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

This is a short week for the markets, as they are closed today in the US. Today, we want to take the opportunity to disagree with two mainstream perspectives on some of the most “popular” market themes:

-The fall of the Euro is an escape valve that offsets the impact of fiscal tightening
This is by now a widespread myth, that will have to test reality, for it is still too early to tell. We disagree with this view mainly because it ignores the cause of the fall of the Euro. It is certainly not an oversupply of Euros, because the European Central Bank, so far seems to be sterilizing the sovereign debt purchases. But above all, because the fall began way before any sovereign debt purchases were made. The fall of the Euro is simply a run against the currency, a crisis of confidence.

What does a crisis of confidence in a currency mean? Currencies are the liabilities of central banks. When people lose trust in the liabilities of an issuer, it’s because they no longer believe in the quality of the assets backing such liabilities. This is exactly what is driving the Euro lower, even before the ECB would announce its purchase and sterilization programs. The Euro is partly backed by gold, but mainly backed , ultimately, by sovereign risk.

Having said this, to believe that the fall of the Euro will serve as an escape valve implies two assumptions:

Assumption No.1:  The fiscal tightening will be successful. We have our doubts on this issue, because the fiscal deficits are not the result of just a few tough years or a bad investment decision (i.e. sub-prime mortgages in the US). The deficits are structural. They are the natural result of a lifestyle. There are demographic drivers (i.e. aging population), taxation and fiscal spending asymmetries within Euro members, and a deeply-rooted market interventionism, causing them. A cut in public employees’ wages or a spending freeze will do the trick? If you believe this, please call us. We have a bridge for sale!

Assumption No. 2: There is an optimal value for the Euro, and this value is “stable”.
This assumption is in total disconnect with the root of the devaluation. It assumes that exogenously, there was a previous value for the Euro, a degree of purchasing power that Europeans did not deserve, given their fiscal deficits. This is a mercantilist view. This is 17th century economic thinking. It’s absurd. People were holding Euros as an alternative reserve asset regardless of the fiscal situation of EU members, because they trusted the Euro and until that confidence is restored the Euro will continue to drop. The Euro will not be any more stable at 1.10USD than it was at 1.30USD, if the structural problem, the fiscal deficits of the Union, continue to be linked to the balance sheet of the ECB, affecting the quality of its assets. Furthermore, this is not a linear development, but it will escalate exponentially, as it gets uglier.

There is a deeper problem here. Why did assumptions 1 and 2 first come to life? They are the result of an indiscriminate use the “comparative statics method”. As we wrote in our last letter, comparative statics macroeconomic models (http://en.wikipedia.org/wiki/Comparative_statics ) ex-ante and by necessity, are based on the general equilibrium theory. This line of reasoning is a typical case of arguing in a circle, because the equations already involve the final equilibrium they try to prove.

-Deflation, or weaker inflation, has won the day
Those who believe in the effectiveness of fiscal tightening and the stability of a lower Euro, are right to believe in deflation. Why? Because they chose to ignore that the ECB is facing a run against its currency. In a typical run against a currency, things don’t remain stable. Politicians fight back and try to kill “speculators”.  The holders of the affected currency have realized they are subject to the inflation tax, that as long as they hold that currency, their savings will be taxed. Therefore, politicians strike back and first, they seek to close all the exit doors. We are currently seeing this coming from Germany. But this is not the only thing they do. They always go for more and they commit their one deadly sin: They raise the bets and escalate the debasement.  We are months (at best) and perhaps years (at worst, though not many) from getting there.

As well, those on the deflation side always look at “asset bubbles” as a market anomaly, as much as they see the current volatility as the result of “animal spirits”, as if there was no rationale behind shorting a currency whose central bank has been taken hostage by Athens. We believe those bubbles are the natural features of an inflationary process, just as pregnancy is the natural feature prior to birth. We cannot have a birth without pregnancy and vice versa, once we observe pregnancy, we know birth is on its way. Does it matter if it takes 9 months? Certainly not.

What are the latest bubbles? Here are a few:

a) USD funding costs (3-mo Libor –OIS spread):
We will surprise some readers here but we don’t see the recent minor spike in funding costs as proof that the crisis is temporary nor as a result of “adaptive expectations” (on this latest point, refer: Bank of America’s “Situation Room” report, May 27th, 2010).

With volatility levels approaching those of 2008, the fact that funding costs are no way near those of 2008 are a clear sign to us  of a “bubble” in the funding market.  This bubble is being bred by the currency swaps (at OIS+100bps) the Fed is providing the ECB with, at the US taxpayers expense. This is the point Congressman Ron Paul made before the Subcommittee on International Monetary Policy and Trade, on May 21st (please, watch at: http://www.youtube.com/watch?v=hMo-V8HoNdc ).
Mr. Paul (on minute 7:35 of the link) asks:

R. Paul:  “…where do we get the USDs to give them (i.e. the ECB) for the Euros…”

Fed answers: “… it is created as a reserve and then unwound, when it comes back…”

Do we need to say more here to prove our case???? Can you imagine a risk manager of any bank replying to her employer’s Risk Committee: “Don’t worry about those lending facilities we provided to our customer. We know they are under priced, but we expect the customer will not use them”? She would be fired instantly! Yet, the Fed is not even audited on these issues!!!

b) Price of oil
How can it be that, having the European Union members lost 23% of their purchasing power (i.e. from 1.60USD/EUR to 1.23USD/EUR) oil does not fall below $70/bbl? Do we need to show a chart here to make this more visual?

These are not bubbles. This is the proof of a monetary debasement that is looking us straight in the face. There is nothing deflationary here and we could go on and on with property prices that do not fall, food prices that increase, air fuel surcharges that keep being charged, etc.. There is only one way to protect ourselves from this: Civil disobedience? Sell your fiat currencies and buy gold? Having seen where the last debasement led us to (i.e. World War II), the Mahatma Gandhi would approve of this pacifist and preemptive method!

Martin Sibileau

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

We have not written since last Thursday because in our view, nothing really new has taken place. We discussed why we were bearish of the Euro and bullish of gold, and so far, the market has told us we are right. We also mentioned that if the Euro Union did not show political unity, jurisdictional arbitrage of deposits would follow (www.sibileau.com/martin/2010/05/17 ). The first stage of this shift has occurred in Spain, where deposits have left the Cajas looking for bigger players. The next move will be (and to a certain degree currently is) out of a peripheral and into Germany or directly out of the Euro system, into gold, Swiss Francs or USDs. We had also warned about the systemic risk of sovereign credit default swaps, back in March, as well as the risk of contagion outside the Eurozone, via currency swaps. These issues, which we suggested months ago, are currently being debated. Since our last letter, three things are occupying our mind:

1. – Evolution of European Central Bank’s intervention (and its opposite, the value of gold!)

This is perhaps the issue we’ve most thoroughly discussed. Our view is that as long as the ECB does not lower the Euro benchmark rate (as the Fed lowered the USD benchmark rate), there is no healing.

The benchmark rate is indeed decreasing, but we don’t think it is as a result of a successful intervention. On the contrary, it is decreasing as the market sees Bunds as a safe heaven vs. peripheral’s debt (An interesting perspective on this issue appeared on Barclays Capital’s Global Rates Weekly, May 21st : “Euro Inflation-Linked: GGBЄi25-A dysfunctional bond”. For obvious reasons, we cannot opine on this trade recommendation, although we disagree on the writer’s view that  the behavior of this bond is an anomaly that will revert to the “normal”.  We explain our view below)

If you think Germany is going to finally foot the bill, the flight to safety doesn’t make sense. Therefore, the fact that the benchmark rate is decreasing as the risk of peripherals increases, shows that there is no “coordination” in the intervention within the Eurozone. The unilateral decision out of Germany last week to ban naked short-selling says it all. The chart below (source: Bloomberg) shows how the spread between Greece and Germany’s 5-yr credit default swaps is widening, exactly since active intervention by the ECB began. As you can see, the spread compressed right after the EUR750BN bailout was announced. In our view, a successful intervention should have kept that spread converging to a level between that of Germany’s and Greece’s. However, it bounced and keeps widening. The ECB has so far reported EUR26.5BN in peripherals’ sovereign debt purchases.

The lack of successful intervention, the lack of coordination, brings us back to our thesis no. 2, first proposed on April 21st, 2009: “…When there is global coordination of inflationary monetary policies, gold cannot be a safe and lucrative asset. When inflationary monetary policies are not globally coordinated, gold is a safe and lucrative asset” (www.sibileau.com/martin/2009/04/21 ). Accordingly, gold has and will continue to outperform, under these conditions.

2.-Market optimism

We continue to be amazed at the level of optimism so many have. Over the weekend, we have come across research pieces calling this crisis a “cloud of volatility”. There are also many who suggest “shopping lists” in the bond market, for when the “volatility subsides”. Of course, there is no suggestion about what will the catalyst be for the volatility to subside.

Others have decided to do extensive research to compare the fiscal situation of Euro members, and calculate the impact of fiscal tightening over GDP, to conclude that “austerity poses no major risk to the Euro economy”…Have we not yet learned that in an overleveraged world fundamentals are worthless? How can someone explain the fact that the fiscal debt of a minor EU member took the value of the Euro from $1.60 to $1.21 in a few months? Or as a friend and reader noticed, how can the Yen be so strong when Japan’s Govt. Debt/GDP is approx. 200%? It has nothing to do with fundamentals! That’s how.

To those who are familiar with mainstream Economics, we suggest this: All the comparative statics macroeconomic models (http://en.wikipedia.org/wiki/Comparative_statics ) that analyze the outcome of the latest policies must, ex-ante and by necessity, be based on the general equilibrium theory. This line of reasoning is a typical case of arguing in a circle, for the equations already involve the final equilibrium which they try to prove.

3.-Upcoming financial regulation in the US

We strongly recommend the aforementioned report (Barclays Capital’s Global Rates Weekly, May 21st ). In it, there is an interesting discussion on the impact of the prospective financial regulation on USD money markets.

Essentially, we understand that there will be two drivers of further illiquidity. The first one is related to regulations on the Federal Home Loan Banking System (FHLB, http://en.wikipedia.org/wiki/Federal_Home_Loan_Banks ). This system of banks, FHLBs, currently provides advance lending to major banks in the US. Under the prospective regulation (Section 165), they would be prohibited from having credit exposure to unaffiliated companies (i.e. other banks) that exceeds 25% of their capital stock and surplus. According to this report, the six largest US banks would see their borrowing reduced considerably, as a consequence of this new limit.

The second driver is the almost too certain upcoming ratings downgrades on US financial institutions, cause by the removal of systemic, governmental, support. This will reduce the number of participants in the commercial paper market and leave money funds (i.e. liquidity suppliers) with the alternative of investing their monies in Treasury bills. Therefore, the outcome will be a perverse crowding out the private sector, as savings finance the pharaonic US fiscal deficits.

How disastrous will these measures be? How much will they hurt the private sector, as interest rates rise? Below we show where the 3-month Libor – OIS spread closed yesterday (source: Bloomberg). In comparison with September 2008, we are still at a relatively low level of stress. However, the pain will be undoubtedly felt, as this process unfolds.

Martin Sibileau

Please, click here to read this article in pdf format: may-20-2010

In our view, nothing really new has taken place, except for the German reaction on Tuesday to deteriorating market conditions. We have already addressed the issue of the systemic risk embedded in sovereign credit default swaps (refer: www.sibileau.com/martin/2010/03/01 ). However, banning their trading is wrong, it leads nowhere and makes matters worse.

Briefly, sovereign credit default swaps are instruments where counterparty risk is totally underestimated today. If Spain defaulted, what would be the value of a credit default swap on its debt, sold by Banco Santander? None, we think, for Banco Santander would suffer the same fate. As these contracts on EU sovereigns are in USDs, the shortage of USDs in case of a default would rise exponentially, pushing the ECB to request additional USDs swap lines from the Fed. It is precisely this scenario that Congressman Ron Paul sought to avoid last week, unsuccessfully. As we wrote back on March 1st, if the Fed satisfied that USD demand by extending USD swaps to the ECB, the contagion would spread 100% across the Atlantic, which is the scenario where we think paper money collapses. We give this scenario a high probability.

Given that this issue must be addressed, what would we have done differently, had we been in Germany’s shoes? We think it would have been enough to pass a resolution, EU wide, explicitly making crystal clear that the portfolios of those selling sovereign protection will not be bailed out with public funds in case of stress and that those responsible for not separating (capitalizing accordingly) those trading portfolios from other (i.e. banking) portfolios would be liable to criminal charges. On such announcement, the market alone would re-price the underlying counterparty risk on the outstanding trades and those who cannot meet the increased margins would have had to quit, leaving a healthier market.

Finally, the fact that the German ban on short-selling was unilateral and comprised a limited amount of financial institutions invites one to speculate that somebody is anticipating something. Why 10 banks? Why not 5 or 12? Why those 10 banks?  As the easier explanation is usually the one closer to the truth, we are left thinking that it was mere idiocy on the part of German authorities, rather than conspiracy.

On another note, in our letter of May 13th we wrote about the alternative the ECB had, to sterilize by issuing debt (for the comments below, refer the chart we made for this scenario: Sterilization with short term debt: www.sibileau.com/martin/2010/05/13, reproduced at the end of this letter). On Monday, the ECB announced it would do so yesterday (Wednesday) with a 7-day tender at a variable rate with a maximum bid of 1%. (this rate is very good, compared to the EONIA, the effective overnight reference rate for the Euro). The total purchases of sovereign debt in the previous week had been EUR16.5BN:

-May 10-14:
a) ECB credits EUR16.5BN of sovereign bonds and debits EUR16.5BN
b) Euro Banks credit EUR16.5BN of cash and debit EUR16.5BN of sovereign bonds

-May 19th:
c) ECB credits EUR16.5BN in cash and debits a EUR16.5BN 1-week term deposit (short-term debt, for the ECB)
d) Euro Banks debit EUR16.5BN in cash and credit a EUR16.5BN 1-week term deposit

Yesterday, the term-deposit was over-offered (given the 1% rate), at EUR163BN, suggesting that thanks to the ECB initiative, there is no shortage of liquidity in the system. The weighted average rate paid (by the ECB) was EONIA-6bps.

An interesting feature of these transactions is that the deposits are eligible as collateral in refinancing. Given the liquidity in the system, we don’t expect any such usage but we ask ourselves how it is that the market cannot short banks or make naked derivatives bets, while banks can use the cash they debit as collateral! Who is playing with fire? What risk manager at any bank would not be fired if he/she allowed a customer to use as collateral funds already used to buy securities?

We continue to read abundant analysis that is positive on the impact of ECB policy, and we continue to disagree with it. Essentially, the optimistic here believe that the ECB policy will lower rates as well as drive the Euro to an optimal value. They also believe that if given time, Euro members can produce significant deficit reductions. They also bring up the fact that Greece is not a meaningful EU member, in GDP terms.

On our side, we fail to see how the ECB will lower rates by buying non-benchmark debt (benchmark debt = Bunds, non-benchmark = Greece, Portugal, Spain, etc.). We understand that this policy will deteriorate the quality of the assets backing the Euro in a spiraling process (=no optimal value or devaluation speed). We can’t see where is the motivation for countries like Greece to effectively cut their spending (or pay their taxes) when they are bailed out, and we laugh at the naïve notion that GDP weight has anything to do with currency risk, in an over-leveraged world.

Finally, on the bullish side, there is (we think) the misunderstanding that the ECB policy is passive (“passive quantitative easing”), because it is financial institutions that decide how much funding is needed. We think this is utterly wrong. The ECB is not bailing out banks. The ECB is bailing out sovereigns’ fiscal deficits, dumped on Euro banks. Euro banks here are only the middle men. How much funding is “needed” is driven by consolidated Euro fiscal deficits. This is key, folks! If the ECB was bailing out banks, the Euro would not have been sold off so dramatically!!! The market sells the Euro because it knows the Euro eventually represents the liabilities of the sovereigns, BECAUSE THE INDEPENDENCE OF THE ECB IS DEAD AND FISCAL DEFICITS ARE BEING MONETIZED. How can someone be bullish of this? How, we ask?

Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt
Figure 2, reproduced from the May 13th letter. Notice that the ECB debt supply/demand graph on Step 3, right, is not yet significant, given that there’s only been one transaction so far (discussed above) and the resulting price was EONIA-6bps. Also notice that on step 2, PIGS debt increases on the asset side of the ECB. Last week, this increase was of EUR16.5BN, representing approx. 0.8% of ECB assets, as of May 14th (Source: ECB), which means that the credit quality of the assets backing the Euro has deteriorated. At this speed (=EUR16.5BN/week), it would take 14 months to have a Euro 50% backed by PIGS debt.

Martin Sibileau

Please, click here to read this article in pdf format:may-17-2010

The main paradigm that has been affecting markets in the last weeks has not changed one bit. Therefore, today we want to note our surprise at reading so many optimistic research notes in light of the current events. Indeed, most of the research we’ve come across last week deems the European Union crisis as something of a temporary nature, which means that if one manages to correctly address risk via relevant capital reallocations, in terms of timing, industry or asset space, one can get by and even earn reasonable returns in this crisis.
Perhaps we are so convinced about the negative outcome of the latest fiscal and monetary policy decisions by the European Union authorities that we are blind and cannot see any reasonableness behind the optimistic argument. Therefore, we have no choice but to address what we think are the main points of our disagreement:

-The ECB will create asset inflation
This idea comes from misleadingly comparing the ECB plan, if any, with the Fed’s quantitative easing policies. We mentioned the differences between both policies in our previous letter already. Basically, the Fed was buying benchmark debt, lowering benchmark rates, to fund the purchases of assets, which are finite in quantity and identifiable. These assets were isolated from balance sheets and were a one-time event. There are no more sub-prime mortgages, no more houses built for sub-prime borrower.
The ECB is not buying benchmark debt, but junk debt. And these purchases fund fiscal deficits, flows, which are unknown in quantity or time. The only way to prevent this from spiraling is seeing fiscal surpluses from those sovereigns that issue junk debt. And that takes time and fortune. Therefore, there cannot be asset inflation.

-Devaluing the Euro will make the EU competitive
This is an issue were millions of pages have been written by thousands of economists. We are among those who believe there is enough evidence out there to confirm that devaluing a currency does nothing for a country’s productivity. In fact, devaluation only destroys the formation of capital, the ultimate driver of productivity. Does it buy time? It does, and we have been a saying too many times that the survival of the Euro required its flexibility. But not this way, not by buying junk debt. The ECB could have devalued the Euro as well by buying Bunds from a trust that would use the Euros to buy a determined and public amount of junk debt, for a determined period, where specific PIGS cash flows are ring-fenced to repay the trust. We said that indiscriminate secondary market purchases were a sure way to hyperinflation or its synonym: A run against the currency (refer end of : www.sibileau.com/martin/2010/05/10 ) .
The idea that devaluation is a potential savior implies that a) there is an optimal exchange rate and b) one can get there in a linear, smooth way. None of these exist.

Lastly, we are also very concerned about some latest news of politicians, particularly in Germany, considering the break up of the European Monetary Union. These comments are very damaging because they can and will easily become self-fulfilling. The expectation (true or false) that the end of the Euro is near would trigger a jurisdictional arbitrage within the EU banking system, that would be very difficult to defuse. Simply put, if you have a savings account at Santander in Madrid and you believe the monetary union will collapse, you will want to shift your deposits to a German financial institution, possibly in Germany. You will want your Euro deposits to be converted into Deutsche Marks, not Pesetas. In the process, the biggest winners will be Gold and the Swiss Franc, and what once was a Union will end in the most bitter resentment between nations.

On this note, not only are we bearish of the Euro and bullish of Gold, but also very bearish of stocks and credit.

Martin Sibileau

Please, click here to read this article in pdf format: may-13-2010

Perhaps it is very early to tell what will unfold in terms of monetary policy in Europe. Nevertheless we can’t afford to wait for more definitions by policy makers. We are forced therefore to examine two main paths the European Central Bank (ECB) may take in the weeks ahead.
On Monday, M. Trichet repeatedly noted that the ECB was going to purchase PIGS debt in the secondary market, but with sterilization. This means that as the ECB buys these assets, it needs to either sell other assets or issue debt, to withdraw the Euros it printed in the first place, for the purchases.
We looked for official statements indicating what assets could be sold, in exchange of PIGS debt. But we were not successful. However, there has been a rumor since Monday that the sterilizing assets, the assets that will be sold, could be German Bunds. We will take this as a possibility, but we give it a low likelihood. But it is important to examine this scenario and draw conclusions, to gain perspective on what is possible and what is not.
Another way to sterilize the purchases of PIGS debt would be to “issue” short-term debt (i.e. Liabilities to Euro-zone financial institutions). With this, the ECB ends up changing the composition of its liabilities, returning one of its components, the amount of Euros outstanding to its initial level (i.e. the level before the PIGS debt purchases began). The other component would be short-term ECB debt. Let’s examine both scenarios:

Scenario 1: ECB sterilizes PIGS debt purchases selling German Bunds (low probability)
Figure 1

In Fig. 1 above, we see two balance sheets, one for the ECB and one for Euro-zone banks.  For simplicity and illustrative purpose, we included a few main categories in both of them (i.e. Gold, loans, FX reserves, Bunds and PIGS debt).
The purchases of PIGS debt take place in step 2. The ECB debits Euros and credits PIGS debt, while the Euros-zone banks credit Euros and debit PIGS debt. As you can see, on the asset side of the ECB’s balance sheet, PIGS debt increases, matched by an increase in the amount of Euros outstanding (liabilities). The ECB buys this debt from Euro-zone banks, which see a change in the composition of their assets: Higher amount of Euros (liquidity) and lower amount of PIGS debt. As the purchases take place, the supply of PIGS debt decreases, lifting its price, lowering its yield (seen in graph to the right).

Sterilization takes place in step 3. Here, the ECB sells Bunds to the Euro-zone banks, which pay with Euros. The ECB debits Bunds and credits Euros. The Euro-zone banks credit Bunds and debit Euros. At the end of this exercise, the composition of the asset side of the ECB has changed: It has the original amounts of Euros (i.e. prior to the transactions), a lower amount of Bunds and a higher amount of PIGS debt. On the Euro-zone banks side, the asset side composition has also changed. The banks have the same amount of Euros, prior to the beginning of the exercise, but a higher amount of Bunds and a lower amount of PIGS debt. A transfer of risk has taken place, from the Euro-zone banks to the ECB. However, this was not for free. In the process, as shown on the chart to the right on step 3, the supply of Bunds has increased, and so has its yield. The yield of the Bunds is the benchmark rate, the Euro “risk free” rate. This scenario therefore, is recessionary, because it makes borrowing more expensive. It crowds out the private sector.

A few more observations have merit here:

1.-The quantity of Euros remains unchanged, but before the transaction, they were backed by a higher amount of Bunds. Now the Euros are backed by a higher amount of PIGS debt, a riskier credit. Should the “value” of the Euros remain unchanged too? If you got the opportunity to choose, which balance sheet do you prefer, as a holder of Euros? The one in step 1 or the one in step 3? Do depositors in Euros need to be aware of this? No, not if this was a once-and-for-all transaction. But, what if this is carried out indefinitely?

2.- As the Bunds are the Benchmark rate, and the benchmark rate increases when we get to step 3, the transaction is “recessive”. We cynically asked on our last letter (www.sibileau.com/martin/2010/05/10 ) why the market would pay more for Bunds, when one could get a better yield for same risk. Well, it turns out that sometimes reality trumps fiction. The chart below (source: Bloomberg) shows the spread between Greece’s 5-yr credit default swaps (long) and Germany’s 5-yr credit default swap. We were not wrong with our contrarian view. You can see at the far right, how dramatically the spread/risk on Bunds has increased since this Monday, while the gap between Greek and German risk is decreasing.

3.-From points 1 and 2, we realize that sterilizing with Bunds generates recession, hurts growth and deteriorates the value of the Euro. The Euro will drop vs. gold and other currencies. If this is the case, we see a very low likelihood for this scenario.

——————————————————————-
Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt (Likely)
Figure 2

Figure 2 above shows the same steps 1 & 2 as in Figure 1. The difference here is in the sterilization process. Instead of selling Bunds, in Figure 2 we see the ECB selling short term debt.
Here, the ECB sells short-term paper to the Euro-zone banks. The ECB therefore credits Euros and the Euro-zone banks credit ECB debt. Effectively, the ECB has changed the composition of its liabilities, leaving the same amount of Euros outstanding prior to the transaction, in exchange for a higher amount of PIGS debt on the asset side of its balance sheet. The banks have also changed the composition of the asset side of their balance sheets. The hold the same amount of Euros, but lower PIGS debt and higher ECB debt.

From this, we can draw the following observations:

1.-The quantity of Euros remains unchanged, but are the deposits of the Euro-zone safer by being now partly backed with ECB debt? Hardly, but this question has to be answered in relative terms. For how long will this persist? If the PIGS sovereigns cannot generate a consolidated net fiscal surplus, and they continue to issue debt, the component of ECB debt backing deposits at the Euro-zone banks will increase, vs. other assets, like Euros or Bunds.

2.-We think this sterilization, at best is benchmark-rate neutral, which means that it should not decrease real interest rates. As the amount of ECB issued increases, its price has to decrease/yield has to increase, as shown in the chart to the right, on step 3. We are not familiar with the European rates markets, but with increasing issuance of ECB debt, the spread between Bunds and this debt will be impacted. How this impact will affect corporate borrowing in Europe is still something we have to work on.

What is the exit strategy under Scenario 2?
We would like now to compare this exercise with the Fed’s purchase of US Treasuries, in 2009. We, at “A View from the Trenches” were perhaps one of the first to emphasize how bullish of risky assets this program was, while others (i.e. David Rosenberg, Paul Krugman) kept telling us it would lead nowhere. (refer our very first letter, on April 14th, 2009: www.sibileau.com/martin/2009/04/14 ).

There are two fundamental, structural, institutional differences between the Fed’s program and scenarios 1 or 2.

a)    The Fed bought federal debt, benchmark debt and in so doing, lowered the benchmark rate. The ECB will not buy a federal debt because there is no such a thing under the current European Union and will not buy benchmark debt, which are the German Bunds. Therefore, how can this program be accommodative? This issue underscores the institutional weakness of the European Union, namely the lack of a unified bond market. What the ECB seeks to do here would be similar to a central bank selling Texas’ debt to buy California’s debt or issuing its own debt, with the implicit guarantee of all the US states, to buy California’s debt.

What could the ECB have done differently?
A similar solution to that of the Fed in 2009 would have consisted in having the ECB buy German Bunds without sterilization, from a trust, administered by the Germans, to fund the trust’s purchase of PIGS debt. In exchange, the PIGS sovereign would have had to ring-fence a cash flow stream to repay the trust. This is similar to what takes place in federal unions, where the federal government collects through federal taxes or alternatively, through specific royalties established with provinces or states. With this structure, the ECB would have been able to carry out an accommodative policy, with specific amounts and repayment sources.

b)    The Fed bought a predetermined amount ($300BN), with a predetermined timeline (until Oct. 2009). With the ECB’s plan, the market ignores both the final amount of PIGS debt in the asset side of the ECB’s balance sheet, its composition itself (i.e. how much from Greece? From Spain?) and nobody knows when it will end.

As can be easily concluded, under scenario 2, there cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system:

a)    What if the so-called “short-term” ECB debt backing deposits is indefinitely rolled over and depositors see the risk and decide not to renew deposits?

b)    If the ECB becomes a riskier bank, its currency will (actually is) no longer be considered an alternative reserve asset and the propensity to exchange it for gold or USDs will increase exponentially. If so, what was the wisdom behind Sunday’s decision by the central banks of the USA , Canada , UK , Switzerland and Japan to provide currency swaps to the ECB? Are currency swaps all of a sudden a “free lunch”? What for were the balance sheets of these institutions compromised? Who pays for it? Should the senior management of those central banks not be audited for decisions of this sort? Who is accountable?

This analysis suggests there could be a generalized run against the Euro as a currency. The Argentinean experience of 2001 offers a analogous case. Back then and there, the central bank did not increase the amount of pesos outstanding. It simply changed the quality of the assets backing those pesos, from USDs (i.e. FX reserves) to government bonds. Argentina did not have inflation. Nevertheless, eventually as in scenario 2, depositors realized that their deposits were not backed by the assets they had expected and decided to rush for the exit door.

Figure 3 below shows the spiraling nature of this process:

Another aspect here is that as this process takes place, the credit quality of the loans held in the Euro-zone banks would quickly deteriorate, further weakening the ECB position.

Would this lead the world to the end of paper money?
We have written many times before, that we were amazed by the fact that regulators did not understand the systemic nature of sovereign credit default swaps. These swaps, which in the case of Euro-zone sovereigns are denominated in US dollars would be the link here, connecting US financial institutions with Euro liquidity problems.

The Fed last Sunday already extended currency swaps to the ECB in a very murky way, which even caused a heated debate in the US Senate. What do you think would happen under a terminal situation, where the European banks’ risk as counterparties would jump exponentially?

And then, friends, would you hold US dollars as a reserve asset, knowing that they are thrown into a hole to fight the last battle?
Doesn’t this actually make gold look like a bargain at $1,240/oz?

Martin Sibileau