With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold.
 
We’ve seen this pattern before too, but it did not go too far, when it happened in 2008. Indeed, one could explain the behaviour by pointing at Mr. Bernanke’s comments yesterday, who made every effort before the Senate’s Banking Committee to be clear on the Fed’s intention to maintain a level of liquidity consistent with that of economic activity (weakness = low rate environment). Or maybe his comments on the possibility of reviewing MBS purchases, if required? But if that was the case, why would stocks not also rise, along with gold and oil? Why would the USD not weaken as well?
 
Clearly, the above factors cannot explain what happened yesterday. But if gold was bought as a way out of future currency debasements, then we have some comments to add here this morning.
 
If you have been reading “A View from the Trenches” long enough, you will remember that we turned neutral to bearish on gold (in USD) after the Dubai event, at the end of November 2009. Essentially, we believe the power of monetary policy coordination is a formidable challenge on gold’s prospects as a reserve currency. Therefore, if yesterday’s rally on gold and gold mining stocks was due to the increasingly likely fall of the Euro, as a consequence of the peripherals’ problems, we think gold bugs could later be disappointed.
 
Why?
 
In the 21st century, there are two global social classes: Politicians and taxpayers (This social stratification truly has global characteristics). If you think politicians will let you taxpayers get away from the inflation tax easily, think it twice. Let’s specifically consider the scenario where the Euro plunges. We think that if this happened, there would be an immediate increase in liquidity preference, expressed as a flight to the USD and the Treasuries markets. In that case, gold and stocks would be sold in favour of liquidity.
To those who disagree with this view, believing this chaotic situation would get off hands, we suggest that the Fed would be able to establish again, as it did in 2008, currency swap lines with other central banks, cushioning the impact of this move. This would be a deflationary event and no central bank would hesitate to provide extra liquidity. In summary, we fail to see a compelling story to be long of gold. And yet we are indeed worried, because the market proved us wrong yesterday and will prove us wrong today too, for gold is already at $1,112/oz.
 
For an historical perspective on this dynamic, let me quote below part of an interview M. Jacques Rueff gave to The Economist (Jacques Rueff: (http://en.wikipedia.org/wiki/Jacques_Rueff ). The interview was published on June 1965, and titled “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 ):
 
 
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.
 
J.R.: 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. We were too gentle in complying with official appeals not to convert our sterling balances into gold…
 
 
The analogy here consists in that France did the same 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. But politicians only care about the present.
 
Martin Sibileau

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

We are back from a relaxing vacation and strangely glad to see that not much has happened since we last wrote. Indeed, the markets bounced from the lows we went through earlier this month, and we were stopped out on our short positions, as we invest on fundamentals, but trade like technicians.

Why do we insist that nothing really changed?
We have not witnessed a single catalyst on the Greek/Euro-zone situation. In the US, Bernanke only continued to confirm the Fed’s view of a weak recovery but recovery at last, while at the same time, he asked Congress to think about a fiscal exit strategy. China continues to expand output on its pegged currency and commodities, in our view, are starting to price unavoidable currency collapses.

We believe that by now, it is self-evident that the world has lost one of the most important functions money provides: Its use as a unit of account. Please, take a moment to think about this, but not in the standard way you have been taught to. Do not think of the USD as a unit of account. Do not think of the EUR for the same reason, or any other currency. Why? Because production, distribution, sales, collections, etc. today are global processes. If you don’t believe this, just look around you. Look at where your watch was manufactured and think of all the different components that had to be assembled, the raw materials that had to be used, where they came from, how they were purchased, paid for and, as important, think about what each of the entrepreneurs responsible for these operations did with their respective profits. What currency did they invest them in? What was the volatility of those profits, after adjusting them for their currency crosses (inputs vs. output)?
If the world wants to continue growing, it will need a strong reserve currency. There is no such a thing today. Yes, the USD continues to be the world’s reserve currency, but by default. And this does not and will not foster economic growth. Hence, our bearish outlook.

We recommend the reader to watch a recent interview (Feb. 21st) with Greece’s Prime Minister George Papandreou, by Andre Marr, at: http://www.youtube.com/watch?v=EJP1Z85Hs9g . This interview painfully reminded us of Argentina’s Plan Blindaje, in 2000-01, when it was announced by the then President De La Rua. We wrote before that Greece’ situation is not comparable with Argentina (refer: www.sibileau.com/martin/2009/12/17 ), but the similarities are striking.

This brings us to our final point. We read today’s Morgan Stanley’s Global Monetary Analyst research note titled “Default or Inflate or…”. In this note, Morgan Stanley’s Global Economics Team suggests that neither defaults nor inflation are likely or even optimal for sovereigns. There are many reasons for this conclusion, which we will not deal with here. However, because of this conclusion, the authors of the note propose that governments in developed countries will push banks to purchase and hold their upcoming debt issuances, “as a prudential measure”. This did actually occur in Argentina and it was precisely what led to the financial collapse of 2001. We admit we had thought about this many times before in 2008. We even thought that the US ownership of banks after their respective bailouts had no other final purpose but to later have the power to steer their portfolio allocation decisions. In particular, we thought that by owning Citi, the US government could raise deposits outside the US to buy Treasuries. Call us crazy, but stranger things have happened…

However, we believe there is merit to this suggestion, although it is a bit early to worry. Under this scenario, there are two issues that concern us. First, this would have an immediate and meaningful crowding-out effect on the private sector. If this was the case, we would even consider another jump in default rates, particularly in the high yield space, which according to Bank Of America (“HY Maturity Wall – How big a Worry”, in “Situation Room” Report, Feb. 23rd , 2010) will see over 85% of all loans outstanding mature between 2012 and 2014. Second, we are concerned about the sovereign credit default swap market, which we think is the real weapon of mass destruction. Strangely enough, no regulator has set its eyes upon it yet and honestly, we don’t think they ever will. It is in the sovereigns best interest, as issuers, to ensure that investors buy their issuances comfortably, under the misleading belief that the systemic risk entailed in such purchases is hedged away with these swaps.  But we ask who in his/her right mind would feel safe buying sovereign risk protection from banks that a few months ago could only obtain liquidity under the guarantee of the same sovereigns they now sell protection on, banks which would be forced to invest up to a considerable percentage of their portfolios in sovereign debt? Is this not as crazy as having children sell insurance on their parents’ financial risk?

Martin Sibileau

Please, click here to read this article in pdf format: february-12-2010

(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)

The statement released by European authorities yesterday was a mere expression of support for Greece, explicitly denying a request by Greece, for financial aid. The markets accordingly sold all things European, including and in particular Spanish financials. The picture does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.

What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for $16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended 4bps steeper at 285bps. The Czech Republic was also deceived when it raised 15-yr debt on Wednesday and Greek banks seem to be facing funding problems. We also face significant uncertainty with the latest developments in Iran.  But on the other hand, the markets received some “optimistic” releases too. Continuing job claims in the US kept their downward trend, Australia also saw an improvement in its labour market and the CPI reading in China was stronger than expected.

Briefly, of one thing we may be certain: Capital is flowing out of the Eurozone and into the rest of the world. But at the same time, capital seemed yesterday to also be preferring commodities and basic materials, which puzzles us, because the macroeconomic backdrop is bearish for us.

In our view, we should not see yesterday’s rally in North American stocks and credit, as well as in crude and oil, as a bullish signal, after the EU meeting’s statement. Why? Because for this rally to be interpreted as bullish, the Euro should have rallied as well! It didn’t and in fact plunged from a tall cliff, specially against the Canadian dollar. A reduction in the purchasing power of the Eurozone should not be seen as something positive for global growth (= for oil demand and hence for the Canadian market!)

Interestingly enough, Freddie Mac yesterday announced that it will buy practically all 120+days delinquent mortgage loans from its fixed rate and adjustable rate mortgage Participation Certificate securities. We had foreseen a move of this type and discussed it in December and on our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:

“…As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity. In December, I associated this process with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)…”

Back to the impressive strength shown yesterday by the Canadian Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At close, 1.05 were enough. The CAD was even stronger of course vs. the Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted such a move?  In our view, the strength in the CAD was not fully reflected in the stocks market (TSX 60), which closed +1.32% higher, at 11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.

Martin Sibileau

Please, click here to read this article in pdf format: february-11-2010

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau

Please, click here to read this article in pdf format: february-10-2010

We’re back and still concerned about the situation the capital markets face and will continue to face. Essentially, (we differ with the mainstream view and) we stand by our interpretation that Europe does not face a short-term liquidity crisis, but an institutional crisis. Institutional economics is one of those underappreciated and misunderstood branches of Economics (in our view, if economists had properly read Von Mises’ “Human Action”, Institutional Economics or Behavioural Economics would have never taken off as disciplines. Perhaps the best known economist within the Institutional tradition is James Buchanan (1986 Nobel Memorial Prize), but we also enjoyed very much and recommend reading the works of Peruvian economist Hernando De Soto).

The institutional economist asks the following question: “If the European Union is actually not a Union, but a Confederation, why should Euros be held as the world’s alternative reserve currency, instead of Canadian Dollars or Australian Dollars or Swiss Francs?” We think this is a valid question and a question markets are asking as we write. But first, let’s briefly describe what a Confederation and a Union are:
Confederations are alliances of sovereign states. “…In a Confederation, the links among members are weaker. The legal instrument of the alliance is a “treaty”. The purpose of a Confederation is economic integration and military assistance among members. Member states remain sovereign and as such, keep the powers of self-determination. Confederated states reserve the right to nullify, reject legislation and eventually, of secession. They may issue currency, keep customs and sustain armed forces. They lack a strong common government, although they may unify their foreign policy.
In a Union, the links among member states are more vigorous. In a Union, one finds a definitive purpose to integrate the states. There is a sovereign federal government, while the states are autonomous. The states can govern themselves, have their own legislation, but these acts are subordinated to the Union’s constitution and federal laws. Secession is not allowed, although member states conserve those rights that they did not delegate to the federal government, when the Union was established….” (our translation from “Curso de Derecho Político”, H. Sanguinetti, 4th Edition, 2000)

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.

In the world of corporate credit, when lenders are not satisfied with the credit quality of borrowing subsidiaries, they may demand cross-guarantees, in addition to an irrevocable guarantee of the parent. Unfortunately, this cannot happen with sovereign debt. The more difficult and painful path for the European Union is to stand up to the challenge and lay the ground for a stronger integration, under a central government that can provide legally and operationally a guarantee for not just the debt of Greece, but of any other state under stress (i.e. Portugal, Spain, Ireland).

Such integration demands political will and time. Unfortunately, the world lacks both. Therefore, we were very suspicious, when at 12:19pm yesterday, Bloomberg announced that Germany was considering assisting Greece. In fact, we smelled something wrong earlier, when after 10am, the Canadian dollar broke its correlation with oil (chart above, source: Bloomberg).

At 11am, it was clear that the source was the cross with the Euro. Somebody knew something that the rest of us ignored (chart below, Eur/USD, source: Bloomberg). And then, the rumor was officially out at 12:19pm, that a member of the German’s Christian Democratic Union had said Germany was considering assisting Greece. The Euro had gained 1% and profits were immediately taken!

We are of the view that the market sold into this strength, for if it the rumor had had real merit, the bounce should have been way stronger. However, we are also concerned about the existing misinformation. As we write (11pm ET), the “Frankfurter Allgemeine” (at 11:02pm ET) reports Mr. Joaquín Almunia (ex-economy commissioner, since Feb 10th, according to Bloomberg) to have only expressed that the European Union should promise protection to Greece. However, Madrid’s “El País” reports that the European Union and Germany are preparing a package for Greece. Le Monde and Financial Times back the latter interpretation.

All we are certain of is that a European plan should put the IMF alternative farther rather than closer, and that’s a good thing. However, a plan for Greece is hardly going to solve the situation, for it is the European Union that is in crisis, not just Greece. And the upcoming strike of public employees in Greece is not going to make life simpler.

Martin Sibileau