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