Please, click here to read this article in pdf format: august-30-2010

If I guaranteed you that I will buy an asset from you, would you go out to sell it like there is no tomorrow? If you did, one would conclude either that you did indeed trust me but are not happy with the price you expect from me, or that you did not trust me at all. On Friday, holders of US Treasuries heard from Fed’s chair Bernanke that the Fed would buy their assets. Bernanke confirmed that the Fed would keep its balance sheet steady reinvesting the proceeds of mortgages paydowns into Treasuries. Yet, the market tossed off the entire curve of the US Treasuries. The reaction was manifestly bearish in our view, and we have no alternative but to turn bearish here. The chart below (source: Bloomberg) tells it all:

This chart shows the price (not the yield) of the active 30-yr Treasury for the last week (Monday – Friday).

On Aug 26th,, we warned that: “…we found it interesting that shortly after the home sales announcement on Tuesday, the 30 yr treasury sold off by approx. 1%. Indeed, it may be seen from the perspective of a flattening move, which is actually taking place since the Fed’s announcement last week. But in any case, the Tuesday’s move, smelled to a “sell with the news” move…” (ref.: www.sibileau.com/martin/2010/08/26 ). Yet, back then, we only intuited the weakness. After Friday’s technical damage, a new game is unfolding, where central bankers (yes, the plural is correct) will coordinate to fight the sell off in sovereign debt. The fight will be cruel, but they can only lose it in the end.

With this in mind, we want to refer back to comments made last August 18th, when we wrote that:

“…those who still see a double dip in the horizon base their forecast on a double dip in the US housing market. Yet, when stocks rise, the resources and materials sector seem to lead and most monetary policy is specifically addressed towards the housing market. Why not base the double dip on a sovereign crisis in the US? Did the government not assume the private sector’s liabilities last year? And if indeed the double dip is finally triggered by a sovereign crisis, why not bet on the sure thing?  Why bet on precious metals rather than short Treasuries? The collapse of the Treasuries market looks more certain than the rise in the price of gold. The collapse of Treasuries will precede and fuel the rally in gold and gold shall only rally if it rallies against all currencies, we think. But first, capital must flee from government debt and only then, among other alternatives, it can chose to go to gold…”  (refer: www.sibileau.com/martin/2010/08/18 )

This is exactly what happened on Friday, when gold remained flat but volatile, while Treasuries sold off. The intraday chart below (source: Bloomberg) shows it all:

With this view, we come back to our 2009 idea that if central banks are successful at coordinating monetary policy, gold will underperform stocks (refer: www.sibileau.com/martin/2009/04/21 ). That is what happened on Friday and what we think will continue to occur in the first stages of the US sovereign risk repudiation, which is just beginning to blossom. Let’s be clear here: In our last letter, we suggested that the bounce in stocks was a mere bounce. After Friday, we are willing to believe in it, as long as the sell off in Treasuries gains steam.

However, to believe that such a scenario is sustainable is misleading. If the trigger of the appreciation in stocks is a massive repudiation in sovereign risk (still to be tested), the dynamics will neither be stable nor sustainable: It will spiral. In its first stage, stocks can be seen as the logical safe place to be, beginning with energy and basic materials, and ending with financials. But as the challenge falls down to the sustainability of central banking and relative price distortions begin to affect production (stagflation), gold will be the natural last beneficiary of the collective fear.

Martin Sibileau

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

In our last letter, we suggested that the tension in the markets was going to be released, to the upside or downside, by an unknown catalyst. That catalyst came the day after, on Tuesday, as the horrible home sales print came out.

But that is history and we would like to now focus on a few things that caught our attention. These are “hints” and the comments that will follow, out of these hints, will be mere inductive reasoning. In our view, deduction is far better than induction, for there is nothing more practical than a good theory. However, at this time of uncertainty, theories are not abundant and we have to look for whatever pieces of information the markets give us.

Given that we are neutral-to-bearish on credit and sovereign risk (yes, that includes the USA), we found it interesting that shortly after the home sales announcement on Tuesday, the 30 yr treasury sold off by approx. 1%. Indeed, it may be seen from the perspective of a flattening move, which is actually taking place since the Fed’s announcement last week. But in any case, the Tuesday’s move, smelled to a “sell with the news” move. Why? Because the bearish news out of the US only imply higher sovereign risk and we are already touching record lows in yields. This is also the reason why we turned neutral-to-bullish on gold on that same day.

The other interesting “hint” was the resistance in the Euro and the price of oil yesterday. Just when Morgan Stanley was issuing a research note titled “Ask not whether governments will default, but how“, that same house was also printing another one, informing of their decision to take profits on the Euro. We thought that was inconsistent at best. It’s true, there are signals that suggest Germany is enjoying a lower Euro, but strength in Germany alone is not going to help the monetary union. In fact, strength in Germany “alone” is what triggered weakness in the Euro, given the lack of a clear wealth transfer mechanism within the union. This shortfall is what creates the jurisdictional arbitrage, from peripherals to Germany and from Germany to Switzerland, for those really conservative. Below we show two charts (source: Bloomberg), which we have discussed before. The first one shows the gap in sovereign risk (5-yr credit default swaps) between Spain (a peripheral) and Germany. You can see we are back at crisis levels. The other chart shows the gap in liquidity costs between the Euro and USD currency zones. It is widening. Sure, it does not necessarily mean that these signals will lead us back to May/June levels. That would be pure induction from our part (hence the above disclaimer). But they also show that the current environment is not constructive either.
Therefore, how would you interpret the bounce in stocks and oil yesterday afternoon? So far, it looks like a mere bounce…

Martin Sibileau

Please, click here to read this article in pdf format: august-23-2010

The air is rarefied as we start the week and Summer enters its final phase. Somehow, the overall macro picture looks like a piece of clockwork, where we can all see where things are heading to (i.e. after (a) the Fed’s decision to have the size of its balance sheet driven by the unemployment rate and (b) finding out on Thursday, after the 500k jobless claim, that the trend on such rate is positive). The other episode in world’s history that comes to our mind, where chaos was so pre-announced, was the start of World War I: Alliances had been established, scenarios were well known and all that was necessary was a catalyst.

-Everybody knows that the liquidity trap we are in cannot be with us much longer and that on the margin, any increase in yields (in the US or elsewhere) is going to do horrible damage.

-Everybody knows that the financial system in Europe is broken and surviving on liquidity lines from the European Central Bank, and that the recovery in the Eurozone, if any, is uneven, which will trigger a jurisdictional arbitrage in capital flows. This arbitrage is nothing else but the other face of that coin called European monetary union.

-Everybody knows that nationalizing the housing Agencies in the US is one more desperate step to avoid the inevitable double dip in the housing sector, which will revert back to the financial sector and finally, the US Treasury.

-Everybody knows that all the financial regulation proposed so far has done nothing (and can do nothing) to guarantee a reduction in systemic risk. The latest intention to make bank debt holders share the cost of banks’ undercapitalization is as absurd as the mere idea that systemic risk can be mitigated in a world of central banking.

-Everybody knows that the US dollars leaving to Emerging Markets are fuelling an unstoppable rise in commodity prices and wages that will soon haunt the developed world back.

And yes, there are a few more “knowns”. All we need is “the” catalyst, and we will see gold wake up and the Ponzi scheme of currency swaps, which was first devised by the Bank of England in the ‘20s and is now abused by the Fed, be put to the test. If it doesn’t resist, the Treasuries market will collapse and we will all look at the drama of 2007-08 with a bit of nostalgia.

But we first need that catalyst…Will it be a deceptive sovereign Euro auction? A surprising jobless claim print? An Emerging Market challenging the status quo by refusing payment in USDs or by shifting central bank reserves elsewhere? An important turn by a G-10 central bank, just like Weber’s comments on Thursday, which left the Euro breaking the $1.273 resistance?

In the meantime, tight stop losses in curve and relative value trades seem to be the safest way to play. Anything else is to tempt the vengeance of the trading gods.

Martin Sibileau

Please, click here to read this article in pdf format: august-18-2010

 

We hesitated about writing yesterday or today, but write we must. Indeed, we find it hard to understand how investor, markets, can have doubts as to what it is to come. The road the Fed has taken is a one-way only, and there is no return. Hundreds of books have been written about the current situation the world is in and many countries in the developing world have already gone through a similar experience, not too long ago.

Why doubt about gold’s potential in this environment? Perhaps because stocks are first in line, to receive the flow of money that is about to be printed. Just like in 2009? No, not necessarily. Back then, we had very depressed asset prices. The upside today is not so visible.

Yesterday, the Euro gained a bit of what had been lost in the past week, on the positive news of Ireland’s EUR1.5BN auction for a 2014/20 refinancing. Euro zone sovereign spreads tightened and this opened the door for the rally in stocks. However, as we have repeatedly written, the weakness of the Euro is based on the weak institutional foundation of the currency zone. As a clear example, while we are all watching with interest the peripherals’ debt auctions vs. today’s  10yr Bund, most will not have noticed on Tuesday that President Obama signed HR 1586, providing $26BN to states with liquidity problems, and extending to Jun/11 Medicaid’s temporary enhanced Federal Medical Assistance Percentage. That’s right, while we all pay attention to how different Euro zone members perform fiscally (pretty uneven, by the way) and in the debt markets, we all find solace in the unified bond market that Treasuries represent. Europe lacks it and is paying dearly for it. Growth differentials, interest rate differentials may only matter temporarily, as the July Euro rally proved. The trend is defined by the institutional weakness.

Along with gold, the Japanese Yen makes also an interesting story these days. You won’t find anyone who will not tell you it is overvalued and yet, it keeps strengthening. Is it truly USD weakness after all? How can we justify weakness in a fiat currency, when its sovereign debt is so demanded?

On the other hand, those who still see a double dip in the horizon base their forecast on a double dip in the US housing market. Yet, when stocks rise, the resources and materials sector seem to lead and most monetary policy is specifically addressed towards the housing market. Why not base the double dip on a sovereign crisis in the US? Did the government not assume the private sector’s liabilities last year? And if indeed the double dip is finally triggered by a sovereign crisis, why not bet on the sure thing?  Why bet on precious metals rather than short Treasuries? The collapse of the Treasuries market looks more certain than the rise in the price of gold. The collapse of Treasuries will precede and fuel the rally in gold and gold shall only rally if it rallies against all currencies, we think. But first, capital must flee from government debt and only then, among other alternatives, it can chose to go to gold.  Last comment on gold:  Yesterday we noticed that gold lost $4/oz after the announcement of Potash’s unsolicited takeover by BHP Billiton. That was a commodity bullish news and yet gold did not rally nor remained unchanged. It dropped. That was indeed interesting.

As you can see, we have more questions than answers this week. But we are certain that if the recovery holds, it will only do so at the expense of a stable/growing supply of money and that no exit strategy will be achievable by any serious central bank. The growth rate in money supply will be incorporated to the market’s collective expectation on the liquidity picture and any deviation from this path will be painful and politically expensive. With this macro backdrop, although counter intuitive, we can see a weak Euro, a timid appreciation in gold and commodity currencies, massive curve/relative value trades in sovereign debt and stable volatility levels. We can also expect stocks to trade range-bound, in the absence of a clear catalyst to shoot them above their 200-day moving average or way below it. In corporate credit, the spread compression picture should hold and we should not be surprised if we see another wave of refinancings to mitigate liquidity risk.

 

 
Martin Sibileau.

Please, click here to read this article in pdf format: august-12-2010

In our last comments, (ref: www.sibileau.com/martin/2010/08/10), we suggested that the relationship between the cost of liquidity in the Euro and USD currency zones and the Euro was breaking and signaling a reversal, together with the widening of Euro sovereign spreads. The mystery was disclosed on Tuesday by the Fed and with it, the whole macro backdrop has changed, rather violently.

The thesis we suggested last Thursday (www.sibileau.com/martin/2010/08/05 ) is totally outdated. The rules of the game have changed dramatically and, in our opinion, for the worse. The Fed’s announcement, explicitly saying that they will target the size of their balance sheet, surprised us, deceived us. Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market.  We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits.  The street is watching…

One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity. Yes, we are aware that this is consistent with Keynes’ idea, which we have so often quoted here, that:

“…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…” (Chapter 13th, “General Theory”)

Output and asset prices have indeed increased since 2009 and the Fed’s effort is exactly directed towards maintaining a given rate of interest. The problem of this perspective is that it is not dynamic. Once the market has incorporated that monetary growth in its expectations, it will demand that growth to remain in place. It’s plain addiction.
On the other hand, we disagree with the popular view that there will be no growth in the supply of money. We think there is in the sense that instead of having a Fed’s balance sheet that shrinks, we have a constant one.  To illustrate our point, let:

Mt = Money supply at time t, measured in months

b= Average mortgage-backed securities and agency debt paydowns, per month

Therefore, before Tuesday, we had:  (1) Mt = Mt-1 – b* t,  

which meant that the money supply on month t equaled that of the previous month, less proceeds from average paydowns that the Fed withdrew from circulation.

Since Tuesday, we have :   (2) Mt = Mt-1 , which means that the money supply on month t will equal that of the previous month. Money supply remains constant.

If we take the difference between (2) and (1), that is to say, if we see what has occurred since Tuesday on the margin, we will see that:  (2) – (1) = Mt-1 – [Mt-1 – b* t]  = (b * t), where (b * t) >0.

Therefore, we think that there is growth now vs. before, which brings us to the next question: why did the market sell off today?
We see the sell off as the market’s way of forcing the hand of the Fed. As we wrote before, the street knows that until asset prices fall more, the Fed will not engage in active quantitative easing. The rational thing to do therefore is to sell before everyone else does so.  If you notice smoke in a room and hear the firemen approaching…why wait? Why not rush to the exits before they get clogged?

From now on, we will need to get to that critical level. Is it a S&P500 at 850pts? Who knows…But once we reach that level, we will have lower activity or a lower amount of goods being produced, but being chased by a market with a higher amount of fiat currency. In other words, we will have stagflation. 

Martin Sibileau