Please, click here to read this article in pdf format: may-6-2010

We wanted to publish our letter yesterday, but given the volatility in the markets, we thought it would be more appropriate to let 24 hrs. pass by before publishing. We will mince no words here: We were surprised by the markets’ reaction in the past two days. This action has turned us into contrarians. We “disagree” with the action seen since Tuesday and we think it has been the product of confusion, idiotic rhetoric from Euro politicians and perhaps too, a certain degree of ignorance on basic macroeconomic/monetary concepts.

Since December/09, we have correctly predicted that the European Central Bank was going to have to relax its criteria to accept sovereign debt as collateral, but this issue is still not 100% clear and this is leading to confusion, which fuels the sell off. We are not fundamentalists, for in this world of fiat currencies, value is the result of undetermined equations. An example of an undetermined equation is for instance: y = 2 +x. The pairs (4, 2) or (5, 3) satisfy it. If “y” stands for value, which one is “fair value”? As you see, the “fundamental” question makes no sense, for y varies with x.

We’ve read, discussed and heard a lot, and here are the reasons for our position today:

-What we find absurd:

There is a line of reasoning that compares the current sovereign events with the credit events of 2008 (i.e. Bear Stearns, Lehman, refer “European Credit Compass”, UBS, April 30, 2010 report).  We could not disagree more. Bear and Lehman were investment banks, funding on a very short-term basis, highly leveraged and were big counterparties in many markets.

Sovereigns on the other hand are not counterparties and the troubled assets, the sovereign debt, have the European Central Bank as counterparty! The fact that the Euro is devaluing on a daily basis shows that this counterparty is working fine, for it is monetizing sovereign debt. Monetizing sovereign debt is the same as paying par on leveraged debt. The ECB, as counterparty, honors the contract and when it does, it adds liquidity. Hence, the excess supply of Euros and its consequent drop in price.

In fact, we should be concerned if the Euro appreciated!!! For this would mean that the ECB, as counterparty, would not be there to pay par on the sovereign debt! That’s why we find comical that some Euro politicians like Mr. Axel Weber openly defend a strong Euro. The survival of the Euro as a currency, ironically, lies on its flexibility to be devalued!

Furthermore, sovereigns have taxing power and assets, and their funding needs are in no way comparable to those of an investment bank. We find even more absurd that those who compared the sovereign problem with the liquidity crisis of 2008 recommend selling volatility or advise that M&A activity may rise as a consequence.
-What we think is flawed
In the past days, there has been another line of reasoning, suggesting that the current actions, i.e. the aid package + debt monetization by ECB only address “liquidity but not solvency”. To make such a statement implies that monetizing debt (=liquidity) does not result in inflation. If you think that printing its way out of debt does not make a sovereign solvent, then it means that you don’t think that printing your way out of debt is inflationary. But if that was the case, why would the ECB fear printing the way out for Greece, Spain or Portugal? Indeed, the question answers itself by reduction to the absurd. The printing process brings inflation, which makes sovereigns solvent, as the burden of the debt falls.

Simultaneously, printing brings liquidity which first decreases jump-to-default risk and later opens the window for refinancings. Did this not happen when the Fed started purchasing mortgages? Did we not have an impressive issuance of corporates in the Spring of 2009? What makes you think that Greece, Spain and Portugal, would not be able to find the same way out in 2011 and refinance at longer durations? If that is not solvency, then we don’t know what solvency is, literally!

Another common belief is that the aid package + debt monetization will be recessionary, increasing real interest rates. We disagree, but in part. There is a temporal element here. We can think of this process in two periods. The first one would be inflationary and bullish, if the ECB accepts all kinds of sovereign debt. The bullishness would of course be based on the low interest rates for a long period. The second one, perhaps years ahead, is recessive, as inflation is always unsustainable and growth stagnates. The assumption here is that inflation is manageable, which is also an aggressive assumption.

Keynes in his Chapter 13 of the General Theory addressed this same point when he wrote: “…Finally, if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money. And 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...”

(What do you guess is the “liability of the wage-unit to rise in terms of money” in Europe?)

Lastly, if the ECB is going to buy sovereign debt, and we think that in the case of Greece it has openly announced so, by lifting the ratings criteria on collateral, we cannot understand the sell off in Euro banks. These banks will have an oligopolistic position in terms of the sovereign debt they own. They are the only ones with access to the ECB window. They will buy at below par, turn to the ECB window and get par. This is called arbitrage, and if quantitative easing in Europe kicks in, these banks will be an oligopoly. Oligopolies earn extraordinary rents.

-What we think is debatable
Since the news on Tuesday about the engagement of Lazard by the Greek government, the rumors of a debt restructuring have increased. Could it happen? Stranger, more idiotic things have happened, and we, for instance, remember the decision by the Argentine government to limit withdrawals from chequing and savings accounts in 2001.

From a “common sense” perspective, restructuring doesn’t pass it for us. Under restructuring, the costs to sovereigns would multiply, because it would be required to capitalize Euro banks against the respective losses. It is also inconsistent with late ECB action, for restructuring occurs under monetary rigidity (i.e. currency board in Argentina), while every day, the Euro depreciates steadily. The devaluation of the Euro acts as an exhaust mechanism, as an escape valve. Escape valves are good because they prevent explosive situations. Hence, the virtues of flexible vs. fixed exchange rate policies.

There is also another aspect that sounds not all too correct to us. It has been proposed (refer BankofAmerica’s “Situation Room” , May 4th) that the sell off was partly triggered by increasing liquidity costs. We agree that liquidity costs play an important “explanatory” role. The metric shown to make this case is Libor –OIS spread. I thought I would put the corresponding chart below (source: Bloomberg), for a picture sometimes is worth a thousand words.  Silence then… (The spread was so low that of course, on a marginal basis, the increase has been relevant. But what else could you expect? Did it take anyone by surprise? Is the ounce of gold not worth +$1,1170 still?)

-What we think happened
First of all, let us say that we never subscribed to the theory that markets may sometimes be irrational. If you see a monster in a room and run out of the room, you are rational. The problem is that there is no monster. You had incorrect information. But you were very rational, for whenever there is a monster in your room, running away is the rational thing to do. It would be irrational to stay. Hence, we think that as a result of confusion, the markets are seeing a monster in the room.

As usual, the confusion is bred by governments. In the US, we have uncertainty over future financial regulation. In Europe, we don’t really have the details of what the ECB will do, but we sort of guess it. In China, we ignore what the intentions in monetary policy are. Given that we are hostage to governments’ fiat currencies, we have no alternative but to shift them from one jurisdiction to another or…take a leap of faith and exchange them for gold.

However, we already saw a similar situation in January 1995, upon Mexico’s sovereign default. Back then, the markets sold off all things Latin American. Argentina was then under convertibility and the markets had no confidence in it. The truth is, convertibility boards like Argentina’s were not well understood, since they are very unusual. Essentially, Argentina’s central bank had to buy every peso it was offered for a minimum of one USD. But the market sold off anyway. Those who shorted the ARG peso lost money. After all, why would you sell a peso under par, when at the central bank window they pay you par? The same should apply this time in the case of Euro sovereigns, if it is true that the ECB will accept ANY sovereign collateral, not just Greek. If the ECB buys all debt at par, it will devalue its currency, and nobody has ever won going against a central bank that wants to devalue its currency.

When Emperor Augustus died, he had ruled over the Roman empire for 50 years, which was approximately the average life expectancy of a human being back in those times. This means that those surviving Augustus’ death had no recollection of what life used to be like in the times of the Republic, prior to Julius Caesar. Therefore, continuing with an imperial government, with an emperor, was the natural thing to do. Today, nobody of consequence in Europe has a recollection of what life was under the hyperinflation post WWI, let alone the gold standard before WWI. The rules of the monetary game are changing and the markets get caught off guard.
-What we think is possible
We like to think in terms of propensities to act, in terms of paths of least resistance, always, always taking the force of entropy into account. Having said this, we wrote before that there were only two solutions to the sovereign debt problem: Guarantees (or cross-guarantees) of riskier sovereigns’ debt (i.e. Greece) by less riskier sovereigns (i.e. Germany) or monetization by the ECB through liquidity lines. The easiest way, the way that allows politicians to save face before their constituencies is the latter.

However, once started, we cannot go back to status quo. The consequences of quantitative easing in the USA cannot be undone. The direct consequence of quantitative easing in the Eurozone is the devaluation of the Euro now and inflation later. Why inflation? Because the purchasing power of Europeans will drop dramatically and governments addicted to monetization will have to keep the circus going. This again, is the path of least resistance, applied to the law of entropy.

The second act here is the contagion of this devaluation/inflation to the rest of the world. In North America, it will mean low rates for longer than expected, which will only keep inflating existing bubbles, like the housing market in Canada. In China? Who knows, given the uncertainties in monetary policy.  However, if China is affected negatively (and this issue demands a whole article on its own merit), emerging markets, the still untouched jewel here will be tossed off.

-Conclusion
As much as we rationalize this situation, we always trade like technicians. Therefore, in the face of this bearish run, we had two alternatives: To turn bearish or walk to the sidelines. We chose the latter, remaining bullish of gold and bearish of the Euro.

Martin Sibileau