Please,  click here to read this article in pdf format: january-28-2010

The bearish trend in all markets remains in place. “A View from the Trenches” has a neutral view since Friday, January 22nd, but we are increasingly nervous on “headline” risk, given the inconsistencies we hear and read on a daily basis from the world’s most influential policy makers. If this situation continues, and we fail to see why not, we will have no choice but to turn bearish sooner than later (For those interested in these inconsistencies, please, refer to: “The trade cycle and money expansion: The economic consequences of cheap money” L. Von Mises, 1946, http://mises.org/books/causes.pdf , pages 197-8 of pdf doc.)

Since our last letter on Tuesday, perhaps the main policy update we’ve had is the confirmation (as it had been widely expected) of the Fed’s intention to pay interest on reserves. These reserves surpass the $1 trillion mark and this interest payment will be charged to US taxpayers. Such is the social efficiency of central banking…This measure will increase the cost of credit, by establishing a floor on the price of “savings”. This is certainly not bullish. It will be effective, no doubt, and it will have an impact on Libor (increase) and the overnight rate. Essentially, the Fed will gain control of the cost of liquidity, as it embarks on its experiment to unwind the quantitative easing undertaken last year. We wish them well, but we cannot help expressing our distaste for price distortions created by governments, and manipulating interest rates is one of such distortions. We always prefer central banks that manage their balance sheets (leaving markets to determine prices) over those that manage prices (leaving markets to determine volumes).

On another note,  Greece has received an abysmal amount of attention in the last days. The market is not pricing a near term default so far and numerous analysts have rehearsed a multitude of scenarios.  At “A View from the Trenches”, we were ahead of the curve, when more than a month ago we went on record saying that we don’t believe Greece will default in the near term (12 months) and that instead, the country’s government will seek to get the indirect and hidden subsidy of the European Central Bank, by placing its debt in the private markets (Greek banks):

“…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…”  (refer: www.sibileau.com/martin/2009/12/17 ).

Since last week, every analyst places this scenario (Greece’s government using the private placement/syndication market) as a likely option. We proposed it more than a month ago, and believe that the current inversion in Greece’s sovereign credit curve presents an interesting trading opportunity. It also makes me think that Latin America’s sovereign space is very rich in light of the new tightening environment in China.
Finally, I cannot help noticing that the Canadian dollar is under real stress lately, with the bullish trend seriously challenged, as shown in the chart below (source: Bloomberg). In the next letters I will write more on this as well as thoughts on gold.

Martin Sibileau

Please, click here to read this article in pdf format: january-26-2010

Yesterday was the third consecutive day with the S&P500 below its previous support of 1,020pts, validating my view on risk. We may need to see more water running under the bridge until we can confirm a trend here. However, reviewing market commentaries, I found that all those who still stay on the bullish side have one thing in common: They see the higher regulation on the world’s banking system as a positive factor for economic growth. In particular, they believe that stronger capitalization and focus on lending, as sought by President Obama’s administration, will be meaningful in withstanding future volatility, and will also drive spreads tighter in the long term. This is a strong assumption I disagree with.

Below are the reasons of my disagreement, which were EXTENSIVELY ELABORATED in the LAST TWO CENTURIES by others wiser than I:

“…Confidence in the capacity of circulation of fiduciary media is not an individual phenomenon; either it is shared by everybody, or it does not exist at all. Fiduciary media can fulfill their function only on the condition that they are fully equivalent to the sums of money to which they refer. They cease to be equivalent to these sums of money as soon as confidence in the issuer is shaken even if only among a part of the community. The yokel who presents his note for redemption in order to convince himself of the bank’s capacity to pay, which nobody else doubts, is only a comic figure that the bank has no need to fear. It need not make any special arrangements or take any special precautions on his account. But any bank that issues fiduciary media is forced to suspend payments if everybody begins to present notes for redemption or to withdraw deposits. Any such bank is powerless against a panic; no system and no policy can help it then. This follows necessarily from the very nature of fiduciary media, which imposes upon those who issue them the obligation to pay a sum of money which they cannot command…” Cp. David Ricardo (http://en.wikipedia.org/wiki/David_Ricardo ), “Proposals”, op. cit., p. 406; Walras (http://en.wikipedia.org/wiki/Leon_Walras ), Etudes d’economie politique appliquee, Lausanne 1898, pp. 365 f.

“…The history of the last two centuries contains more than one example of such catastrophes. Those banks that have succumbed to the onslaughts of note-holders and depositors have been reproached with bringing about the collapse by granting credit imprudently, by tying up their capital, or by advancing loans to the State; extremely serious charges have been brought against their directors. Where the State itself has been the issuer of the fiduciary media, the impossibility of maintaining their redeemability has usually been ascribed to their having been issued in defiance of precepts based on banking experience. It is obvious that this attitude is due to a misunderstanding. Even if the banks had put all their assets in short-term investments, i.e. in investments that could have been realized in a relatively short time, they would not have been able to meet the demands of their creditors. This follows merely from the fact that the banks’ claims fall due only after notice has been given, whilst those of their creditors are payable on demand. Thus there lies an irresolvable contradiction in the nature of fiduciary media. Their equivalence to money depends on the promise that they will at any time be converted into money at the demand of the person entitled to them and on the fact that proper precautions are taken to make this promise effective. But - and this is likewise involved in the nature of fiduciary media - what is promised is an impossibility in so far as the bank is never able to keep its loans perfectly liquid. Whether the fiduciary media are issued in the course of banking operations or not, immediate redemption is always impracticable if the confidence of the holders has been lost…” L. Von Mises (http://en.wikipedia.org/wiki/Ludwig_von_Mises ), “The Theory of Money and Credit”, Chapter IV, p. 321-2, Yale, 1953.

As you can see, blaming banks has been fashionable since immemorial times and financial systems will never be stronger by making their operations more expensive. Therefore, the idea that credit spreads will eventually tighten because of better capitalized banks is absurd. And if credit spreads do not continue to tighten, the rally cannot continue. Moreover, why would banks seek to be better capitalized and pay for all the embedded costs? This is why their stock prices are off their highs.

Please, note that I am not bearish here, but neutral. As I write above, we need to see more water running under the bridge until we can confirm a trend.

Martin Sibileau

Please, click here to read this article in pdf format: january-25-2010

You will not find a short-term view in today’s letter. I can speak for the long term, in a negative way, but not short term. And I dare to say that those who venture to give you a short term forecast are naïve at best and irresponsible at worst.

Over the weekend I’ve gone through diverse readings on last week’s action and I feel that a lot of folks are in denial mode. After China’s and President Obama’s decision to go after their respective banking systems, I fail to see why things should go back to normal. On this point precisely, I may confirm at least one thing, and one thing only, that will be of value going forward. Let me explain…

When last year I went against mainstream economists with my forecast on higher stock and commodities prices, regardless of fundamentals, I based my view on developments in the funding markets. Specifically, I was monitoring the 3-mo Libor – OIS spread. This spread, as you know, measures the cost of liquidity in the system. This cost dropped violently during 2009, and as it dropped, the new liquidity was allocated to the equities, credit, fixed income and commodities markets. Liquidity “healed” in 2009. Last week, many analysts noted that because liquidity is still intact, the witnessed sell off is a mere correction. I think that observation is misleading. We do not face a liquidity problem, it is true. But we face other problems.

In the chart above, I seek to make more visual, why going forward I will not make conclusions based on the liquidity of financial systems. It is more evident to me that policy rates in 2010 will remain basically unchanged where it matters (USA, Europe, China), with the only caveat that if the situation in Greece or others deteriorates faster than expected (i.e. it will deteriorate anyway, but here speed is key), we may see additional measures by the European Central Bank, to sustain liquidity in the Euro zone. Therefore, we may expect Euro weakness to continue.
But as you can also see above, the latest policies are impacting the distribution stage of the credit market. While central banks are not draining liquidity, they and their governments are making distribution more expensive. They want distributors to be better capitalized, to hold higher reserves (in China) and to be less concentrated (no economies of scale). This will impact distribution economics and distributors will try to pass on to the borrowers (consumers) the higher costs. And they will succeed. Like in any other consumers’ group, in the borrowers group there are those who can afford and will pay for the higher costs, and those who cannot and will see their credit availability restricted.
Such a segmentation does not help economic growth. As well, observe that in the meantime, if liquidity continues to be injected by central banks, we will get closer and closer to inflation in consumer prices. So, it looks like in going forward, we may get this combo: Higher consumer prices, less growth, higher than expected defaults, stagnant to lower stock prices, higher credit spreads, stable unemployment and higher volatility driven by the possibility of sovereign defaults.

Martin Sibileau

Please, click here to read this article in pdf format: january-22-2010

What was President Obama thinking? I know I told you yesterday that of the two forces I saw, I expected the non-neutrality of money to prevail. Well, I think 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 trust I am clear.

Please, do not lose perspective here. Earnings do not matter. Fundamentals do not matter. This was and continues to be a liquidity crisis. When leverage increases, prices increase. When leverage decreases, prices decrease. The latest political action in the USA and the decision to prohibit banks from running proprietary trading operations, from sponsoring hedge and private equity funds, and to cap at 10 percent the market-share on deposits is first nothing else than idiocy of the first order and secondly, a hit to the relevering game that was taking place since last March.

It is true, the concerns on the sustainability of Greece’s fiscal path added to the fire yesterday morning. There was a rumor circulating early yesterday that the European Central Bank would consider a loan for Greece. It was immediately dismissed. But folks, let me say this: Whatever assistance Greece may get from Europe will not be explicit. Nobody will face the scrutiny of public opinion or the moral hazard of such a move. As I wrote earlier, I believe Greece still has a lot of tricks at hand that can use to its benefit, to keep financing its current deficit. One of them is with the private placement market. If Greece continues to use it, selling its debt to local banks (which take deposits in Euros), then Greece will have infected the Euro zone with its disease, forcing the European Central Bank to provide liquidity lines to its financial system. This would be a hidden way to support the deficit and I would be surprised if it is not explored. Therefore, to me, Greece is only noise in the market. Loud noise, but still noise…
The situation in China is different. A lot, really a lot of different outcomes can play out when we think of how the People’s Bank will manage to rein in inflation and its currency appreciation. On top of this, we must also not forget India’s latest developments, but these are the subject of another letter.
Thus so far, only by the idiocy of politicians that don’t get Keynes’ right, we witnessed a huge technical damage to all the key macro prices yesterday. And I find it very hard to repair this damage. What did Keynes write? We quoted him endless times and we quote him again: “…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…” (General Theory, Chapter 13) That’s right! Folks in Washington, London, Frankfurt, Beijing and Tokyo: Please, be consistent. If you are going to print our way out of this one, the world will need an increased quantity of money, to maintain the rate of interest (or marginal efficiency of capital). There is no other way!

Finally, a few comments on the Canadian dollar. As you can see in the charts below (source: Bloomberg), which show the CAD vs. the USD and EUR, it seems that the appreciating trend of the Canadian dollar remains in place. It is being seriously challenged as we write, but it looks like it is still in place.

Martin Sibileau

Please, click here to read this article in pdf format: january-21-2009

Yesterday’s action was actually very “timely”. Yesterday, I had written that the non-neutrality of money was one of the forces shaping the market scene. But also, I wrote that the other force or dimension was “time”.
In 2008/09, practically every country witnessed a transfer of losses/risk from the private to the public sector. Each country, at the same time, was embarked on different fiscal deficit paths (sustainable or unsustainable), if it was a debtor country, or monetary imbalances paths (sustainable like Canada’s or unsustainable, like China’s), if it was a creditor country.
Embedded in Keynesianism, is the belief that when output increases after a slump and prices rise, we need to increase the quantity of money to maintain a given rate of interest. Therefore, once liquidity has been injected, all we have to do is wait until activity picks up, driven by a positive marginal return on capital. And waited we have and continue to . However, when Keynes explained this view, the world was not as global as it is today. There is only one interest rate. If we oversimplify the current situation (with a bit of a physiocratic taste), we can think of today’s global exchanges in terms of three factor-competitive monetary zones:

These zones are characterized for being competitive in supplying the global economy with production factors: There are
competitive raw materials exporters, labor exporters and knowledge exporters. In the chart above, the arrows indicate flows, affected by the respective foreign exchange crosses. Some of these zones are encountering different problems.
Relevant to the knowledge exporters, within Europe, we find institutional problems, between its Central bank and members’ fiscal deficits. Because this zone should be competitive in terms of its “institutional infrastructure (i.e. rule of law, developed capital markets), when the institutional infrastructure is affected as in Greece, there is room for an intra-zone arbitrage. Hence, the Euro is sold and the USD is bought. Why not? Interestingly, if such infrastructure weakness took place in Latin America, nobody would care, because Latin America is not competitive at exporting it.
In the case of China, I think that what happened yesterday after reading the statements of Mr. Mingkang (Chairman of China’s Banking Regulatory Commission), was the product of cultural misconceptions. We, in the West, are used to democracy. But China is not a democracy. When China ordered to stop increasing new loans, we were taken by surprise. The surprise was twofold. Firstly, it is hard for us to grasp the degree of authority this measure carries. A suggestion like this somewhere else would immediately bring smiles. (We would quickly see that there would be a segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore). Secondly, this measure is surprising because of its absurdity. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest. For a creditor country like China, a central bank that prohibits new loans sounds like a manufacturing company that asks its distributors to keep buying its output, while at the same time does not allow them to further sell it to their respective customers.

I don’t think China ignores this, which is proof that all China seeks is to delay the appreciation of its currency, very much in line with what the Bank of Canada is doing with its open market operations and its interest rate policy. Hence, the timing dimension referred to above…Back to my first point, every policy maker today believes in leaving monetary conditions as steady as possible, until activity matches outstanding liquidity. In some zones, activity has grown faster than expected. In others, it is growing more slowly. In the meantime, foreign exchange crosses correct and generate volatility, as “A View from the Trenches” had anticipated and as is reflected in the break of correlation between USD weakness and US stocks markets.

But in the end, I remain optimistic that the non-neutrality of money that I discussed yesterday will prevail as the dominant force. The credit markets seemed to agree with this view yesterday. In the investment grade space, for instance, the widening was smooth, with the IG13 index up only 2 ½ bps intraday. That to me was very telling…

Martin Sibileau