Please, click here to read this article in pdf format: march-31-2010

This Monday, we attended a conference of The Economic Club of Canada, which had Mr. Paul Jenkins, Senior Deputy Governor of the Bank of Canada, as speaker. From the brief presentation titled “Beyond Recovery: Sustaining Economic Growth”,  we conclude the following:

-The Bank of Canada is most likely not going to explicitly intervene, if the Canadian dollar reaches parity and beyond. The speech itself was a message to Canada’s export sector to increase productivity to confront this appreciation.  The operative word here is “explicitly” because as we have written many times here, the Bank of Canada does actually intervene in the market via its repurchase agreement transactions.

-During the question period, we asked Mr. Jenkins about the Bank’s view on sovereign credit default swaps. We posed this question in a very open way, to test the reaction. Our impression was that Mr. Jenkins was not familiar with this asset class, as he referred us to upcoming G-20 meetings that will address regulatory matters related to the issue. We cannot blame him, since Canada has so far never been quoted in the sovereign credit default swaps market, given its relatively solid financial position.

-We are concerned about the view the Bank of Canada has on productivity, relative to the environment the country is in these days. We do not want to get too theoretical here, but we think the Bank of Canada still holds the nineteenth century view that value is based on the productivity of production factors. The Bank is lately making comments on the productivity of Canada, on the belief that if productivity increases to match the appreciation of the Canadian dollar, the country will remain “competitive” and avoid inflation.

Why are we concerned? Well, what is productivity anyway, and why do you think the Canadian dollar has appreciated?

I am sure most will agree with the opinion that the latest appreciation of the Canadian dollar, in light of the increasing sovereign risk concerns coming both from Europe and the US, was driven not only by the “commodity bid” that accompanied the recovery of 2009, but also by the “safe-haven bid”, which has left this currency almost neutral vs. gold. We first proposed this thesis back in June 2009 and refreshed it on March 4th (refer: “Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 and “The stars favor Canada”, in: www.sibileau.com/martin/2010/03/04 ).

If we are correct, Canada is not only competitive supplying the world with commodities, but with financial, fiduciary services too. The main fiduciary service is ironically supplied by the Bank of Canada (which means its staff is grossly underpaid) that seems to be very competitive providing a reserve asset to the world. In fact, perhaps this country is way more productive exporting a reserve asset than oil or gas or mining products or engineering services. But would this productivity be included in the Bank of Canada’s calculations? Why not? Why should we worry if we are not more competitive than Brazil destroying our forests to win the forest products market? Why should we be concerned if we are not effective contaminating our boreal landscape with oil sands projects so that we may compete with the Saudis in the energy sector? What is wrong with being competitive with fiduciary services? The Bank of Canada of course doesn’t share our perspective and will never clarify that they implicitly make a subjective judgment on productivity.

Lastly, for those interested in the formal aspect of this discussion, we refer to the concept of a “Social welfare function”, under the Theory of Public Choice. In our opinion, for the Bank of Canada, this function is:

W = y1 + y2 + …+yn ,

where W is social welfare and Yi is the income of a sector i among n in the Canadian society. To maximize the social welfare function we may seek to maximize for instance the income of sector 1 at the expense of sector 2, if we deem sector 1 is “more productive” than sector 2. Does it make sense to you? In our view, the function (and by the way, we don’t think there is such a thing as a social welfare function) should be: W = y1 =y2 =…=yn. But this is a discussion for another time!

Martin Sibileau

Please, click here to read this article in pdf format: march-29-2010

The main factor driving last week’s action was the summit of the European Union, and its declarations regarding Greece (We could also include the US Healthcare bill as another factor, but its consequences are still unclear). In particular, France agreed with Germany to allow the IMF to be engaged in a potential aid package. The reaction from the European Central Bank (ECB) on this resolution was mixed, with Mr. Trichet first suggesting it was a “bad idea” and later supporting it…. The ECB has no alternative but to show support.
We bring Greece’s situation to your attention today for two reasons. The first one is related to our comments back on February 10th  (refer: www.sibileau.com/martin/2010/02/10 “An Institutional perspective on the Euro”) when we had anticipated this outcome. Back then we wrote:
“…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…”

The second reason is related to our comments back on January 7th and 22nd (refer: www.sibileau.com/martin/2010/01/07 “Don’t forget Greece” and www.sibileau.com/martin/2010/01/22 “What are they thinking?”). Last Thursday, the ECB decided to extend its emergency collateral rules into 2011.  The decision was naturally welcome by Greece, with Prime Minister G. Papandreou explicitly saying it will “greatly assist banks”. We had also anticipated this move, when we wrote:
“…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…”
We are not gurus. We do not have the crystal ball at “A View from the Trenches”. If we were able to predict this, it is because we’ve seen and lived through it before. Greece in 2010 is going through the same dynamics Argentina went through in 2000. When we identified this link between the ECB and Greece, we suggested to focus on the spread in the credit default swaps market between the National Bank of Greece SA (NBG) and Greece’s sovereign risk. We chose NBG only because its credit default swap is the most liquid of the Greek banks’ financing the government. As you can see in the chart below (source: Bloomberg), this spread has widened since we first addressed it on January 7th.

It is clear that the “infection” of risk transferred from the sovereign to the financial system is in full effect, with Greece’s sovereign risk now tighter than that of its banks (We understand (but cannot confirm) that Greek banks already have bought half of this year’s issuance by the Greek government). If the ECB validates this transfer, something to monitor as the collateralized BBB- liquidity lines are used, the spread should narrow to lower absolute levels. What would have given in then? What will have been the escape valve to address the imbalance? The value of the Euro, which should fall (all other things equal), with this quantitative easing measure. Therefore (as we warned on Dec.17th (www.sibileau.com/martin/2009/12/17 ), on occasion of Greece’s initial EUR2BN private placement) , all those who invest their savings into Euro-denominated assets will be subsidizing Greek taxpayers. It is a hidden tax, and one that neither Merkel nor Sarkozy need to explain to their constituents. For the rest of the world, in our view, this loss in European purchasing power will be a drag on global economic growth.

Another point we would like to make here is also related to the summit of the European Union as well as to our comments on Canada, made on March 4th (www.sibileau.com/2010/03/04 ). Essentially, we have put forward the notion that Canada and the Canadian dollar are no longer receiving just the “commodity bid” (i.e. “mercantilist bid”), but also the “safe-haven bid”. We suggested that to visualize this, one could follow the spread between the ETF “XIU.TO”, that tracks the S&P TSX 60 composite (orange) vs. the ETF “IGT.TO”, which tracks the price of gold, in Canadian dollars. We updated the chart first shown on March 4th, below (source: Bloomberg):

This spread widened as the Greek situation worsened, as anticipated back on March 4th, and it tightened last week (i.e. as gold increased in Canadian dollar terms, the TSX fell), following the summit of the European Union. We think this proves our point.

And lastly, a word on “method”, as followed at “A View from the Trenches”. On Mach 22nd we said that “…What is about to happen politically and in terms of monetary policy has never been seen before. Therefore, any quantitative assessment done based on historical stats will be pure misleading inference…”

Think about what we’ve done above: We proposed a theory (hypothesis), suggested a proof (thesis, i.e. focus on the spreads described above), and later tested the hypothesis (demonstration: sovereign vs. financials spreads, and XIU vs. IGT). We like the deductive method because we think that there is nothing more practical than a good theory. Other analysts play a pure inference game. They take observations going back to the ‘70s and give you, for instance, the inferred probability that a certain event will trigger an expected result. We think this inductive approach is misleading and totally clueless, although it always looks more “scientific” because those suggesting such inferences are statisticians providing trading ranges. However, we could provide trading ranges in our deductive approach as well (We don’t provide trading ideas in this letter for obvious compliance reasons though). The trading range game and its cousin, the so-called “tail risk”, is what gave birth to correlation books and to synthetic CDOs among other things, and we all know how it all ended. They were the product of inductive reasoning.

Martin Sibileau

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

Where to start today? There is plenty to discuss, so we will try to summarize, if possible. Unfortunately, we think it is possible. Indeed, perhaps the most commented news yesterday, aside from the European summit beginning in Brussels today, was the drop of the 10-yr US swap into negative territory (chart below, source: Bloomberg).

Many explanations have been suggested. Let’s first describe what we mean by negative US Swaps. The swap is the difference between the 10-yr implied Libor and 10-yr Treasury. When this spread is below zero, it implies (=the operative word here) that the market prefers private risk over Treasury risk. It implies deterioration in Treasury risk. But it does not mean there is one, not at least this time, in our view. More likely, we think, the negativity of this spread is driven by a technical, namely the rush to hedge fixed-rate positions. In this we agree with some analysts, and believe the negativity is a result of the recent increase in long term issuance.
How can we summarize this? This move in swaps would be consistent with the following chain of events: Ongoing recovery –> Higher interest rates –>refinancing wave (last chance) in corporate credit (long-term for short-term)–> hedging needs driving long-term swaps negative –> credit spreads underperforming swaps –> stocks pushing higher –>gold lower

Consistent with this line also, we show stocks vs. gold (chart below, source: Bloomberg), in Canadian terms (TSX 60, represented by the ETF XIU.CN vs. IGT.CN, gold in Canadian dollars). This is a relationship we suggested on March 4th and which is proving us right, for it makes money.

Two last comments: We are not showing the corresponding chart today, but we want to bring your attention to the latest upwards move in Libor. This was widely expected, even before the Fed announced its intention to pay interest on reserves. The other comment we want to make goes back to our letter from March 4th (www.sibileau.com/martin/2010/03/04 ) and is also in line with the chain of events above. It is about Canada and the Canadian dollar. With Canada’s less problematic (on relative terms) fiscal situation and public refusal to regulate as much as the rest of the world, the Canadian dollar/market is increasingly getting the “safe haven” bid. This is reflected in the EURCAD cross, in our view. The bottom line here is that “mercantilist” explanations (=Canadian strength explained by commodities strength, foreign trade) will be less relevant going forward. Even with higher interest rates in the US, the Canadian dollar should do well, ceteris paribus. Of course, nothing is ever ceteris paribus. But if you ask, we think that the changes about to come, affecting the European Union, are actually supportive of the CAD too. What could derail Canada’s path? Canadians! Yes, the Canadian government, and therefore we worry every time we read Mr. Carney’s “mercantilist” concerns on Canadian productivity vs. a strong CAD. It makes no sense to us.

Martin Sibileau

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

To be fair, one could say that during last week, nothing really new, really surprising, took place. Instead, we saw the revival of “repressed” market themes and fears, that helped volatility rise last Friday. Those themes or fears are:

-Inflation: Under this theme we have to include two sub-themes: Aggregate price level and asset prices

Last week we learned about increasing pressure on the aggregate level of prices (however this is measured by the monopolies that are the Reserve Bank of India or the Bank of Canada) in India and Canada, adding to the inflation fears in China. India saw a policy rate hike and the market now discounts one in Canada, over the second quarter of 2010.
We are clearly at an advanced stage in the credit expansion process (initiated on December 5th, 2008 at 2 pm, when the Fed bought its first pack of Agency debt within its Agency debt purchase program, which ends this month). We use the operative word “clearly” because, by now any digression in the markets’ expectations vs. the “rate” of money supply results in a clear hike in volatility and valuation correction. This is now a structural problem and it will get worse before it gets better.

From an asset price perspective, the unintended consequences of quantitative easing policies are unfolding, leaving us in awe. Last week, two research teams (BofA and Barclays Capital) published separate and interesting comments on how fertile the environment is today for a renaissance in LBOs (leveraged buyouts). Yes, while the world is seeking to deleverage, the unintended consequence is that credit spreads and rates have tightened enough to grant LBOs. Of course, such LBOs would be limited to a certain segment of credits and banks are more regulated than before. Nevertheless, the mere fact that this is a possibility and that speculative trades are recommended thereupon has caught our attention. We took note.

-Political risk: Regulation and protectionism
Honestly, we dislike discussing political risk. Even more so when such risk is in the developed world. But the risk is there, unfortunately and may affect us through the FX market. We will make only this comment on the US-China dynamics: We don’t think that China’s goal is to hold the value of the Renmimbi steady. What China wants to hold steady is the financing of US sovereign debt. Furthermore, we see such purchases as one of the most flagrant injustices in the history of income redistribution. Every time the People’s Bank of China buys US debt, millions of Chinese workers are being denied the opportunity of a higher standard of living, for the benefit of fellow exporters who, at the same time, have no alternative but to deposit their profits offshore, in safer harbors like Australia or Canada. This is a disgrace which ultimately can only be resolved from within. But China is not a democracy and any shift from the current status quo will be against established interests. The more the US pushes the line here, the farther we will be from reaching a solution. In the meantime, this is unsupportive of the USD and supportive of the Canadian dollar.

-Europe’s institutional problems
Last week, Germany publicly invited Greece to explore the possibility of a solution outside of the European Union. From the beginning, we have dissented with the mainstream view (held for instance by Jeffrey Rosenberg, from BofA) that Greece’s problems are only a short-term liquidity issue (refer: “An institutional perspective on the Euro” www.sibileau.com/martin/2010/02/10 ) We have said that the Greece situation reflects an institutional problem that endangers the very existence of the Euro. We think we were right on this one. In fact, more than a month ago, we said:
“…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…”

And as soon Germany’s position was known on Thursday, the Euro suffered materially. In summary, we think that this spring, the world will enter into totally unchartered territory. What is about to happen politically and in terms of monetary policy has never been seen before. Therefore, any quantitative assessment done based on historical stats will be pure misleading inference.

Martin Sibileau

Please, click here to read this article in pdf format: march-18-2010

Since European leaders confirmed their support to Greece a few days ago and the Fed repeated that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period” in their last Federal Open Market Committee statement, the rally in stocks and credit, driven by a lower USD has continued, reaching new highs. What seemed to be the next and unavoidable hurdle for the market, the oversupply of Agency debt once the Fed stops it purchase program, is no longer a concern. This week a few market analysts have revised their demand expectations for this product and it appears the demand will be there (refer: “Against All Odds”, US Fixed Income Situation, BofAML, March 12th and “Where next for the Treasury Market?”, Fixed Income and FX Research, UBS, March 17th ). Will the demand be there for mortgages because they are intrinsically a good product? No, they will be there because alternative investments in credit are already too tight and traditional mortgage investors are underweight this product.
If this sounds counterintuitive, then let us add that although most agree that credit is already too tight and can still become tighter, default expectations have not necessarily decreased, particularly in High Yield. Finally, fundamentals are signaling a stronger than expected recovery in the US, Canada and Europe.

Is this all the lagged consequence of the earlier quantitative easing policies? Certainly, but why should we care?
In our view, the latest action in the markets proves that they are dependent on a given rate of money supply. This is a difficult concept to grasp in the developed world, for it is the base upon which the dynamic theory of inflation was developed. A rate of money supply is a dynamic concept, and we are used to think in “comparative static” terms. The dynamic approach to inflation evolved during the ‘60s, mostly under the so-called “heterodox” line of economists. In Latin America, Dr. J.H. Olivera’s contribution to the theory is widely acknowledged.
Basically, this line of analysis sustains that agents in the market “get used” to a rate of money supply, which they incorporate in their expectations. For instance, if you have the Fed buying, say, $10BN of mortgages/week, the respective market incorporates this liquidity metric and invests accordingly. It is a “sticky” expectation and the problem with it is that policy makers begin to interpret that the problem is with the markets, in that they expect “irrationally”. More so, when an exit strategy like that of the Fed is being widely publicized. But this interpretation is incorrect, because it ignores the non-neutrality of the rate of money supply.

Regardless of expectations, the intervention of central banks in the rates markets has a real impact that distorts relative prices. In our present case, the intervention has been steady and consistent, and we have become too comfortable with it.
Think about it for a moment. Think about the message the markets are sending: “Don’t worry about the upcoming supply of public debt, because there will be demand for it”…But, what is supporting that demand? Low-yield investment alternatives and a sea of liquidity. Where does that liquidity come from? From the Fed’s purchases of public debt, which reminds me of chapter XII of “The Little Prince”, by A. de Saint-Exupéry, reproduced below:

“What are you doing there?” he [The Little Prince] said to the tippler, whom he found settled down in silence before a collection of empty bottles and also a collection of full bottles.

I am drinking,” replied the tippler, with a lugubrious air.

“Why are you drinking?” demanded the little prince.

“So that I may forget,” replied the tippler.

“Forget what?” inquired the little prince, who already was sorry for him.

“Forget that I am ashamed,” the tippler confessed, hanging his head.

“Ashamed of what?” insisted the little prince, who wanted to help him.

“Ashamed of drinking!” The tippler brought his speech to an end, and shut himself up in an impregnable silence.

Martin Sibileau