Please, click here to read this article in pdf format:july-29-2010

From our vantage point, the last 72 hours are confirming our long-term perspective that the recent strength in the stock markets is baseless.

There are currently two main arguments supporting the belief that the recent strength in asset prices may have longer legs. The first one refers to the positive surprises of earnings vs. expectations, which (for instance) the greater part of the S&P500 constituents are showing. In Europe, sovereign refinancings have been carried out without major problems and banks have “formally” passed the stress tests. The second argument refers to the asset shortage in the credit space. This means that there is more capital chasing yield than there is demanded. This applies not just to corporate credit, but to sovereign as well.

We think that these arguments are both misleading. Earnings are past information and should not be a decisive factor. Outlooks are more relevant to us and, in macroeconomic terms, the outlook is not too compelling.

Today, governments are raising and not lowering taxes. When governments cut spending, they don’t do so by privatizing assets, which triggers resource allocations. Governments simply cut temporarily. This is quite the invitation to evade rather than to pay taxes.

Monetary aggregates are barely expanding (i.e. Europe) or not expanding at all and, given the destruction of global savings, armies of young people will remain unemployed for longer than most imagine. The incentive lies in saving and paying or refinancing debts, rather than investing. Regulations punish entrepreneurship and encourage companies to use or reduce the existing labor force, rather than to hire.

Interest rates are currently useless as the transmission mechanism that they are and which is needed to guide savings to productive endeavors. In summary, we have a hard time justifying the recent “asset inflation” most want to see in the last days rallies. Gold proved the case, we think. Other assets should follow.

The second argument is essentially an insult to intelligence. Indeed, asset shortage does support the current technical compression in credit spreads we are witnessing, but it should hardly be supportive of economic growth on its own. That would equal to argue that investors will keep investing just because they have the funds available to do so, regardless of the return/risk profile of the investment opportunities considered.

A final testimony of our two points above is the situation the Euro zone financial system is in. As we had anticipated in May, the European Central Bank has had to increase the refinancing as well as the short-term facility rates, in order to carry their liquidity and sterilization operations respectively. These operations are obviously affecting the inter-bank Euro rate, Euribor, which is slowly approaching the 100bps level. When we add this to the institutional and sovereign risk crisis the Euro zone is in, the result is a fragmented, two-tiered, financial system. With excess liquidity in the Euro system close to EUR150BN driven by the stronger banks, the weaker banks still survive at the expense of the central bank. Yesterday, for instance, at the 3-month Long-Term Refinancing Operation the ECB held, 70 banks were bidders, for more than EUR23BN. In this refinancing, EUR4.8BN were maturing and taken by 24 banks. In conclusion, the weak (banks) get rewarded by the central bank, while the strong (banks) cannot find investment opportunities. This is hardly a promising environment.

Martin Sibileau

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

We start the week without the uncertainty of the Euro stress tests and with further data on the US macro picture, namely, the two factors driving discussions and action last week. On the stress tests, readers by now know our position from day one: They are flawed by method and any comparison against the US case is misleading.

Banks in the US were financing a stock of assets, mortgages, the counterpart of brick-and-mortar investments, whose generation collapsed much, much earlier than the tests carried out in March 2009. When the US were doing their stress tests, they were actually counting their dead. European banks were and continue to finance fiscal deficits, which lack an identified pool of assets backing them. The generation of deficits has not stopped at the time of the tests and will continue for the foreseeable future. The Euro zone banks are  not counting their dead, they are simply speculating whether they can survive if the illness becomes mildly worse. Therefore, they must present their illness as mild. There was an element of surprise on Friday, hours prior to the announcements: The stress tests were carried out on the banks’ trading books. With this, we think, Euro zone financial authorities surrendered every last drop of “moral authority” to defend their case. Time will tell, and in the meantime, the only thing that markets will now care about will be the evolution of fiscal deficits. Rightly so!

We had anticipated our opinion that the Euro would drop on the news. As the chart below shows (source: Bloomberg), it did drop intraday, right after the disclosure that the tests were on the trading books, but it managed to close higher, although within what seems to be an increasingly clear renewed downward trend, since it last peaked at 1.30+, on July 20th:

The US macro picture is challenging. On one hand, we are seeing earnings that surprise on the upside, but on the other, activity indicators are neutral at best. In credit, spreads are tightening, by the mere fact that there is more demand for spread than supply. The question here is whether the trend towards lower spreads, driven by the gigantic amounts of cash stored on the sidelines, will fuel the last push required to avoid a double dip. This concern has shifted also to the analysis of monetary policy.

While months ago we were debating what was the most appropriate way to a approach an orderly exit strategy by the G-3 central banks, today everyone is focused on how best can monetary policy accommodate a moderate growth. Back in the ‘30s, Keynes had clearly conceived a recovery where monetary policy would have to be accommodative.  We first raised this point more than a year ago, on April 28th, 2009 ( “A Keynesian Perspective”, www.sibileau.com/martin/2009/04/28 ), and have very often quoted one of his famous paragraphs, from Chapter 13th, of his “General Theory”:

“…whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(…)…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...”

Every research note on interest rates today, is pointing at the slowdown in the growth of monetary aggregates. This had been foreseen by Keynes, who openly, just like Krugman, was in favor of an increase in the quantity of money. The problem with this approach is that it is not dynamic, it is short-sighted. Monetarists (i.e. Milton Friedman) blamed “expectations” for the failure of Keynes’ approach. Given the market’s expectation that higher amounts of money would trigger inflation, prices were increased in a self-fulfilling path, if “capacity”, slack in the system, was gone. Today’s Keynesians don’t disagree, which is why Krugman is always reminding us how weak activity is.

The Austrian school, however, looks at the problem from a different perspective. Unlike monetarists or Keynesians, Austrians acknowledge that credit expansion is non-neutral, generating what people generally refer to as “asset bubbles” or asset inflation. As the problem of asset inflation compounds, its final version, general inflation, becomes more evident. The level of activity or its opposite, the level of slack in the system is irrelevant. That was the reason behind our bullish call on stocks all along 2009 and that may be what is fueling the recent strength in stocks. However and unlike in 2009, this latest strength would be based on the speculation that the quantity of money necessary to maintain a given rate of interest will increase. In 2009, the rally was based on facts. In 2010, it is trying to survive on speculation. The chart below (source: Bloomberg) shows that since July 20th, when the Euro last peaked, the S&P500 is making higher highs and higher lows, although still below its 200-day moving average, which stands at 1,113pts. We doubt the S&P500 will break this trend without the actual monetary increase supporting it. And if such monetary support shows up, we doubt the price of gold will remain indifferent vs. stocks, like it did in 2009.

Martin Sibileau

Please, click here to read this article in pdf format: july-22-2010

The action in the past 48 hours has been horrible, to say the least. We went from a strong close in stocks on Tuesday to a loss yesterday, amid Bernanke’s speech, before the US Senate’s Banking Committee. We acknowledge the S&P500 has made a higher intraday low, closing at 1,069.59pts, but we still need to see higher highs sooner than later, to believe in a possible rally.

Volatility is thus the winner here, as confusion reigns. To us, very little makes sense these days. We think we have a clear long-term picture of this global crisis, but first we need to survive the present, to be able to enjoy the future.

There are two main macro “themes” this week: 1) US weakness and 2) Stress tests on Euro zone banks.
To discuss the first theme, we will do something very unusual in us: We will discuss Bernanke’s testimony today, before the Senate Banking Committee. We really hate to watch these speeches but our intuition told us everyone would be watching it too. Why? Nobody has a clue (we think) about where things are heading to. However, as the chart below shows (source: Bloomberg), the S&P500 is in a clear downward trend, making lower highs and lower lows. Until we can see a higher high, we will not be ready to accept a change here. The pink and green lines are the 100-day and 200-day moving averages, respectively:

It is clear that since mid May, on the peak of the Euro zone troubles, these averages have been broken. So, what does Bernanke have to do with all this? Everyone had been expecting some insinuation of the possibility of additional monetary stimulus under this stagnation. But Bernanke, predictably, just limited himself to say that the Fed has the firepower to use, when needed. That was the right thing to say. Why? Because as Bob Janjuah (RBS) in his early June commentary suggested, the Fed has very little ammunition to shoot. All they can do to lift asset prices is to engage again in securities purchases, just like we showed in our first graph, on our first letter, on April 14, 2009, when the Fed was carrying out its $300BN monetization of US debt (www.sibileau.com/martin/2009/04/14 ). If this is the case, Bernanke really has to see asset prices fall significantly more, say an S&P500 around an 850pts level, to ensure its medicine will be felt. Bernanke was bearish on purpose today, and fortunately took the opportunity to remind that room full of ignorance that the US deficit is “becoming” unsustainable. We feel Bernanke would have wanted to be more bearish in his comments, to accelerate the march towards the 850pts level, but with the tension between the Senate and the Fed, which has now gained more power under the new finance bill signed today by Mr. Obama, Bernanke risks being accused of not supporting the job creation efforts. He went even as far as to remind the Committee of the importance of the Fed’s independence. How will the USD behave in a downward path, vs. the Euro or other currencies? Will gold be able to remain above its 100-day average? Gold closed today at 1,185.10, while the 100-day average now is at 1,180/oz.

We think the CAD is the obvious candidate to suffer here, while on the Euro, things are not so clear, which is what brings us to our second point today.

As we wrote before, we consider the stress tests of the Euro zone banks simply irrelevant. They are misleading and totally miss the core of the Euro problem. Banks will be tested against their holdings of sovereign debt. But the value of that debt depends on its supply and demand dynamics. In terms of demand, let’s just say that some banks, as in the case of Greece, were forced to buy the debt. Supply will be a function of the financing needs of the Euro sovereigns. If fiscal deficits disappoint in at least one country, the contagion will spread all over the Euro zone again, because of its institutional nature, which is fragmented and lacks a unified bond market. Unity will have to be addressed (again) at the last level, the European Central Bank, affecting the value of the Euro once more. Therefore, running an inventory on sovereign bonds is ridiculous. It’s like checking how wet you are and how much wetter you can get while you’re under heavy rain.

When the US ran the tests on US banks, the inventory was on mortgages. The underlying source of the mortgages were houses and housing starts dropped dramatically, from the 2.2 million/yr to yesterday’s 549 thousand data release. And while bonds are sold from governments to banks and banks to the ECB in Europe, mortgages were bought from banks by the US government. The difference in approach is abysmal!

In summary, we would not be surprised if these stress tests tell us nothing new, and it would make sense too that the Euro retake its downward trend after the news, with a sell-off. However, as we pointed out on Tuesday, the situation in the US may mitigate the Euro’s trend.

Lastly and returning to Bernanke’s situation, we think it is a difficult one. When securities purchases began in March 2009, spreads were wide both in corporate and agency debt. If Bernanke retook such purchases towards the end of 2010, he will find much tighter levels. Unlike then, the monetary expansion would hurt credit more, we think, on renewed inflation expectations. Would the new money spill over onto stocks as an alternative? Or should it buy gold? What if a US state or municipal issuer suffers a liquidity crisis? Will these events occur before or after the November elections? There are way too many variables in this landscape. Volatility is the natural outcome.

Martin Sibileau

Please, click here to read this article in pdf format: july-19-2010

Back from a relaxing vacation in Canada’s wilderness, we are left to explain last week’s developments. The reader knows how bearish of the Euro and bullish of gold we were and how the long gold/short Euro trade broke in tears last Friday. Well, we think the trade did, but we still believe that gold is in a long-term bullish trend, while the Euro is in a long-term bearish trend. Most importantly, we think that these trends are not anything new and that we had already anticipated their drivers. Where were we “mistaken”?  We excluded an additional factor in our discussions of last May: Weakness in US risk assets. Let’s see…

Below we reproduce the original chart for our scenario 2, put out on May 13th, upon the initial announcements by the Euro-zone authorities to address default risk of its members. Under this scenario, the European Central Bank (ECB) was to sterilize its sovereign debt purchases with short-term debt. We anticipated then that the risk of doing this was in increasing the interest rate it had to pay on the issuance of its short-term debt (see supply-demand curves at bottom right), which would translate into a “riskier” ECB:

This is exactly what we wrote then:

“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 debt 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 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?“

“… 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…” (ref: www.sibileau.com/martin/2010/05/13 ; “ECB Plan = End of paper money?”)

Now, what has happened two and some months later…?
Since sovereign debt purchases began, the ECB has successfully sterilized the consequent monetary expansion via short-term deposit operations (i.e. short-term debt issuances). These operations have had a 1-week term and to date, they have sterilized EUR60BN. Although the amount tendered every week has been volatile but oversubscribed, banks have consistently required a higher rate from the ECB, as we had foreseen it would happen, on May 13th. The current weighted average rate is 56bps, vs. the initial 28-31bps, while the marginal rate reached 75bps, on July 6th. This term-deposit rate is expected to converge to the ECB’s refinancing rate, pushing EONIA ( the Euro Overnight Index Average) higher, to 100bps. For reference, compare this 100bps rate with the US 3-mo OIS-Libor spread, which stands at 34bps or the UST 3-mo bills at 15bps, and you will have to believe that interest rate differentials should now be more relevant on the EURUSD cross than before, in favor of the Euro.

Since May too, we have seen a shortage of investment opportunities in the credit space, driven by the liquidity generated in part, with the sell-off in equities (We think it is relevant to see gold’s performance within this framework, to understand how robust this asset has been in light the sell-off). This excess in the demand for yield opportunities has been favorable to the latest sovereign debt refinancings coming out of the Euro zone, particularly last week, notwithstanding the widening in sovereign spreads we have been highlighted in our past letters (for instance, refer to our previous letter of July 6th: www.sibileau.com/martin/2010/07/06 ) , between Germany (benchmark) and the rest of the Euro zone members.

How had we therefore conceived a spiraling run against the Euro and why have we not seen it yet?
On May 13th (again!), we described the process in a chart we reproduce below:

As can be seen, we had expected a “material” increase in the risk of the ECB, which has not yet crystallized. It will crystallize as it becomes more evident that the ECB needs to intervene in the sovereign debt market, and we think this will occur  in the months ahead, when the “cut-spending and raise taxes” strategy of Euro zone members produces less investments, less demand, lower tax revenue and more tax evasion.

In summary, we can identify three drivers behind the Euro strength. The first driver we think was the actions of both the Fed, via currency swaps and the Swiss National Bank, with direct currency purchases, that sustained the Euro. On May 31st, we even provided the reader with the sad evidence of this currency manipulation, which Congressman Ron Paul so criticized before the Subcommittee on International Monetary Policy and Trade, and which was confessed by the Fed, in a video available online (watch minutes 6:22 and 7:36 of this video) for our posterity at : http://www.youtube.com/watch?v=hMo-V8HoNdc .

The second driver has been the aforementioned increase in sovereign spreads, vis-à-vis with the factor we had not foreseen: US weakness in risk assets. As equities sold off in the US, the Treasuries market has become overbought, with yields at record lows across the curve. We believe that this rate differential in currency zones (discussed above) has triggered a perfect text-book response, strengthening the Euro and weakening the USD. In between this, lies the Canadian dollar, undermined by US weakness reflected in lower commodity prices, and moderated by a strong local economy.

Lastly, the third driver of Euro strength has been the obvious short-covering of Euro bears. But as we have taken the time to explain, we think it is clear that there are fundamental reasons behind this dynamics.

We can no longer ignore the weakness in the USD zone, reflected on the latest earnings reports, which is fueling a drop in investors’ confidence. Some of these investors (i.e. Peter Schiff, see his “Schiff Report” on Youtube, of Thursday July 15th: http://www.youtube.com/user/schiffreport?blend=1&ob=4#p/a/u/2/nwVxTnXumtQ ) speculate this weakness will bring about more stimulus in the US, which will further depreciate the USD. We agree that this is a possibility but here, our intuition (yes, this is pure intuition on our part) tells us that this conclusion underestimates the currently increasing dislike for the Obama/Bernanke’s policies and the strength of the Tea Party movements across the nation. However, we think everybody agrees that if the Fed does not engage again in direct securities purchases, it will at least keep its policy rate at the current record low level. While our intuition tells us the US is politically shifting to the right faster than Europe, our reason reminds us that the Euro problem is not a “demand strength” problem, but an institutional one, which we have discussed in detail. And the institutional problem has not been solved, but patched, with the creation of the European Financial Stability Fund.

The Euro should remain strong as long as the rates differential between currency zones remains “sustainable”. Will a 1% 1-week ECB term-deposit rate be sustainable at the end of this year, if the fiscal picture does not improve? How bad things have to turn in the US, to make that 1% “look good” for a sustainable period? Can we be naïve enough to believe that Europe or China would not be affected by US weakness?

In the meantime and with respect to the rates dynamics, we are seeing “tactical” relative value trades proliferate, which decrease the differential between Germany and other Euro zone members. But we think we are about to see a new chapter in the US, that may make this Euro strength remain longer than most imagine. In the end, if fiscal deficits in Europe cannot be reduced (our base case), gold should retake its bullish trend against all currencies.

Martin Sibileau

Please, click here to read this article in pdf format: july-06-2010

The summer doldrums are here and investors (including ourselves, of course) are trying to understand the latest “structural” foundations driving the markets. One can think of these drivers in terms of different markets, currency areas or asset classes. However, there seems to be one in common, when we take a global perspective. Namely, the realization that going forward, economic growth will be lower than previously expected, muted, whatever that final number is.

Growth is in our view one of the most difficult economic concepts to grasp. Without getting theoretical here, we just want to say that personally, we prefer to treat “growth” just like biologists treat the concept of life. Biologists do not try to describe life itself, but as a set of characteristics proper to organisms (i.e. homeostasis, metabolism, reproduction, etc.). Along the same line, growth to us is all about “improving the ability to improve” what we collectively call our living standard.
Given that all of us have different ideas about “living standards”, it is critical first that we can freely trade to reach them, at minimal transaction costs. And secondly, in order to trade, we need “clean” prices. However, we are always limited by present resources, so that at an aggregate level, inevitably, we end up having to reduce present consumption (i.e. saving) in favor of future consumption. The price of that inter-temporal exchange is what we call an “interest rate” and therefore, in order to correctly assess that trade-off between present and future, it is imperative that interest rates be as “clean” as possible. When free trade is reduced and interest rates are manipulated, growth is seriously damaged and with it, our aspirations.

Since 2009, governments, in the name of temporal solutions, have affected the value of our indirect medium of exchange (i.e. money) and consequently our liberty to trade. Compared to December 2009 (only 7 months ago) it is, for instance, approximately 22% cheaper to buy products from the Euro-zone, if you earn your income in US dollars. Somebody pays for this (i.e. the German taxpayer) though. Governments have also been affecting our liberty to channel resources from the least productive to the most productive enterprises, by regulating our financial systems without compromising their own ability to keep printing money. The damage is so extensive that citizens of the world, in search of an escape valve, are affecting the relative prices of economic jurisdictions. This is an ongoing process with no end in sight, as the charts below show (source: Bloomberg).  As you can see, savings within currency zones are shifting between member jurisdictions. In the case of the Euro zone, capital is leaving Spain , Greece or France and goes to Germany (i.e. sovereign spreads of these countries vs. Germany’s widen, as the charts below show) . In the case of the US , capital is fleeing “provincial” risk, in favor of federal risk (also shown in charts below). The ongoing nature of this process suggests that given the institutional weakness of the European Union, its currency will be more affected than that of the USA . But in the end, everybody loses, which is why we are bullish of gold.

This process has multiple stages. The current perceived confusion, we think, is simply driven by technicals resulting from the growth underperformance. On the demand side of investments, money has been printed since March 2009 in excess and is still out there (unsterilized). On the supply side, private investment opportunities are being crowded out by sovereign ones, leaving a relative “spread-tightening” force in corporate credit, while markets sell off equities, in anticipation of slower growth, or as we like to say, the diminished ability to improve our living standards. Overshadowing this, we are coincidentally faced with a technological revolution that allows us to live longer, impairing all previous actuarial calculations done by pension funds and flooring unemployment rates in the developed world. This should be another reason to deregulate savings and allow individuals to save at the rates of their choosing (Yet, in Canada , for instance, the government is contemplating the expansion of the Canada Pension Plan). In the meantime, some analysts still dream of a decoupled world, where emerging markets, which now carry out a meaningful trade among themselves, can be resilient and sustain a weak recovery on their shoulders.

The Canadian dollar is debating itself in this macroeconomic backdrop. As long as relative differences between jurisdictions exist, there will be a “reserve currency bid” for the CAD. But in absolute terms, as long as the global misery increases and commodity prices fall, the Canadian dollar will suffer. Will we have a story of relative contrasts that finally lead us to some consolidation followed by growth, or will we have a story of fading relative contrasts that leaves us with a picture of unanimous poverty? The correlation between gold and the CAD is vanishing (-0.7479 at the start of the year, vs. -0.0453 yesterday, source: Bloomberg), which indicates that the story of global misery is winning the bet.

Martin Sibileau