(“A View from Trenches” is temporarily no longer published on a daily basis. Over the past year, we enjoyed writing every day. However, we are very busy of late, undertaking another project that hopefully will be finished by next Fall. We will write as often as possible, but not on a daily basis. Thank you so much for your support and understanding)

Since our last letter, the markets have continued to rally, on the assumption that Greece’s fiscal problems will not spill over to other peripherals mainly, but on the more broad based belief that global activity will continue to recover. Hence, as expected, gold is underperforming, the USD is being sold together with Treasuries and oil and equities rally. In our last letter too, we had explained why we favored Canadian equities over gold. We disagree with the general notion, the true vox populi that the not-so-crazy fiscal budget for 2010 plus rising commodity prices are lifting the CAD. In our view, the CAD is being lifted by default, by Canada’s historical inertia, which in a moment of global volatility, looks like a safe island in a brave ocean. It is true, that inertia is the result of a relatively stronger fiscal position, but it is also apparent to us that smart beats strong, and a smart government that truly opened this country’s economy and financial system to foreign investment could run a wider fiscal deficit (if it so wished), with a still stronger CAD.

In Europe, on the other hand, we do not think fiscal problems will just vanish, and we see the proposal by Germany’s Finance Minister Schaeuble to create a fund similar to the International Monetary Fund, but for the Euro region (as reported by Financial Times Deutschland) as ridiculous. However, we respect one of Denis Gartman’s rules of trading (rule no. 8 ) and think like fundamentalists, while we trade like technicians. Therefore, we are enjoying the recent ride on Canadian stocks.

What perhaps may have gone unnoticed yesterday was the New York Fed’s announcement that will use money market funds as counterparties in its reverse repurchase agreements, to add capacity to drain reserves. We had initially alerted of this on Sept 30/09 (www.sibileau.com/martin/2009/09/30 ), which (for the sake of intellectual honesty) we first learned about from Bank of America’s Global Rate Focus report, on Sep 25/09. Later on Oct 21/09, we wrote:

“…the Fed will eventually need to take liquidity off the market. One of the tools to achieve this is the reverse repos, where the Fed exchanges Treasuries in its balance sheet for cash (that leaves the market). The problem with this is that the volume required is so huge, that the current dealer infrastructure is not enough. Thus, money market funds, for instance, would have to participate in the effort. But if money market funds were to hold these Treasuries, the crowding out effect on the commercial paper market would be significant, affecting rates…” (refer: www.sibileau.com/martin/2009/10/21 )

On this news, Bloomberg reported yesterday too, that there is currently a shift out of Municipal debt, and in favor of Treasuries (i.e. Federal debt). The same has and continues to happen with European peripherals’ debt in favor of German bunds. But given the institutional differences of one currency zone and the other, in the US the currency is not affected. It took the US a four-year civil war to define itself as a Union, finally in 1864. We certainly hope Europeans figure that one out faster and peacefully!

In the meantime, as the Fed starts engaging money market funds, we fear that problems will pile up. Here’s a potentially challenging scenario:

Some municipal issuers will have difficulty accessing the commercial paper market and may draw from liquidity lines that banks extended to back such commercial paper. Would banks in the US dare to show a strong hand against governmental entities in financial trouble? I don’t think so. Who’s going to end up footing the bill, then? Corporate issuers, as liquidity dries. Simultaneously, if this crowding out process unfolds, the credit quality of municipal issuers will be affected, increasing capital requirements of financial institutions. Under this scenario, if the US Federal government shows a sustainable fix to this problem, the USD will strengthen and gold will continue to drop. Otherwise, if the problem gets out of hand, we will get inflationary signals, with the both interest rates increasing and the USD depreciating. Please, keep in mind that this is a long term view, so typical of “A View from the Trenches”. In the meantime, our view is that in the absence of further volatility in sovereign risk (very unlikely), the other asset classes will see slight pricing revisions, consistent with a more sustainable fiscal path. Relative value and curve trades are in full fashion these days…

Martin Sibileau