Please, click here to read this article in pdf format: september-02-2010

If we had to use one word to describe the action so far this week, we would pick “confusion”. Perhaps a reflection of it is the number of analysts that updated their long-term forecasts (bearish), differentiating them from tactical, short-term ones.

Yesterday’s rally began with the Euro jumping from 1.2680 to 1.2850. Was it triggered by the news that the Spanish central government’s budget deficit had narrowed 48% in the first seven months of this year? Was it the action of a central bank? On Tuesday, the Euro currency zone saw a small addition (but at least not a decrease) of liquidity in the order of EUR2.8BN through the ECB’s one-week repo operation, while yesterday, the ECB refinanced EUR61BN to sterilize its sovereign bond purchases, also for one week and at 33bps. Clearly, this intervention could have not caused the rally in the Euro. If we have therefore to suggest a cause for the broad rally in risk yesterday, we will say that it is a correction within a bearish trend, in addition to the fact that yesterday was the first day of the month. Another factor was the reinterpretation of the Fed’s intentions behind the decision to reinvest mortgage paydowns into Treasuries. It appears that the Fed’s fear was not so much on the decline of real output but on the speed of these paydowns. There is always a way to spin things in a positive way, right?

The activity data released so far has not been supportive to say the least and the weakness in the oil market attests to this. We believe that after the Jackson Hole meeting, a new coordination among central banks is underway. A lot of tricks will be played and one has to sharpen the senses to see behind the fog.

We will soon see (we think) a Bank of Japan supporting Treasuries with Yens or the equivalent: Devaluing the Yen via Treasuries purchases.

On the other hand, China announced on Tuesday that it will allow domestic companies to keep some foreign-currency income overseas on a trial basis starting from Oct. 1 (source: Bloomberg). This will be an experiment limited geographically (for companies in Beijing and the provinces of Guangdong, Shandong and Jiangsu). At “A View from the Trenches”, we had anticipated this move back in January, where in a series of letters, we reviewed the intervention efforts by the People’s Bank of China, on the “distribution channel”. Back on January 21st (refer: www.sibileau.com/martin/2010/01/21) we wrote:

“…We would quickly see that there would be segmentation in the credit market, where exporters borrow offshore and internal consumption is financed onshore…(…)…. No central bank can simultaneously sustain a fixed exchange rate regime and control the local rate of interest…”

We were referring to the Bank’s intention to delay the credit expansion process, fuelled by their USDs purchases from exporters. The segmentation will soon be a fact, as there will be an oversupply of USDs offshore, looking to be invested. Who do you think will benefit? Not the average citizen, of course, but the big exporters. With cheaper credit, a higher Yuan should be more tolerable.

Meanwhile in the Euro zone, the next wave of sovereign debt refinancings approaches. In some countries, like Ireland and Greece, the fiscal situation has not improved and the European Central Bank continues to devise ways to avoid a run against its liabilities. We’ve seen for instance purchases of Greece bank debt, guaranteed by the Greek government. You see, instead of having the ECB directly buying the sovereign debt, banks would buy it with funding from the central bank. Greek banks issue government guaranteed bonds that sell to the ECB and with those proceeds, they are able to finance their government. In the end, the ECB’s balance sheet has Greek sovereign risk, but without having to intervene in the sovereign debt market and to sterilize such intervention.

In summary, we are entering the final stakes of this game of musical chairs and with the coordination of central banks to keep the music going, it will be difficult to invest following macro fundamentals. In the US we are faced with technical insolvency at all levels of government (municipal, state and federal) and yet, with the Fed and other central banks buying Treasuries, we can see record low yields and tighter credit spreads.

In this environment, should gold not be able to rise and establish its price beyond $1,250/oz?

Martin Sibileau