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 [...]
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.
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.