Archive of September, 2010
Published on September 28th 2010
Please, click here to read this article in pdf format: september-28-2010 We spent a lot of time going through FX intervention mechanisms in the last two letters, and did not have the time to write about what is obviously moving markets lately: The Fed’s decision to bring inflation to a level consistent with their target [...]
Please, click here to read this article in pdf format: september-28-2010
We spent a lot of time going through FX intervention mechanisms in the last two letters, and did not have the time to write about what is obviously moving markets lately: The Fed’s decision to bring inflation to a level consistent with their target employment level and the ongoing fiscal crisis in Ireland (the sovereign credit default swap widened from 200bps, the low in July to 500bps last week). Honestly, there is not much more we can add here and we won’t, except that we are surprised by the strength of the Euro and not only vs. the US dollar, but the Canadian dollar as well.
If we had to give a quick answer to this recent appreciation, we will point to actual weakness in the US dollar, post FOMC communiqué on September 21st, rather than intrinsic strength on the part of the European Monetary Union. As we wrote before, many analysts suggest the Euro should be strong because of the access the distressed members have to the European Financial Stability Facility. However, we think the opposite is true. If these countries ever need to access that facility, the whole monetary union will be in crisis, as a race will start among peripherals to use it before it’s gone and Germany feels the real pain of honoring their guarantee to contribute funding, perhaps even alone. Yes, we think there is a chance that the approval the parliaments of the respective union members gave, might be denounced by some countries.
But today, perhaps we should bring collective attention to the Euro in relation to the Canadian dollar. Since the communiqué by the Fed, the Canadian dollar has been underperforming. It is as if suddenly, Canada’s relative fiscal and financial situation were irrelevant. Gold has made new records and yet Canadian mining stocks are not (for instance, check gold vs. iShares S&P TSX Global Gold Index Fund, ticker: XGD.TO). Oil is showing strength, but the energy sector represented in the TSX is not (for instance, check crude oil vs. iShares S&P TSX Capped Energy Index Fund, ticker: XEG.TO).
There is increasing concern about the highly leveraged balance sheet of the average Canadian citizen and about the real estate market, particularly in the condo sector. The Bank of Canada is on a difficult position: If it raises its policy rate, to bring it to a more “neutral” level, it will face political pressure from the “export” lobby and the left, which of course sees the Bank as part of the official party. If it leaves it unchanged, the Canadian dollar will depreciate and inflation will be accelerated.
If Canadians don’t want to see their purchasing power fall, the world will need to see evidence that something new is coming up: Lower taxes or privatizations or spending cuts (By the way, this also applies to any society). It doesn’t matter which one or what combination thereof. Otherwise, in the absence of nice surprises, the trend will be for the Canadian dollar to fall on weakness and to underperform on strength. We don’t often write about Canada but when we did, we said that “…Canadian stocks are rising because foreign money is flowing in! And for foreign money to keep flowing in, Canada must show it can provide a stable currency. The world is starving for stability! All Canada needs to do is to remain quiet, while the rest of the world misbehaves and voices its anti capitalistic rhetoric…” (refer: “Meanwhile in Canada”, June 2nd, 2009: www.sibileau.com/martin/2009/06/02 and “The stars favor Canada”, March 4th, 2010: www.sibileau.com/martin/2010/03/04 )
September 21st marked the end of the good times for Canada. Canada is now linked to the fate of the US sovereign crisis. Stability is no longer enough. It can be found in gold, by those who seek a reserve asset, or in emerging markets, by those who look to profit from growth. The onus is on Canada to show the world that it can also outperform.
Published on September 23rd 2010
Please, click here to read this article in pdf format: september-23-2010 Continuing with our last letter, which laid out the details of the Yen intervention (ref.: www.sibileau.com/martin/2010/09/23 ) we want to proceed to answer a few questions. But before that, let’s clarify the concept of sterilization… Under sterilization, a central bank seeks to bring the [...]
Please, click here to read this article in pdf format: september-23-2010
Continuing with our last letter, which laid out the details of the Yen intervention (ref.: www.sibileau.com/martin/2010/09/23 ) we want to proceed to answer a few questions. But before that, let’s clarify the concept of sterilization…
Under sterilization, a central bank seeks to bring the supply of money back to the original size it had, prior to an intervention in the markets (in this case, in the foreign exchange market). The outcome, after the sterilization is carried out, is a change in the composition of the asset side or the liabilities’ side of the central bank’s balance sheet.
Let’s take, as examples, the last interventions of both the Fed and the European Central Bank (ECB).
When the US dollar spiked in the midst of the liquidity crisis of 2008 or when the Greek problem generated a rush to sell Euro and buy US dollars, the Fed extended cross-currency swaps to the ECB (and other central banks too).
These swaps are an asset to the Fed, which is matched by the creation of a reserve, as Mr. Daniel Tarullo, member of the Board of Governors of the Fed explained to Ron Paul, on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ). The mechanism is shown in the graph below
In step 1, the Fed creates money out of a reserve, which in step 2 debits for a cross currency swap (credited). That cross currency swap is an asset to the Fed, which it extends to the ECB. To the ECB, it is a liability and the ECB credits US dollars. Does anything here seem out of place? If this puzzles you, you are not alone. This was criticized way back in the ‘30s, as Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ), in his book “The Monetary Sins of the West” wrote:
“…On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government’s attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:
There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold exchange standard. Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit….” (Here is the link, refer page 12 at : www.mises.org/book/monetarysin.pdf )
Anyway, the interesting point here is that at the end of the exercise, on the balance sheet of the Fed, both assets and liabilities are matched in terms of currency. If the US dollars depreciate, this doesn’t impact the assets of the Fed.
The Fed does not need to sterilize this intervention, because the currency swap has a finite term and the rate charged by the other central banks, like the ECB, to their financial institutions (i.e. Euro-zone banks) using this facility is punitive enough to encourage repayment. In fact, the rate establishes an implicit cap in the market, since no bank will pay more for US dollar funding than what they can if they borrow from their respective central bank. The intervention, effectively, depreciates the US dollar.
In the case of the European Central Bank, sterilization did take place this year. We actually described the mechanism in our letter from May 13th (www.sibileau.com/martin/2010/05/13 ) and reproduce the graph below.
In step 2, we see that the ECB purchases government bonds from peripheral countries (i.e. PIGS debt), issuing Euros. To bring the supply of Euros back to the original size, the ECB (Step 3) issues debt, which is bought by the Banks (i.e. the banks place the Euros in deposit). In effect, this debt has been issued under weekly refinancings, using the Term deposit for SMP facility. Deposits (i.e a liability of the ECB) amounted to EUR61.5BN by September 21st. Here, as can be seen, sterilization consisted in an exchange of liabilities: Euros in exchange of Term Deposits.
How did the ECB manage to depreciate the Euro, even under sterilization? Because it decreased the quality of the assets backing its liabilities: The proportion of riskier sovereign debt backing the Euro increased. Most importantly still, the message to the public was that, if required, that proportion could grow even bigger (as reflected in the current fears about the Irish banking system).
Once again, the important concept here is that both the asset side and liabilities side of the balance sheet of the ECB are denominated in the same currency: The Euro. As in the case of the Fed, there is no mismatch here. If the Euro drops in value, it does affect assets by the same proportion it affects liabilities.
At this point, we are prepared to address the intervention of the Yen. We reproduce here the graph shown in the previous letter.
As we wrote, in order to sell Yen to the FX market to devalue it, the Ministry of Finance issues Finance Bills (i.e. Finance Bills 1), which are “bought” by the Bank of Japan, in exchange for Yen (i.e. Yen1). Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases. At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1.
Let’s stop for a moment here. As you can see, without sterilization, the Ministry of Finance ends up holding US dollars as assets, and Finance bills, in Yen, as liabilities. They have a mismatch here.
What happens if they sterilize? We show the process below:
To bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills (i.e. Finance Bills 2) in the market. The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2.
Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. (In fact, it sounds inappropriate to call this “Sterilization”, because the Bank of Japan does not participate in it and as a result, there are no changes in either the asset side or the liabilities side of its balance sheet).
But the important thing here is that even after this “sterilization”, the Ministry of Finance still has US dollars on the asset side of its balance sheet. The mismatch, now against Finance bills 2, remains.
This is why we think sterilization is irrelevant here. Why? Because as long as these US dollars continue in the balance sheet of the Ministry of Finance, they will be a source of further imbalances. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:
P&L = D US dollars (in its Assets) / D t – D Finance Bills 2 / D t
(* D = Delta)
As the Fed engages in further quantitative easing, as it clearly stated yesterday in its the FOMC statement, the P&L of the Ministry of Finance will deteriorate. A negative P&L can be bridged with higher taxes (not acceptable), sale of assets (not in question), less spending (not possible) or higher debt.
Thus, the Ministry of Finance, as the US dollar falls further, will have to issue more Finance Bills, to cover the deficit, which may be substantial, given the massive size of its interventions. But as it issues more debt, the interest rate will increase, appreciating the Yen even more against the US dollar. This is a self-feeding, spiraling problem.
How can the Ministry of Finance get rid of the currency mismatch? By selling the US dollars to another central bank!!! This is why we have been saying that coordination with other central banks is more relevant than sterilization.
Which central bank wants to buy US dollars? None at the moment.
The Fed? They can’t! They are actually doing the opposite: They are buying Treasuries to sell US dollars!
What is then the Ministry of Finance to do with the US dollars? Buy treasuries? Most likely and in doing so, the Japanese tax payer will be further financing the American consumption party. With this intervention, finally, the last asset left to serve as reserve for our savings is gold. The verdict is unanimous. The Yen gets the contagion from the quantitative easing policies of the US, the US debases its currency, and those holding Euros are at the mercy of the politicians in the peripheral countries.
What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!
Published on September 20th 2010
Please, click here to read this article in pdf format: september-20-2010 In our last letter, we made the point that the intervention to devalue the Yen was supportive of gold. We explicitly decided to exclude from our comments the details of the intervention, but now in hindsight, believe it was not appropriate. Therefore, we want [...]
Please, click here to read this article in pdf format: september-20-2010
In our last letter, we made the point that the intervention to devalue the Yen was supportive of gold. We explicitly decided to exclude from our comments the details of the intervention, but now in hindsight, believe it was not appropriate. Therefore, we want to start the week going through these details. We think it is important to understand the same because they give us a lot of information and we can deduct important conclusions.
Without further ado, let’s examine how this intervention should work. The operative word here is “should”, because the intervention is still in its early stages and there is speculation about its effectiveness. We refer the reader to the latest research by Bank of America’s G10 FX Strategy team published on September 16th, 2010 (our source), for a slightly different perspective on the mechanism we will describe below. We understand this mechanism is best explained in a work titled “Modern Monetary Theory”, written by Mr. Shirakawa, who is currently the Governor of the Bank of Japan (we have not been able to access it yet). Finally, we wish to devote two letters to the analysis of this event, given its relevance. In today’s letter, we will go through the details and some important conclusions. In the next letter, we will explain the differences between this type of intervention and the one we are used to see, via central banks. We will also examine why coordination with other central banks, which is missing so far, is important and how that in turn gives support to gold. Let’s start…
In Japan, the FX intervention is carried out by the Ministry of Finance, rather than the Bank of Japan. In order to sell Yen to the FX market to devalue, the Ministry of Finance issues Finance Bills, which are “bought” by the Bank of Japan, in Yen. Let’s call these first issuances Finance Bills “1” and Yen “1”, which are issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (graph 1):
Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases. At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1. However, to bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills in the market. We will call this issuance Finance Bills 2, which are shown below (graph 2). The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:
Of course, as the Ministry of Finance goes to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increases. Given the current market conditions, the impact on price must be minimal. However, as in any other bond market, as supply grows, yield tends to grow (i.e. price tends to fall), to encourage market participants to buy the increased supply.
Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. The Ministry of Finance has USDs on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (graph 3):
The three graphs above show the balance sheets of all the participants in this intervention: The Ministry of Finance, the Bank of Japan, the FX market and the Yen Government debt market. However, we think it may also be interesting to show the intervention in terms of cash flows. Therefore, we show graph 4 below, where we can see that de facto, the Ministry of Finance ends up acting as intermediary between the Government debt market and the FX market. In essence, the intervention “moves” Yen from the Government debt market to the FX market, and this is a “fragile” movement, because it lends itself to arbitrage. Hence, the importance of central bank coordination, to gain “independence” from this source of Yen supply.
Why does this movement of Yen lend itself to arbitrage? Because an asset can never have two different prices in different markets. Whenever that occurs, arbitrageurs fix the problem.
You may question why we think the Yen has two different prices. Well, let us answer that question with another one: Why would the Yen Government Debt market need a “middle-man” (see graph above, graph 4) to provide Yen to the FX market?
It doesn’t!!! The Yen Government Debt market is “not willing” to buy US dollars (i.e. provide Yen) from the FX market at a loss (i.e. buying US dollars at above market prices).
So, who ends up taking the loss? Who ends up buying US dollars at above 82 Yen per dollar? The Ministry of Finance does, which means the average Japanese tax payer! This person is subsidizing the big exporting conglomerates of Japan, so that they can provide “financing” to the American consumer who is broke. The subsidy can be significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen will tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) will lose purchasing power.
In the long term, the Ministry of Finance incurs into a deficit (if the USD depreciates further) which can only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:
D US dollars (in its Assets) / D t – D Finance Bills 2 / D t
(* D= Delta)
If the Fed undertakes quantitative easing again, the value of the US dollars will fall, generating a loss to the Ministry of Finance. Will they keep buying US dollars then?
Today, we have laid out the general details of the Yen intervention. In the next letter, we will examine other issues/conclusions associated with it: Why is it important to coordinate with other central banks? How would that coordination work? What makes this intervention different to others? Why did Mr. Shirakawa note that under this mechanism the issue of sterilization is meaningless? Is the coordination supportive of gold? Can the intervention affect US interest rates (i.e. Where will the Ministry of Finance invest the US dollars it buys?). These are all important questions and they need answers.
Published on September 17th 2010
Please, click here to read this article in pdf format: september-17-2010 In the last 48 hours, the most relevant event is undoubtedly the decision by Japan’s Ministry of Finance to intervene in the FX market and weaken the JPY vs. the USD. There is a lot of speculation (in fact, this is not new, since [...]
Please, click here to read this article in pdf format: september-17-2010
In the last 48 hours, the most relevant event is undoubtedly the decision by Japan’s Ministry of Finance to intervene in the FX market and weaken the JPY vs. the USD. There is a lot of speculation (in fact, this is not new, since the intervention was being heavily speculated since August) as to what should be the right amount of Yen to dump to investors for the intervention to generate results. Some speculate with trillions… There is also research on whether or not the new money should be sterilized, on how it will affect interest rates (the Bank of Japan sells JPY for Treasuries) and there is also a general agreement that under the current macro conditions, no other central bank will coordinate with Japan to help with the intervention. We will not deal with the technicalities of this, for the reader has abundant material available elsewhere.
What we want to draw collective attention to is the bigger picture here. With the intervention, the Yen will be increasingly backed by the sovereign debt of a bankrupt nation. The more successful Japan is in devaluing its currency, the higher the percentage will be, of such debt backing the Yen. This should not surprise anyone but as G. Orwell wrote, sometimes the first duty of intelligent men is the restatement of the obvious. So, let’s restate it: If the Euro is increasingly backed by distressed sovereign debt and liable to banks that finance distressed Euro sovereigns, and if the US dollar is explicitly financing US fiscal deficits, the intervention to weaken the JPY (by also financing US deficits), leaves gold as the last reserve of value. And its price is certainly telling us that this is the case. Some see the Euro as the natural winner here, on a relative value basis (i.e. it has already cheapened), but we doubt reserves will reverse to the Euro zone.
As we wrote in our last letter (and in many others too), the problem the world faces is of a general distortion in relative prices. This distortion causes stagnation, as prices cannot play their role in the allocation resources. Hence, we should not expect productivity increases. We should not expect economic growth. Instead, we will see a massive deterioration in purchasing power in the developed world as a lower amount of goods being produced is chased by a higher amount of debased currency.
The first that comes to our mind is that under this context, even though the ongoing monetary policy is inflationary, stocks should not necessarily protect us from the upcoming monetary/sovereign crisis. The effects of the crisis are not neutral. We will not see asset price appreciations precisely because of the uncertainty of increasing interventionism (at a global scale). The path of least resistance is to take all that amount of debased currencies and exchange it for gold. We’ve seen this happen before, time and time again, in developing economies, when these lose their national currencies. First, their citizens see asset prices rise, but soon stagnation sets in and everyone loses purchasing power. Misery reigns and only those who managed to exchange their savings for a foreign currency can survive by speculating with the price distortions. Of course, they are later blamed for the crisis by politicians. We fear the (developed) world is going to see another round of this pathetic play.
We would like to leave with a very visual chart here: The ratio of gold to oil (Long gold/Short oil) since the beginning of the century (source: Bloomberg). It’s worth more than thousands of words…
Published on September 14th 2010
Please, click here to read this article in pdf format: september-14-2010 Since our last letter, nothing relevant has taken place. The world keeps bidding for risk since the announcement that banks are not going to be required to raise capital as fast as expected. The European Monetary Union, with its fragile banking system is the [...]
Please, click here to read this article in pdf format: september-14-2010
Since our last letter, nothing relevant has taken place. The world keeps bidding for risk since the announcement that banks are not going to be required to raise capital as fast as expected. The European Monetary Union, with its fragile banking system is the big winner here. But as we said, this is not relevant, because this is more of the same.
If we had to summarize the macro picture today, we could say that while the US is trying to implement a Keynesian solution to the financial crisis and falls short of the recipe (i.e. money supply does not fall, but does not increase either), the European Union refuses to accept problems and hides the dirt under that big rug called the European Central Bank (i.e. the stress tests were a bad taste joke). On the other hand, the UK shows inconsistency in reducing spending and increasing taxes, while Japan seems lost in terms of how to address capital inflows. That leaves the Swiss Franc and commodity currencies as the best looking alternatives, but for the latter, this only applies as long as activity levels don’t disappoint (i.e. Chinese tax payers keep footing the bill with their purchasing power depressed).
Speaking of activity levels, we are constantly hearing / reading about a concept which we think is flawed, namely how negative is for an economic system to have current output below “potential” output. This is a very “mainstream” concept. The Taylor rule, for instance, is based on it (refer: http://en.wikipedia.org/wiki/Taylor_rule )
This whole concept, in our opinion, is an absurd. There is no such a thing as “potential” output. The mere idea of its existence implies that the role of the pricing system in the resource allocation process is irrelevant. Why would firms not produce to capacity, unless doing so is unprofitable? When firms do not produce up to their potential, they make a conscious, educated decision not to do so. The fact that they have the capacity to produce more is irrelevant, because doing so would generate a cost which is not compensated by the marginal revenue, including the risk of holding unwanted inventory. Furthermore, how can we measure what the potential output for an economic system is, when a whole different set of relative prices would be required to achieve that additional employment of resources? Who can claim knowledge of that set of relative prices that will take a system to full capacity? The assertion that such a set of prices is known goes against the assumed neutrality of money that central banks employ in their models (i.e. Taylor rule).
The source of the problem is the original miscalculation of firms, when they purchased the capital goods that allowed them to achieve that higher capacity. They did so because the respective cost of capital was lower than what the risk apparently entailed.
If up to here you thought these comments were of academic interest only, we beg you to look closer at what has just happened yesterday, post-announcement of the implementation of higher capital ratios. The mandate for what was considered a prudent 7% capital ratio has been delayed until 2019 and investors, after receiving this “price” signal, decided to dump good money after bad to a financial system that is now becoming incapable of distinguishing a real from a nominal return (if you refer to our previous letters, you will see that we have never been believers in either stress tests for the Euro zone or higher capital ratios to decrease systemic risk, as long as central banks remain alive)
This specific announcement lowered the cost of capital for banks, with the intention of increasing the banks’ “output”, i.e. making more loans. Relative prices for risk (i.e. what the bank buys) have not changed. There has been no intrinsic, fundamental change, for instance, that should justify a 1.1% daily increase in value of the S&P500 we saw yesterday. However, given the lower cost of capital, risk shall be in higher demand. Credit spreads shall further compress and the distinction between good and bad credit risk will be blurry at best and absent at worst. In the event that it may take too long to increase that demand, banks will also seek to merge, and the so feared too big to fail institutions of 2008 will look like babies by the time the next crisis arrives. Have we learned anything in the last three years?
The global economy is not underachieving. There is no potential output we need to get back to. What we need is to return to a transparent and efficient pricing system, so that we can all (this is already an issue of global proportions) save and consume what we want, not what politicians want us to, and resources can be allocated to those enterprises that have an effective demand.