikipedia.org/wiki/Falsifiability ), I will stick to what has worked. I will not be bearish until I see that demand for liquidity is not met by supply. So far, it has been met. With all the turmoil, all the noise of the last days (I call it noise because except for the labor stats, everything else was not surprising), the 3-mo Libor – Overnight Index Swap spread is still at record lows, below 10bps. In addition, the trend in corporate credit is still that of spreads compression.

Lastly, with all the activity in sovereign risk, an interesting “convergence” in sovereign spreads may occur within the European Union. Given that the base hypothesis here is that the Union will not break, its main contributors (France, Germany, Netherlands et al) should end up bailing out the peripherals. Under that scenario, the credit default swap of the big brothers should widen, while that of the peripherals would tighten (in the long term), converging towards a new equilibrium, consistent with a new NOMINAL rate of interest for the Euro. The quote from Keynes above continues to be prophetic and eternal.

Please, click here to read this article in pdf format: december-17-2009

I thought that as the end of the year approached, things were going to get boring. Nothing could be farther from the truth. With most analysts agreeing on the future path of interest rates (first half of 2010 unchanged but stimulus programs are unwound, second half of 2010 rates begin to raise, except in the US. US yields however increase), there is still confusion around the impact on different markets. In addition, we see markets are paying more attention to fundamentals. Yesterday both the consumer price index (1.8% yoy, as expected) and crude oil inventories (-3.7MM vs. -2MM expected) suggested that we are getting closer to the end of cheap money…On this basis, the US yield curve continued to steepen with stocks selling and the USD appreciating. Oil reached +$72/bbl from its previous $69.87 close.

As I wrote before, in 2010 I expect a higher USD and higher stocks with higher yields in Treasuries. However, yesterday after the FOMC statement, the activity in the Treasuries and stocks markets seemed to refute this thesis. The statement was nothing new, with the repeated “exceptionally low rates for an extended period” phrase. This was of course interpreted as a validation of future inflation, and the 30-yr Treasury plunged. So did the S&P500. However, equities (+0.11%) and yields managed to end almost flat. At the end of the session, the USD was losing strength. I think it may be too early to reach conclusions here, but I took note of it. The same can be said about gold, which I found erratic. Was it related to the fall of the Euro and the Yen (after the Nikkei reported that the Basel Committee on Banking Supervision had decided to delay enforcement of stricter capital requirements for Japanese banks)?

Lastly, in our letter from yesterday, I incorrectly compared the situation in Greece with that of Argentina. Although it is true that in both countries the governments “stuffed” local banks with their own debt, the comparison is not correct. In Argentina, the financial system was totally compromised, because the peso was under a convertible (with the USD) system, where the Banco Central had given up the ability to act as a lender of last resort. In Greece, the situation is radically different. The EUR2BN private placement that was announced yesterday is nothing else but an undisclosed tax on Euro zone taxpayers, to subsidize Greece’s fiscal deficit. Greece cannot get a direct subsidy, but the banks that took on the government debt have access to liquidity facilities from the European Central Bank. Thus, the 250bps spread on Euribor charged for the issuance was an arbitrage on taxing jurisdictions, earned by the shareholders of the respective lenders and in a more diluted way, by Greece citizens too. The “white glove” move was subtle, beautiful and simple, with no direct impact on the foreign exchange markets.

Martin Sibileau

Please, click here to read this article in pdf format: december-16-2009

All of a sudden, the world seems to be paying attention to fundamentals, rather than liquidity. It is strange, because I think that there is widespread consensus that liquidity or the lack thereof will play in 2010 a role as important as it did in 2009.

Yesterday, the markets traded on the Producer Price Index (PPI), which surprised to the upside, with a 2.4% change year over year. When you think about all what happened in 2009, including the first three months, a positive change of this order seems relevant, at least before revisions. On that note, the market sold the long end of rates, the USD appreciated and stocks had a range bound session, closing down (S&P 1,108pts or -0.55%). The 2Y10Y curve steepened +3.5bps. Investors immediately associated this reading of the PPI with inflation and crude oil could reach again the $72/bbl level.

On my preceding two letters, I proposed shifting in 2010 to USD denominated assets, favoring equities as an asset class. I do not like thinking this way, but I have no choice.

In the interest rates markets, there could be two drivers. The first one would be the credit multiplier in action, as activity and lending pick up. The second one could be an increase in rates, either directly caused by central banks or by an oversupply of sovereign debt. These two drivers would continue to compress corporate spreads and, given the perception of lower default risk, investors would have to shift their monies to equities, if they need higher yields. At the same time, with the increase in lending and spread compression, companies may seek alternative sources of capital (dynamic), as well as capital structures (static). This could be achieved via equity buybacks, with debt. In a way, the financial sector is leading this trend, as financial institutions have been repaying TARP funds.

Simultaneously, with the increase in rates, the USD would become more attractive, ceteris paribus and a flow of foreign capital would return to the US to further fuel the spread compression in corporate credit. In summary, the problem with this picture is that debt is cheap. I call this a problem because it shows that we would be printing our way out of the mess triggered in 2007. Debt has to be expensive, in order to avoid this. How can you make debt “expensive”, or at least stop it from cheapening? With central banks selling assets, touching relative prices in the same fashion they did back in the spring of 2009. Will they do it? I hope for the best, but fear the worst.

Having said this, I must now dig deeper and 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. This means that there will be enough demand for both sovereign and corporate debt. This assumption is always challenged. Yesterday, for instance, we learned that the Government of Greece did a EUR2BN private placement with five local banks (National, Alpha, Piraeus, EFG and Imi) at 250bps over 6-mo Euribor. This is very serious and I am surprised to see that the Euro still trades at USD1.45+. The last time I saw a government placing (forcing) debt among local banks was in Argentina, before 2001. The other important assumption here is that as activity picks up, commodities, raw materials or wages (in Emerging Markets) do not rise. I am not too comfortable with this notion for now.

Finally, the main issue here is that I think that we are heading towards this cycle of higher rates, lower spreads, higher equities and higher USD, which is not sustainable in the long term, unless as I said, central banks engage in “asset management” (asset sales). This should keep volatility floored at a certain level and should prove a formidable challenge on gold bulls.

Martin Sibileau