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