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

We start the week with three main themes, plus the absence of one. Indeed, yesterday the EU/IMF disclosed the “85 Milliarden Euro Rettungspaket für Irland”. So far, this is to the best of our understanding, what has been agreed to:

-In terms of sources, das Paket will consist of EUR17.5BN contributed by Ireland + EUR22.5BN contributed by the IMF + EUR22.5BN contributed by the European Financial Stabilisation Mechanism + EUR17.7BN by the European Financial Stability Facility  + EUR3.8BN in bilateral loans from the UK + EUR1BN in bilateral loans fra Sverige og Danmark.

We note that the sources of the EUR17.5BN Irish support will be Irish Treasury (yes, I know…) and the National Pension Reserve Fund (no different than what Kirchner did in Argentina a few years ago, when the private pension funds were nationalized and put to good use financing the federal fiscal deficit).

-In terms of uses, das Paket will assign EUR10BN to capitalize Irish banks, EU50BN to cover budget financing needs and EUR25BN as contingent banking support. And here is where things get rather interesting…After Kanzler Merkel would threaten with haircuts on senior bank debt holders, European finance leaders yesterday had to commit to a plan, post-2013 (i.e. when temporary crisis facilities expire) that would treat writeoffs only on a “case-by-case” basis (as reported by Bloomberg), addressing “collective action clauses”. In our view, although this offers a bit of calm to investors, the “technical” damage has been done and it will be difficult to repair, unless there is now an explicit rejection by the EU finance ministers on the issue. They don’t want that? Fine, Mr. Market will eventually force their hands. Just sit tight and watch… What’s next now? Portugal?

The second theme that will impact this week’s action, and perhaps more to come, is the situation in the Yellow Sea, between the Koreas. The recent mediation by China to hold discussions among the Koreas, Russia, the US and Japan smells to a set-up to us, to buy more time for North Korea. It raises the question too, of whether this would have all not been planned before hand. Now, if South Korea rejects the invitation, it will look bad on them. If they don’t, nothing will come out of it, except that the dictatorship to the north will have won time. This could have been a great opportunity for China to demonstrate they are politically up to their pretension to be a global superpower. Because nothing will be solved, in our view, Asian stocks will be capped on their potential to the upside and the price of gold will keep a premium.

The third theme in our view is the expectation, after Black Friday, that consumer spending is slowly recovering and that this will be a force behind a “trend to rally”. Certainly, the recently announced $600BN monetization of federal debt by the Fed (also known as Quantitative Easing II) will also keep a bid on asset prices.

Lastly, another theme is actually the lack thereof, that we may see more clear if and once the public becomes comfortable with the situation in the EU: Namely, the lack of an exit strategy in the US. See, since the beginning of this year, the EU has been working towards gaining trust. Let’s recap:

 First, nobody thought they would pull out a spending cuts program. But so they did! We now have spending cuts from Ireland, UK to Greece. Yes, citizens protested big time, but the cuts are here to stay. Yes, they are not enough, but there is always more to cut and privatizations have not even been discussed yet. What about spending cuts in the US? 

Later, nobody believed the EU would really pull out a package for Greece. Yet, they rescued Greece and now Ireland. They even worked out a mechanism to address future crisis and most importantly they put deadlines to them: 2013. What did the US do on its municipal and state debt problem? So far, the municipal bond market suffered a huge outflow of money two weeks ago and Wall Street is making every effort to downplay the issue, as we expect of course, from those who make money distributing this debt.

Finally, the European Central Bank stated that their government purchase bonds would be sterilized. Nobody believed them (we included) and nevertheless, they did so issuing their own debt (EUR65.8BN at Nov 24th) and without driving rates to expensive levels. What has the Fed done? This is all brewing USD weakness in our opinion and it won’t be long till we see it bursting.

 
Martin Sibileau

Click here to read this article in pdf format: november-24-2010

We usually publish on Mondays, but this time, we wanted to see things play out before coming back. We stand therefore by our forecast published back in September, when most saw the European Financial Stability Facility as a source of strength for the Euro, while we publicly disagreed: We saw this facility as a the key that would trigger chaos within the Union. The chart below (source: Bloomberg) redeems us: the Euro fell by four cents vs. the USD, since the Irish requested access to the facility.

In our last letter, we suggested that the best way to understand the ongoing action within the EU is to use a “game theory” approach, of a non-cooperative nature, we should add. We put forth three main players: Ireland, Rest of peripherals and Core Europe. Now that the bailout for Ireland is news, a new dynamics unfolded. Early yesterday, Bloomberg reported German Chancellor Angela Merkel declaring that the prospect of serial European bailouts was “exceptionally serious”. However, we listened to the speech ourselves (Click here to watch it ) and believe the press may have taken Ms. Merkel out of context, which implies that the markets may have overreacted but also, that there is more in hand here .

Now that Ireland seems to have gotten away with its corporate tax structure, other “participants” in line (i.e. Portugal) have learned something: Time is on their side. Why? Because marginally, once a country’s sovereign yield shoots up and becomes the next in line, the marginal pain is bigger for Core Europe. When Greece’s bubble went bust, Ireland felt the pain, Core Europe barely felt it. When Ireland’s bubble goes bust, Portugal feels the pain and Core Europe begins to take notice. By the time Portugal’s bubble goes bust, the pain for Spain will be felt and Core Europe will be very uncomfortable, since France or Italy will be the next in line and Germany simply can’t afford this.

Therefore, the sooner Core Europe deals with Portugal, the cheaper it will be to cut the pain. How does Core Europe force Portugal to come to terms? By pushing their sovereign yields higher than the policy makers of the first-in-line countries expected. How? By going on record, like Ms. Merkel did yesterday, saying that the situation is exceptionally serious. That way, Portugal’s credit risk jumps 35bps to 490bps threatening with a margin increase at LCH Clearnet. This move leaves the first-in-line country unable to raise capital and asking for help to the EU and European Central Bank (sooner, rather than later! This is the point!). To us, this makes sense…Otherwise, why would someone as serious as Ms. Merkel say what she said with such a brutal sincerity? When are politicians sincere?

Where does this all leave us? It leaves us with a change in our view: We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place. However, if they succeed, it may well have again a chance to become the world’s reserve currency, if the US doesn’t correct their monetary mistakes. Why? Because the only way to succeed is through a dramatic institutional change, a true federal pan-European structure. In the meantime, the opportunity to become a reserve asset grows for gold by the day, because the risks of failure are just too big to be ignored.

Martin Sibileau

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

A quick note to finish the week…We think we are entering a new stage in the dynamics of the Eurozone, and that the ongoing negotiation between Ireland and the European Union as well as the weakness in the Euro prove that the comment we made on September 9th was appropriate. We wrote:

“…Another interesting perspective is that which finds strength in the Euro, from the fact that peripheral countries can now access the European Financial Stability Facility, which is now effectively operational. We actually see it the other way: Precisely because the weak countries will access this facility, the break of the European Monetary Union will be accelerated, as the rich countries are faced with true costs; costs which until now were being piled under the big rug (the balance sheet) of the ECB…” (www.sibileau.com/martin/2010/09/09 )

Since November 4th, the Euro has embarked on a very defined downward trend. Counter intuitively, this should not occur.  Ireland does not need to access the market before June 2011 and if it required funding, the European Union is ready to sign the cheque. Therefore, what is behind the weakness?

To understand this issue and our previous comment, we need to see first that Europe has first and above all an institutional problem. Secondly, one can use the Game Theory approach. We are not well versed in this approach. We studied the theory while as undergraduate students and thanks to the extraordinary advancement of mathematics, we know it has evolved tremendously since John von Neumann and Oskar Morgenstern first published in 1944 the famous “Theory of Games and Economic Behavior”. We are very reluctant to use formal approaches to human action but we think the particular negotiations that are currently taking place can be easily analyzed under this method. Here are what we think can be premises:

1.-Ireland’s financial position, just like any other peripherals, deteriorates with the passage of time. However, as it does not require funding until June 2011, its position vs. time is stronger than that of Portugal or Spain (i.e. the first “derivative” of loss vs. time is lower for Ireland. But not the second. By 2011, everyone is on the same leveled field ).

2.-Ireland knows (1) above (i.e. has perfect information) and uses this upper hand to better negotiate the terms of the inevitable bailout. However, if it waits too long, the advantage is lost.

3.-Portugal, Spain and Italy know (i.e. have imperfect information) that once Ireland gets help via the EFSF, spaces will fill quickly. There isn’t simply enough room for everyone. The EFSF cannot be but for exceptions. Otherwise, there is no catch! An EFSF for everyone can simply not be AAA rated: A bank that lends with leverage cannot honor all deposits at once. Furthermore, keep in mind that there are no defined pan-European taxes supporting draws under the EFSF, but a promise from each respective EU member to get those funds somehow (Another important aspect here is that the IMF is contributing an additional 50% , which a friend and reader pointed to us is simply another important source of debt monetization).
Therefore, once Ireland draws under the EFSF, a race will start by Portugal, Spain and Italy to win the next seat, to be the next in line to draw, before the window closes. Be ready. All kinds of tricks and influences will be played at this point.

4.-Core EU members (i.e. Germany, France, Netherlands) know that the puck must stop somewhere, before their own solvency is compromised. If it is compromised, the only way out is a blanket, wide monetization of government debt by the European Central Bank, a massive currency crisis, assuming the EU monetary union doesn’t break. What are they doing about it? Ms. Merkel has been pushing to for the creation of a debt crisis mechanism, in which an “orderly” bankruptcy is carried out and whereby sovereign bondholders take a haircut. This is simply a wrong and absurd idea, which if implemented, it will only accelerate the demise of the monetary union. On this note, we think it is worth reading UBS Tommy Leung’s recent comments (UBS EU Credit Stategy – Daily Morning Walk, November 16th, 2010: “A glaring contradiction”) where he reflects upon this issue. Mr. Leung observes that this mechanism would discriminate between sovereign debt issued prior and after 2013, effectively creating a two-tiered EU sovereign debt market. This actually goes against the natural solution for Europe, which is a unified bond market! In this scenario, bonds issued prior to 2013 would be structurally senior to those issued from 2013 on. Mr. Leung further asks how would this be consistent under Basel III, where banks holding these bonds assign a zero risk-weight to them. Clearly, if a restructuring mechanism is considered, the possibility of default cannot be ignored.  Mr. Leung leaves the topic here, but we don’t. If default cannot be ignored, the arbitrage within the EU financial system will be immediate, with depositors shifting their savings from the banks holding the subordinated bonds to those holding the senior bonds. This can only deteriorate the balance sheet of the European Central Bank.

Where does all this leaves us? What can core EU members do? Nothing! Absolutely nothing. What will they do? Force more fiscal discipline on the other peripheral countries. But as we saw in point 3, once Ireland access the EFSF, these countries will have a strong incentive to fill in the last seat available. In other words, they will seek to show they can’t survive without it.

The US cannot react to this, as it is too concerned with its own problems. The latest performance of municipal debt is very telling in this respect. How can China react? By holding lower amounts of Euros as reserves and shifting that allocation to gold, slowly but steadily.

Lastly, we want to bring collective attention to the recent pressure the Fed is facing. Not only is there internal dissent regarding QE2, but also on Tuesday, as everyone must know by now, an open letter to the Fed was published by the Wall Street Journal, criticizing this latest move. Now, at our desk, we always have Bloomberg TV turned on and yesterday we noted how guest after guest was asked by different news anchors whether the Fed should not reconsider its dual mandate. Once an answer was given, the Bloomberg anchors replied asking whether Mr. Bernanke would likely resign on such change, noting that this is a possibility, given the new Republican majority in Congress. Are we thinking too much here? Were we watching a press op unfold or was this pure coincidence?

Martin Sibileau

Please, click here to read this article in pdf format: november-16-2010

We are writing with hesitation this morning. For the first time in a long time, we feel at a loss in terms of markets’ near term direction. We want to believe that the trend in asset inflation is alive and healthy and that what took place on Thursday-Friday, was simply a correction, following last week’s increase in margin for silver contracts (discussed in our previous letter of Nov 11th). But there are simply too many things going on, which are proving powerful enough to temporarily halt asset inflation.

-Ireland
We have dealt extensively here on the institutional problem of the European Union. Ireland represents only one more variation of it, just like Greece did earlier in May. Yes, Ireland’s problem differs from Greece’s in that the source of the increase in the fiscal deficit is a once-and-for-all loss (i.e. bailout) on mortgages. In this respect, it would appear more similar to the US in 2009 than to Greece in 2010. But the problem is always the same: The government can increase its deficit, but cannot monetize it on its own. It needs the complicity of the rest of the Union members. So far, they say they’re in!

Our view: One can never underestimate idiocy. Ireland has now the support of the EU but refuses to accept it, undermining everyone else’s efforts. Why? Because there is a general feeling that independence will be lost. First, they floated the idea of making senior bondholders of the affected financials lose their seniority in a bail-in scenario. It didn’t go far. Now, they pretend they can wait for they are pre-funded for 2011. But the problem is that other EU peripheral members are not in that situation and the refusal to face the problem infects the entire EU bond space. We think there is no alternative but to monetize the financials losses using the European Financial Stability Facility. This means that the EFSF, a Luxembourg-registered company owned by euro area member states, will issue AAA debt to fund the Irish government. With the proceeds, the Irish government “should” buy the distressed assets of its insolvent banks (i.e. it should not capitalize the banks, but buy their assets outright). This transfer would tighten credit spreads on the banks and widen it on Ireland’s sovereign risk. Thus, how will Ireland cope with it going forward? In 2011, if necessary, it will sell its debt to the European Central Bank, further debasing the Euro. Should this not be long-term supportive of commodities? Of course it should!

-US Sovereign risk
We were one of the first to note this early on November 9th. Now, it is vox populi. On November 9th we wrote:

“…we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis…”

The US yield curve continues to steepen. The ProShares UltraShort 20+ Year Treasury ETF (ticker: TBT), for instance, is +17.5%, since the last FOMC announcement, on November 3rd.  And this gain has been forged on stocks rallying or selling off, on the USD rallying or selling off. The trend appears to be firm. Not only that: Since last Friday too, the US federal debt market is also “crowding out” the municipal debt market. Flows into municipal bond funds seem to have be slowing at fast and furious pace, according to a report from Bank of America’s Municipal team, published yesterday. Yesterday too, 10 Yr AAA Muni rate closed at 2.75% (+11bps) heavy supply.

Our view: We see the municipal/state financial situation impacting on the value of the USD as we see peripherals debt in the EU impacting the Euro. On top of this, the Fed is facing political pressure from the Republican party to not proceed with the announced QE2, while no real action plan has been counter offered to address the ever growing fiscal deficit. Here, the path of least resistance is easier to visualize. Ben Bernanke has told us he has no shame monetizing deficits. The currency crisis of the United States has simply begun, in our opinion. Should this not be long-term supportive of commodities? Of course it should!

-China and other net creditor markets
China and the rest of the emerging markets insist on sustaining their activity on the back of a cheap currency, pegged to the USD. If the USD itself is debased, they will have to do the same with their currencies. Therefore, they must confront inflation. But since they did not witness a deleveraging a l’Americaine in the past years, inflation picks up easily there. What are they doing? Anything to stem the inflow of capital to their currency zones: Taxes on capital inflows, increase in reserve requirements for banks (i.e. lower credit multiplier), increase in interest rates…

Our view: Any textbook on macroeconomics will explicitly tell you this is absurd. When a country controls its foreign exchange, it loses control over interest rates and prices. In the short term, these markets can use all the tricks available to them. This shows how dictatorial they are, for there is a lobby group in control denying the working masses the benefits of their hard work. These emerging markets are condemned to remain emergent and anyone telling you the opposite is simply blind to the fact that economic growth is ultimately the result of only a strict respect for private property. The inflation tax is anything but that and in the long term, these markets are bound to lose their competitiveness caused by this distortion in the relative price of capital. Should this not be long-term supportive of commodities? Of course it should, because their supply will decrease, relative to their demand, as real wages fall in these markets and labour and capital to produce them becomes scarce.

Martin Sibileau

Please, click here to read this article in pdf format: november-11-2010

Since our last letter, commodities (excluding oil) have sold off. The developments out of Ireland have impacted the Euro, as we discussed earlier and, in addition on Tuesday, the CME announced at close that deposits and margins on silver contracts and hedge positions would be raised. These two factors have temporarily affected liquidity on risky assets.

The first one, Ireland, has obviously an important spillover potential, as the banking system is technically insolvent and, if bailed out, will require either Irish taxpayers or EU taxpayers to foot the bill. If it isn’t bailed out, it will then affect the capital of other financial institutions within the EU mostly, with Irish exposure. On that note, sovereign credit spreads of Peripheral EU jumped yesterday and the situation is understandably affecting the Euro. The chart below (source: Bloomberg) is very telling. Since it peaked on November 4th, the Euro has embarked on a very well defined downward trend.

This trend is draining liquidity from the market, although not to worrying levels, for the Euribor-OIS spread is still low, at 26.4bps. Some may argue that it is due to the intervention of the European Central Bank…which is true and may continue, producing an “orderly” fall of the Euro, in spite of wider sovereign spreads. Of great help is the fact that the Irish government does not require to access the capital markets before 2011. All this is what, in our view, is preventing gold from resuming its upward trend, to prove once more that it is on its way to become the world’s de facto reserve asset.

Having said this, we want to return to a point we made on Tuesday, when we wrote that:

“…we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis…”

Yes, the yield curve steepened since Nov 3rd, but the chart below (source: Bloomberg) should also be visual enough to raise concern over the wisdom of the Fed’s recent decision. As long as the money being “printed” by the Fed causes a shift from Treasuries (long-end mostly) to cash, without lifting commodities or stocks, we will be in the proverbial liquidity trap and the USD will be far from a crisis. But as soon as the massive unwind of pre-QE2 positions and short USD/long EUR positions (which we think are causing the confusion) is over, we will see the weakness in the long-end of Treasuries as the seed of a materially higher price of gold and the beginning of the US currency crisis.

Martin Sibileau