Archive of June, 2010
Published on June 28th 2010
Please, click here to read this article in pdf format:june-28-20101 With a shortened week in Toronto, courtesy of the G-8 & G-20 summits, plus Argentina making it to the quarter finals in the World Cup, we have lost the pulse on the day-to-day developments, to gain perspective in what is to come. Perhaps the biggest [...]
Please, click here to read this article in pdf format:june-28-20101
With a shortened week in Toronto, courtesy of the G-8 & G-20 summits, plus Argentina making it to the quarter finals in the World Cup, we have lost the pulse on the day-to-day developments, to gain perspective in what is to come. Perhaps the biggest headline these days is the upcoming regulations affecting financial institutions in the US and Europe, and on this, we will focus our comments today. In both currency areas, efforts are wasted on the issue of the capitalization of banks. In the US, the goal is to avert future systemic crisis, while in Europe it is to provide more certainty to investors worried about the implications of the rising sovereign crisis.
The underlying belief here is that even though banks have (by definition under fiat currencies) a portfolio of leveraged loans, there is an optimal level of capital that can stop a run against a financial institution from becoming a widespread financial crisis. This is completely absurd, but acknowledging the absurdity would lead to review the usefulness of central banking, which is blasphemy. Why is increasing banks’ capital levels absurd?
“…If the fiduciary media are issued only on good security and if a guarantee fund is created out of the bank’s share-capital for the purpose of covering losses, for even under prudent management losses cannot always be avoided, then the bank can put itself in a position to redeem in full the fiduciary media that it issues, although not within the term specified in its promises to pay…(…)… even if the fiduciary media are completely covered by the assets of the issuer, so that only the time of their redemption and not its ultimate occurrence is open to question, this cannot have any sort of influence whatever in support of their capacity for circulation; for this depends exclusively upon the expectation that the issuer will redeem them promptly.
To have overlooked this is the error underlying all those proposals and experiments which have aimed at guaranteeing the issue of fiduciary media by means of funds consisting of non-liquid assets, such as mortgages….” Chapter IV “The Redemption of Fiduciary Media”, The Theory of Money and Credit, L. Von Mises, Yale, 1953.
If Basel III or the upcoming Financial Bill in the USA is not one more of those “proposals and experiments which have aimed at guaranteeing the issue of fiduciary media”, then we should not be writing nor should you be wasting your time reading us…
The other experiment we are witnessing these days is the establishment of stress tests for the Euro-zone banks. The assumption here is that because bank tests “worked” in the US providing certainty to investors, they will also work in Europe. We find that assumption totally flawed. As we wrote already many, many times here, the cases of US in 2008/09 and Europe in 2010 are radically different.
What triggered the crisis in the US was a revision on the value of assets held in the banks’ portfolios, i.e. mortgages or their respective derivatives. In economic terms, these are stocks. And once that revision was triggered, the creation of these assets stopped. The market for mortgages and their derivatives collapsed. It made sense therefore, to carry out a one-time inventory account of these assets held in the banks’ portfolios, with the stress tests.
What triggered the crisis in Europe was a revision on the sustainability of fiscal deficits and their impact on an institution called the European Monetary Union. In economic terms, deficits are flows, not stocks. And once the revision was triggered, the generation of these deficits did not stop and will not stop in the foreseeable future. The market for the corresponding government issues did not collapse and they are being monetized by the European Central Bank and now the Swiss National Bank. It makes no sense therefore, to carry out a one-time inventory account of the sovereign debt held by banks, which ends up anyway in the balance sheet of the European Central Bank. Nobody will be any more certain about the soundness of a Euro-zone bank today than he or she will be tomorrow or was yesterday. The mere suggestion that such tests be enforced shows the ignorance of policy makers on economic matters and makes gold a much clearer investment thesis.
On a final note, Professor Joseph Stiglitz, Nobel prizewinner who was senior economic adviser under President Clinton and is currently professor of economics and finance at Columbia Business School, was interviewed by The Independent this Sunday (http://www.independent.co.uk/news/uk/politics/osbornes-first-budget-its-wrong-wrong-wrong-2011501.html ), and among other things, he had this to say: “The problem was that, in the US, the stimulus wasn’t big enough“… “Too much of it was in tax cuts. And when they gave money to the banks they gave it to the wrong banks and, as a result, credit has not been restored – we can expect a couple of million or more homes to be repossessed this year than last year – and the economy has not been restarted…(…)….Governments should set up their own banks to restart lending to businesses and save struggling homeowners from repossession. If the banks aren’t lending, let’s create a new lending facility to do that job. In the US, we gave $700bn to the banks; if we had used a fraction of that to create a new bank, we could have financed all the lending that was needed…”
At “A View from the Trenches”, we were not surprised to read this . Last April 19th, we warned about the ominous consequences that the case against Goldman Sachs was anticipating in our mind:
“…The upcoming financial regulatory framework will be supportive of monetization. Hence, the need to press institutions, as we first glimpsed on Friday. As the issuance of Treasuries and rise in policy rates eventually increase the cost of capital, it will be evident that the sustainability of the recovery/valuations will be more fragile. The government will continue to blame Wall Street for not lending enough to Main Street, while it simultaneously generates a crowding-out effect on corporate credit with the implementation of Basel 3. Under Basel 3, regardless of its final shape, banks will be forced to hold government debt as liquid assets (vs. other corporates) and to issue more equity to raise capital. In countries like Argentina, we have seen this coercion take place already. How was the liquidity shortage circumvented? The government itself became the major lender (i.e. Banco Nación). Would the US not do the same through its Agencies? In our opinion, US financial institutions will be the losers in this game, while gold starts to look like the real winner…” (refer: www.sibileau.com/martin/2010/04/19 ).
When a government actually starts lending under increasing sovereign spreads, why would investors own sovereign risk, when they can get a higher yield from financials, with the same underlying risk?
Published on June 22nd 2010
Please, click here to read this article in pdf format: june-22-2010 We’ve started the week with a weekend announcement, by the People’s Bank of China, which has been already widely analyzed in itself and in terms of its implications. (refer: http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488 ). Our initial reaction was caution. We don’t really believe, as the Bank of [...]
Please, click here to read this article in pdf format: june-22-2010
We’ve started the week with a weekend announcement, by the People’s Bank of China, which has been already widely analyzed in itself and in terms of its implications. (refer: http://www.pbc.gov.cn/english/detail.asp?col=6400&id=1488 ).
Our initial reaction was caution. We don’t really believe, as the Bank of China does, in equilibrium values for the Balance of Payments or even the virtue of having a Balance of Payments equilibrated, let alone in the “management” of foreign exchange for that matter. Those conceptions belong to 17th century mercantilism, which David Ricardo so much fought, for the final and large benefit of Great Britain. Essentially, this move was political in nature, to appease the critics expected at the G-20 meeting this upcoming weekend in Toronto. Nobody really thinks the Yuan will appreciate significantly and nobody really paid much attention to the fact that the text mentioned a basket of currencies backing the Yuan, rather than the USD or USD assets.
In the long term, all things equal, this “flexibility” should increase the purchasing power of the Chinese people and therefore, global consumption as well. It was along this line of reasoning that the markets reacted initially, taking the EUR above 1.2450 USD. We, like everyone else, expected oil stocks to rally, but perhaps unlike most, we thought the news would be neutral to non-energy stocks and gold. We were half right or half wrong, but not because of the forecast, but because of subsequent intraday political news.
If we had to answer what triggered the late sell-off in risk yesterday, we would point to the declarations coming out of the European Central Bank, which would impose new fiscal rules, where deficit offenders may lose voting rights, as well as the ratings downgrade BNP by of Fitch Ratings (long-term issuer to AA- from AA). The declarations from Europe signaled everything but cohesion. If we had to answer what triggered the sell-off in gold, we would plainly answer that is was profit taking. Sometimes, explanations can be that easy.
Finally, there are two “things” that we think may become more relevant in the near future. The first one is related to the analysis Barclays Capital’s Credit Research team published last Friday (June 18th) about the liquidity position of Spanish banks (refer: European Credit Alpha: “Spanish banks: Long-term headwinds but no acute crisis”). Basically, the report concludes that “…there is no funding crisis for large Spanish banks, although cajas (i.e. savings banks) are in a more precarious situation…”. This in itself did not catch our attention. What caught our attention was the conclusion that the misunderstanding over Spanish banks, which has taken their credit spreads wider, was simply caused by the fact that the large banks were reducing their reliance on covered bonds for funding, “…in favor of cheaper ECB repo funding…”. The note concluded suggesting that: “…The issue is therefore one of cost of funding (a profitability issue) rather than access to funding (…) outside the caja sector…”. Having read this, I invite the reader to go back to our letter of April 19th, where we explained fiscal deficit monetization in Europe. We reproduce the chart below:
As you can see, we had published the chart in reference to Greek banks. Now, it seems the chart fits Spanish banks too… As we wrote two months ago:
“…in step 1, governments place debt at banks. Among other sources of funding, Banks use deposits (in Euro) to leverage their capital in this transaction. In step 2, banks may turn to the ECB to exchange the government debt for liquidity, at face value (at par). The final outcome is shown in step 3: Basically, the ECB has bought government bonds, in exchange of fresh money. This is an indirect monetization, which transfers wealth from all the holders of Euro notes to the taxpayers who enjoy the fiscal spending of governments that use the ECB. The size of this transfer equals the fall in purchasing power of the Euro vs. other currencies/commodities, multiplied by the amount of Euros in circulation. It is easy to see that soon, every government will compete to place its debt at the ECB, to win this game…” , and competing they are, really, which is why we are increasingly reading all sorts of rumors about the future of the Euro. For instance, the Daily Telegraph this weekend reported that there are ongoing discussions for the creation of a “super euro”, which would include France, Germany, Holland, Austria, Denmark and Finland only (refer: http://www.telegraph.co.uk/news/worldnews/europe/7837874/Germany-and-France-examine-two-tier-euro.html)
Is there any doubts that with news like these, the markets would take a more cautious view? If there are, please, continue to read below.
The second “thing” that concerns us is another research note about the impact on USD liquidity at expiration, on July 1st, of the ECB’s 1-year 1% long-term refinancing operation (refer: Barclays Capital Interest Research: “Libor: Buckle Up?”, June 21, 2010). What are we talking here? No less than EUR442BN. We understand that the ECB will not refinance this for an additional year. Instead, the ECB will offer a 3-month operation, for an unlimited amount. The street is watching therefore what remains with the ECB and what goes out. However, most banks have liquidity and it is estimated that currently there is about EUR300BN surplus liquidity in the Euro area market.
How is it that a Euro refinancing operation may impact USD liquidity? The bigger the size of this refinancing on July 1st, the higher the likelihood that the quality of the assets of participating banks be lower than it had been expected. Therefore, this could provoke a reassessment of counterparty credit risk in the Eurodollar market. Would this put pressure on gold, as analysts estimate Libor may rise to 75bps? Was yesterday’s action the omen?
Published on June 17th 2010
Please, click here to read this article in pdf format: june-17-2010 We have been at a loss trying to understand the markets since last Thursday, when the Euro began its rally. The chart below (source: Bloomberg) shows however that so far, the Euro has not “yet?” been able to break through and close above its [...]
Please, click here to read this article in pdf format: june-17-2010
We have been at a loss trying to understand the markets since last Thursday, when the Euro began its rally. The chart below (source: Bloomberg) shows however that so far, the Euro has not “yet?” been able to break through and close above its 30-day moving average of 1.2327USD. We can see why, and certainly hope the market does see that too.
On Tuesday it became official that Spanish banks are surviving thanks to a lifeline from the ECB, which is earning its reputation as lender of last resort. After Greece’s risk rating downgrade by Moody’s on Monday, the ECB is applying a 5% discount on their sovereign debt, when submitted as collateral. In the case of Spain, the news in our view could not have been worse: Spanish banks in May had the access closed to the capital markets, and borrowed EUR85.6BN from the ECB, which apparently is almost twice the size of liquidity needs at the time of Lehman’s collapse in 2008. How the Euro could have rallied on such news is also impressive, and makes us think that the short covering has been brutal.
The other chart at the bottom (source: Bloomberg) shows the spread between Spain’s and Germany’s sovereign risk. It continues to increase. It’s been a volatile path, but a sure path nonetheless.
We have come across some research that suggests the intervention of the Swiss National Bank, although significant vs. the Swiss Franc, could not have sustained the recent rally in the Euro on its own, to the +1.23USD level. Perhaps it triggered the chain reaction, which involved equities, but it could not have sustained it. Along the same line of reasoning, it seems to us that the situation with British Petroleum also triggered the current rally in oil and Canadian oil sands equity plays, which is more evident after yesterday’s bearish inventory data, released by the Department of Energy.
Fiscal data out of the US is also not encouraging (after all, we are at the beginning of a major, major sovereign risk crisis), but that is a matter for another time. When will we see a return to the downward trend in the S&P 500 200-day moving average?
Finally, we want to discuss an idea suggested yesterday by Morgan Stanley’s Global Economics Team (ref.: “The Lure of Liquidity”, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that “…the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other…”. Essentially, monetary policy, which this report calls “Passive quantitative easing” is to blame for this spiraling circle. It is also proposed that had the ECB activated “Active quantitative easing”, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been different…the crisis would have been contained.
We could not disagree more with this flawed and misleading notion. It is flawed because it doesn’t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing “stocks” (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing “flows”, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.
This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this story. The banks did not “decide” to buy government bonds. They, as the case of Greece very much illustrates, were forced to buy these bonds (something we also singled out as far back as December 17th, 2009…remember the initial private placement of EUR2BN with the National Bank of Greece et al., when the problem first came up), as much as Basel III, pro-forma, will force other banks to dump corporate credit in favor of sovereign credit. The Euro problem is institutional, is a problem inherent to the structure of the Union in itself (i.e. lack of a unified bond market) and the only way to deactivate it now is by showing net consolidated fiscal surpluses with clear transfers from the rich members to the profligate members. Politically, it’s a tough sell.
Published on June 14th 2010
Please, click here to read this article in pdf format: june-14-2010 There isn’t really anything new to support a different direction for the markets, since our last letter. We have seen the Euro stable around 1.20-1.21 USDs, with gold holding ground at the 1,220-1,230 $/oz and the S&P500 seeking to firm at 1,080pts. We wonder [...]
Please, click here to read this article in pdf format: june-14-2010
There isn’t really anything new to support a different direction for the markets, since our last letter. We have seen the Euro stable around 1.20-1.21 USDs, with gold holding ground at the 1,220-1,230 $/oz and the S&P500 seeking to firm at 1,080pts. We wonder what could be justifying this situation, given the continuous lack of clarity on the European Central Bank’s intentions or the institutional weakness in the European Financial Stability Fund (EFSF), which we discussed last week.
On Friday, we read that stock prices were reacting to positive news from Asia, overcoming the fears coming from Europe. We always have difficulty believing in these “animal spirit” explanations and are instead inclined to think that the resistance in all markets could have possibly been triggered by the intervention of the Swiss National Bank (SNB) in the foreign exchange and sovereign debt markets. The Swiss Franc, together with gold, has been a credible alternative for those fleeing the Euro-zone, but who still want to leave their capital in the Continent. This has provided a strength to the currency that for some (ridiculous mercantilist) reason concerns the SNB.
In any case, we always pay attention to movements like those on Friday, when both stocks and Treasuries rally simultaneously…with the Euro! We attach the corresponding chart below (source: Bloomberg, orange line: S&P 500, white line: 30-yr Treasury):
Lastly, we think investors ought to pay careful attention to political developments. In our view, there is a slow but steady movement to the right. It is a weak shift so far, a headless shift, but a shift nonetheless. We think that if the move continues to the end of the year, with the elections in the US, the perception on sovereign risk may change radically, strengthening the USD. But this is only a fragile speculation of ours, so far.
The Tea Party fraction in the US has been winning ground inside the Republican Party, as the primaries in Kentucky, Connecticut, Nevada and California are showing. In Canada, last week we had former Minister of Foreign Affairs and currently MP for Beauce, Québec, M. Maxime Bernier, present at the Economic Club of Canada. M. Bernier, a member of the Conservative Party, openly suggested the return to the gold standard. We were really, really caught off guard on that one. We were not alone, as the media extensively discussed these declarations. Given that M. Bernier was surely trying to attract attention, like every other politician does, we are the more surprised to see that he chose such a radical stance in monetary matters in a country whose financial system, except for the Asset-Backed Commercial Paper embarrassment, has not suffered.
As well, in Belgium, a country who saw a sharp rise in the risk of its sovereign debt, the Flemish separatist N-VA party emerged successful in this weekend’s elections. The nationalist parties are expected to win 30 of 150 seats in Belgium’s lower house. We think these are all signals of the times to come. These times will be more about debate and discomfort, rather than coordination…and we ain’t seen anythin’ yet on the Asian front!
Published on June 9th 2010
Please, click here to read this article in pdf format: june-9-2010 Since February 8th , we have repeatedly stated (unlike mainstream economists) that the weakness in the Euro is not due to a solvency or liquidity crisis, but to an institutional crisis: “…If the European Union is actually not a Union, but a Confederation, why [...]
Please, click here to read this article in pdf format: june-9-2010
Since February 8th , we have repeatedly stated (unlike mainstream economists) that the weakness in the Euro is not due to a solvency or liquidity crisis, but to an institutional crisis:
“…If the European Union is actually not a Union, but a Confederation, why should Euros be held as the world’s alternative reserve currency, instead of Canadian Dollars or Australian Dollars or Swiss Francs?” We think this is a valid question and a question markets are asking as we write…
…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. 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…” (“An institutional perspective on the Euro”, February 10th: www.sibileau.com/martin/2010/02/10 )
We trust the later developments in Europe have proved our case, particularly after the IMF’s involvement. On May 10th, the European Monetary Union announced the creation of an European Financial Stability mechanism with a special purpose vehicle (SPV), the European Financial Stability Fund (EFSF). The EFSF would provide up to EUR440BN, while the European Commission would extend an additional EUR60BN facility. The mechanism involved the IMF, which would contribute an additional 50%, our EUR250BN. Post the announcement, which included the launch of the European Central Bank’s (ECB) Securities Market Programme, the markets sold off. At “A View from the Trenches” we had anticipated this reaction on May 10th and further elaborated on it on May 13th. More specifically, on May 13th we wrote:
“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…” (“ECB Plan = End of Paper Money?”, May 13th, 2010: www.sibileau.com/martin/2010/05/13 )
Since Monday, June 7th, more details on the configuration of the EFSF have emerged, which is the reason why we preferred to wait until today to publish our first letter of the week.
Why are these details so relevant to us? We want to know if there will be an institutional innovation in the European Monetary Union that can allow the Euro to find a bottom, although temporary. We think this is the only guarantee for the survival of the Euro as a currency. In our view, two necessary conditions have to be met:
1.- Germany and other sponsors stand unconditionally behind the SPV or Trust (and has accordingly significant control over it)
2.- There is a clear, ring-fenced source of repayment for the SPV
With these conditions met, the Euro would stabilize temporarily. The stabilization would depend on the ratio of the speed in fiscal improvements of Germany and France vs. the speed of fiscal deficits in the peripherals. As you can deduct, we are being realistic here. We don’t ask for peripherals to reduce their deficits, but to at least keep them constant, while the situation improves for the SPV sponsors. We don’t ask much, we think.
Lately, many economists are forecasting that the lower Euro will significantly help the export sector in Europe to offset the impact of the upcoming fiscal tightening. We don’t want to get into the details but suffice it to say that on average, the two “forces” neutralize are expected to neutralize each other, albeit generating a lower than anticipated growth in GDP.
But as we have written before, this crisis has nothing to do with fundamentals, although it is comforting to hear that a lower Euro will help. We must add too that it can only help if it is low and stable. Otherwise, if the Euro spirals downwards, the benefit of the current low Bund yields will disappear. On this note, we must acknowledge we were very pessimistic: We had written (also on May 17th and 20th ) that we failed to see how the ECB would lower the benchmark (i.e. Bund) yield. Benchmark rates are at record lows, but not as a result of the ECB’s Securities Market Programme, but by the jurisdictional arbitrage investors are playing, which we discussed on May 17th.
Finally, returning to the main issue of today, i.e. the details on the EFSF, this is what we preliminary understand (A final decision will be reached on June 17th ):
-The EFSF will be backed by national (from Euro-zone nations) guarantees on a pro-rata basis: Not joint or several. The guarantees will reflect the ECB capital subscriptions (not higher than 120%) of the nations.
-These guarantees are contingent . There is no previous funding involved nor any collateral identified in the EFSF. Guarantees will be priced at a rate equal to the difference between the market cost of the national debt and the cost of IMF money.
-If a contingency takes place, the EFSF will issue debt backed by the aforementioned guarantees (currently, analysts estimate that the weighted-average rating is Aa1, Aa+ equivalent, which implies the need for over collateralization, should a AAA rating need to be attained).
-National parliaments will not need to vote on activation or disbursements. Euro finance ministers still have to approve the activation of the SPV.
-The EFSF will be managed by the European Investment Bank, in Luxembourg
-The EFSF can issue debt to make loans to or buy sovereign bonds of Euro members. This will require unanimity. Funds cannot be released without the IMF simultaneously funding its corresponding 50% contribution.
-The EFSF is created for three years, although the loans it makes can have a higher tenor.
Briefly, although we admit this takes the Euro-zone closer to a much needed unified bond market in Europe, we think the structure of the EFSF, with a) guarantees not joint or several, and b) without an identified source of repayment, falls short of complying with the minimal conditions to stabilize the Euro. Back on February 10th, we suggested that:
“…In the world of corporate credit, when lenders are not satisfied with the credit quality of borrowing subsidiaries, they may demand cross-guarantees, in addition to an irrevocable guarantee of the parent. Unfortunately, this cannot happen with sovereign debt. The more difficult and painful path for the European Union is to stand up to the challenge and lay the ground for a stronger integration, under a central government that can provide legally and operationally a guarantee for not just the debt of Greece, but of any other state under stress…”
So far, we think the European Union is not up to the challenge…yet, which leaves the bullish trend on gold and the bearish trend on the Euro intact.