Archive of December, 2010
Published on December 21st 2010
Please, click here to read this article in pdf format: december-21-2010 This is our last letter of the year. Briefly, we want to go over the main themes that we leave with, to touch upon a subject that we have already expressed our concerns on. Let’s see… To give structure to our first point [...]
Please, click here to read this article in pdf format: december-21-2010
This is our last letter of the year. Briefly, we want to go over the main themes that we leave with, to touch upon a subject that we have already expressed our concerns on. Let’s see…
To give structure to our first point (i.e. main themes), we will classify the themes according to their respective currency zones. Starting with the US, we must say we’re impressed by the level of optimism expressed in the many research notes we’ve read in the past week. The outlook for 2011 is too good and shared by too many, which is a recipe for deception. Most of it is based on the fact that from a fundamental perspective, 2011 will “suffer” from a negative net issuance in almost every credit/fixed income class, exacerbated by the Fed’s announced purchase of $600BN in Treasuries. This shortage in net issuance is to us the main theme, the basis of an expected asset reflation trade. Do we agree with this view? No! This view is not dynamic. This view assumes market participants will be comfortable once the negative net issuance is over and we enter 2012. This could never occur, because once the force behind the reflation weakens, the pain will be even less tolerable and a new source of price inflation will be sought.
For the European Monetary Union, next year will be quite the test. We differ with those who see indecision in European politicians to take the next step towards a fiscal union. But we fear more the idiocy or lack of understanding by politicians, of certain economic fundamentals. To tell sovereign debt investors they will be subordinated to supranational debt (i.e. European Financial Stability Facility), to threaten those they call speculators but provide liquidity to the market, will only take the pricing of future badly needed issuances to unsustainable levels, seriously jeopardizing any chance of survival.
In the meantime, in 2011, we think the UK will keep playing its Keynesian game of debasing real wages (i.e. inflation) and cutting fiscal spending, as long as investors allow it. The UK has an enviable sovereign debt maturity profile (i.e. long-term skewed), where the benefits of a small inflation surpass the political costs of frugality….for now…
We see China’s oligarchy further condemning the masses to coerced saving, by increasing the segmentation of its capital markets. Hong Kong will profit, while mainland Chinese labour will foot the bill, continuing to work at suppressed wages for the party to continue in the West. How do you segment capital markets? You disrupt the credit multiplier raising the reserve requirement ratios, forcing exporters to clear payments in Hong Kong, taxing capital inflows, raising the exit costs for foreign capital. All in the name of a pegged Yuan. Can this last another year? We think it can.
Finally, Emerging markets and the “other dollars” will walk the tight rope, as they try to keep their economies open and at the same time, seek to prevent the import of inflation from Helicopter Ben. This, as David Hume back in 1752 wrote, is futile. It’s a losing proposition. In the case of Canada, we would not be surprised if the Bank of Canada abuses its repurchase agreements or the if Canadian Home Mortgage Corp., on behalf of the export lobby, injects liquidity in the market by repurchasing mortgages. All this to keep the Canadian dollar from going beyond parity. It will be sad, but it will happen.
Now, to our second point. We have followed and continue to follow with utmost interest the political career of US Congressman Ron Paul. We sympathize with Mr. Paul’s cause for sound money, but he and his political life reminds us of Cicero in the face of Rome’s final days as a Republic. Mr. Paul may be remembered by historians of the United States, just as Cicero is remembered by historians of Rome. There is however a small but relevant difference between Cicero and Congressman Paul: Cicero took sides. Cicero, in the end, sided with Octavivs. Yes, Octavivs betrayed Cicero, but Cicero, also saw that neutrality was a sterile path.
Congressman Paul is not taking sides. Having been repeatedly asked lately what his plan is as the new chairman of the Financial Services Subcommittee on Domestic Monetary Policy, with Congressional oversight of the Federal Reserve, Mr. Paul replied that he would simply seek to allow gold or any other asset to compete as legal tender with the US dollar (in addition to audit the Fed, that is). We understand the noble intention behind this, but we can’t support it. We have no idea as to what the real chance is for this innocent proposition to be enacted. But we can say that this plan will only have the unintended consequence of creating unnecessary discredit to the Austrian economics tradition. Why? Because it is no plan! No, we are not advocating to plan monetary policy. That is also very un-Austrian. We are simply noting that to “end the Fed”, a plan is required.
A simple example (among many others that this short space doesn’t allow us to elaborate on) should help visualize our point. If gold has a chance as an alternative asset, in simultaneous competition with the US dollar, it will only be natural that we witness once more Gresham’s law at play. Gresham’s law, simply put, states that bad money displaces good money out of circulation. In a leveraged system like the one we live in, this means that market participants would arbitrage the system. They would simply borrow in US dollars and save in gold . To some degree, this is starting to slowly occur, but today the speed of this change is driven by the deterioration of the paper money, not by the quality of gold as legal tender. However, if gold was allowed to compete, this process would take place faster. This would quickly lead to the bankruptcy of the entire financial system, as we know it , for the cost of borrowing would increase exponentially, in real terms (i.e. in gold). But, if Mr. Paul does not end the Fed, as long as this institution survives, it will be forced to provide liquidity to the financial institutions, creating hyperinflation along the way.
What is the problem with hyperinflation? That those who still earned wages in paper money would see their income (and possibly their wealth too) destroyed. Please, note the following:
1.-Fiscal deficits, as long as the government does not bail out banks, would have NOTHING to do with this hyperinflation Mr. Paul’s plan would bring.
2.-The Fed would create hyperinflation by providing liquidity, not bailing out banks as in 2008, when it bought defaulted liabilities. In fact, as inflation spikes, it would be extraordinary to see defaults in paper money (i.e. bad loans), for the cost of paying off US denominated debts would decrease along with the higher rate of inflation
The only way to prevent hyperinflation would be to create fiscal surpluses and use them to buy gold to back the US dollar, for the Fed to be able to compete against gold-backed notes. Now, if you think the public and the financial lobby would allow monetary developments to get to this stage, you really are an optimistic in life. In the process, Mr. Paul and the rest of the Austrian movement would be blamed for creating inflation and making the poor poorer.
Given the impossibility to save the Fed, the next stage, which would see the Tea Party ousted from Congress for decades, would be to unwind the Fed. And the United States would have a multitude of unregulated banks issuing gold-backed notes, lending more than they have in deposit. It would only be a matter of time, until the next Ponzi scheme is uncovered and by then, given the absence of a lender of last resort, the public would seek to solve the problem with regulation. Someone would remind Americans of the good old times when there was a lender of last resort and the United States was the global power, and we would see central banking back in place.
We can’t let that happen, Mr. Paul. We need a plan to unwind the Fed without creating hyperinflation. The good news is that it is technically possible.
We want to thank everyone for accompanying us on our second year and wish you all a great 2011!
Published on December 17th 2010
Please, click here to read this article in pdf format: december-17-2010 This week we have been a bit confused with the market action. Although we believe that the recent increase in yields is due to higher output expectations, which drive a reallocation in portfolios out of fixed income and into equities (i.e. expected to provide [...]
Please, click here to read this article in pdf format: december-17-2010
This week we have been a bit confused with the market action. Although we believe that the recent increase in yields is due to higher output expectations, which drive a reallocation in portfolios out of fixed income and into equities (i.e. expected to provide higher returns adjusted for risk), we think that the recent price action has not been so clear to prove us right.
As the charts below show (source: Bloomberg, five last), the downward trend in the long-end (30-yr) is clear. However, that was not the case for the S&P500 in the past five trading sessions.
Gold and commodities also plunged this week (charts not shown). What is this telling us? Most have suggested this drop was caused by a stronger US dollar. Are we seeing the glass half empty here? The Euro, in spite of all the bad news out of Ireland and Spain (ratings outlook reviewed by Moody’s) has not moved below 1.32. The Canadian dollar, in spite of all the weakness in commodities, has only been trading around parity with the USD. Where is the USD strength, we ask?
On August 18th, we wrote the following:
“…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 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 choose to go to gold…“
The market action we have seen so far, sort of fits with the above prediction. Sort of, because stocks and the Euro have been trading within a range…Will this continue? Was this simply the effect of illiquidity close to Christmas? Was it profit taking?
We note that, if following the price action vs. the prediction above, we concluded that we are at the initial stages of a sovereign (i.e. US) and currency crisis, we would be using inductive reasoning…and we despise induction at “A View from the Trenches”. Therefore, we still stick to the portfolio reallocation theory, until we see evidence of stocks and oil falling out of their respective recent trading bands.
However, the US hasn’t even drafted a plan to seriously cut its fiscal deficit, while at the same time keeps doing everything possible to scare capital out of its borders. Latest data show a relevant outflow of foreign money from municipal and federal US debt (refer: Bank of America’s “Situation Room” report, December 15th, 2010).
In the meantime, as we pointed out on November 29th, Europe is taking slow but steady steps to consolidate its monetary union…
Published on December 14th 2010
Please, click here to read this article in pdf format:december-14-2010 We think a quick recap of the market action in the last days is warranted today. On November 29th, we made the point that the European Union was showing willingness, commitment to overcome their structural (i.e. institutional) weaknesses as well as fiscal imbalances. We added [...]
Please, click here to read this article in pdf format:december-14-2010
We think a quick recap of the market action in the last days is warranted today. On November 29th, we made the point that the European Union was showing willingness, commitment to overcome their structural (i.e. institutional) weaknesses as well as fiscal imbalances. We added that the US, in comparison, had done nothing to address its internal and escalating problems.
Later, on December 2nd, we pointed at some “signs” that were telling us a developing story: a Euribor-OIS spread that had not exploded even in the face of Ireland’s stress, strength in the price of oil, activity and prices picking up in the US. So far, the Euro has gained about 4 cents vs. the USD, since we wrote on November 29th, oil has risen another $10/bbl and a rally in risky assets, though not too strong, has unfolded, rising yields. This rise in yields moved us to discuss in our last letter, whether a stronger US dollar was conceivable. We didn’t think so…
However, given the latest increase in yields, as of last week, we have in our personal portfolio moved a bit away from commodities, in favour of US stocks. Do we think that the rally in commodities is overdone? No, we simply think that (and specially in the case of gold) the macro situation, which includes the unstable inflation picture out of China, points towards a bit of caution in owning gold, which may underperform relative to US stocks. However, as the fiscal view in the US deteriorates in 2011, we believe that the rise in yields that began post QE2 announcement will crystallize into a more clearer run against the sovereign and its currency. That will be the time when we will add to gold aggressively. But that time lies in the future.
Now, as we approach the end of the year, we expect activity to wind down. However, there are certain themes that will continue to gravitate, themes that like a drifting iceberg, look not so big at first sight, but hide a lot under the water. They will definitely be a source of volatility in 2011 and we must be ready to understand their implications. Today, we will single out a few, situated in different geographies, but all political in nature.
Starting with the US, we are concerned about the latest publicity Congressman Ron Paul is gaining on his recent appointment to chair the House Domestic Monetary Policy Subcommittee, overseeing the Fed. As we wrote before, Mr. Paul has not disclosed any alternative to the Fed and has so far only advocated freedom for gold to compete with the US dollar. All this rhetoric against fiat money will end up firing back, we fear, if the only celebrity politician the Austrian school has, does not profit from this unique opportunity to lay out a credible plan for “the way out”. Why would this be one of the themes of 2011? Because it will impact the degree of liberty the Fed will have, as 2011 progresses and the fiscal collapse of the US is exposed naked.
The counterparty to this US theme is the inflation theme in China. It is nothing else but “the other side of the same coin”. It is also political in nature, because something that could have naturally been resolved following a simple macroeconomics textbook is artificially prolonged by a political class seeking to keep a status quo based on a horrible savings rate coerced upon the Chinese working class. The volatility caused by this theme will continue to be expressed in the uncertainty regarding interest rates and credit supply disruptions (i.e. higher reserve requirements) in the Chinese market, affecting commodities.
Another 2011 theme will be the institutionalization of a proto federal structure within the European Union, supporting a unified debt market. We think the EU may end up surprising too many here in 2011. Will there be other runs against peripheral debt and banks? Of course, and it will be exactly those runs that will ensure, in our view, a cohesion to force the next step for the Union.
Lastly, in Canada, we have missed a great opportunity in the past two years to become a leading financial hub. We have also done nothing to ensure a stronger economic growth and everything to facilitate a future deleveraging crisis. The Bank of Canada is to blame here, with its irresponsible lax policy towards credit and currency. It is sad to read how Governor Carney yesterday warned Canadians of their high debt levels, which he himself misled them to take. It reminds us of that scene in the Devil’s Advocate, when Al Pacino, the Devil, tells us how God sets the rules in opposition:…”Look, but don’t touch! Touch, but don’t taste! Taste, but don’t swallow!”. Mr. Carney tells us the same: Have low rates, but don’t get into a lot of debt! If you get into debt, don’t use it to consume! But if you have to consume, do so with caution!…It would be funny, if it wasn’t sad…
Published on December 10th 2010
Please, click here to read this article in pdf format: december-10-2010 This wasn’t a good week for us. We began it in bed, sick, trying at the same time to figure out what was happening in the markets, caught in the midst of a sell-off in Treasuries and stronger US dollar. But, could we be [...]
Please, click here to read this article in pdf format: december-10-2010
This wasn’t a good week for us. We began it in bed, sick, trying at the same time to figure out what was happening in the markets, caught in the midst of a sell-off in Treasuries and stronger US dollar. But, could we be heading towards a stronger USD?
To begin, let’s say that the USD action was triggered by the possibility of seeing the Bush tax cuts extended. There are no details yet but some have ventured to quantify the cost of this by US$200-300bn in increased fiscal deficit in 2011 (refer: “New US fiscal plan rattles the bond market”, Bank of America’s Rates Research, December 8th, 2010) . Loyal to our Austrian school approach, we have no idea nor are interested in venturing what the actual cost will be either in absolute or relative (i.e. % of GDP) terms. As good Austrians, we don’t care about the determination of balances, but about coordination, speculation, also known as human action.
On that note, we understand that all else equal, there will be a higher need by the US government to access the capital markets to finance the revenue that could be collected, if the tax cuts are not extended. We will assume, to be in line with the market’s expectation, that the tax cuts will finally be extended.
Over the past days we have heard and read all sorts of comments on the implications of this. Vox populi dixit that this fiscal move will generate “growth” (Note to the readers: The word “growth” here is used with the meaning assigned by the masses, when they refer to consumption. But growth, indeed, is nothing else than higher productivity). Given this higher “growth”, the propensity by Helicopter Ben to print more money will decrease, on the margin, strengthening the US dollar. The other popular variation to this reasoning is that Helicopter Ben may not need to print less money but he may start rising rates earlier than what had been priced by the bond market. Hence, the sell off in the long end of the Treasuries’ curve that we witnessed this week (i.e. higher rates, lower prices).
In our view, this reasoning is flawed at best, and idiotic at worst. Not only that: We are angered to hear it coming from people that we know are smart enough not to believe in it. Why? Because it assumes that the US will continue to run a growing fiscal deficit undisturbed, without the need for the Fed to monetize the increased debt levels. Yes, we believe that lower tax rates generate higher fiscal revenue, but only when accompanied by other good policies. However, note that by extending the tax cuts there would be no lower tax rates. There would only be a continuation of the existing ones, in cohabitation with a growing fiscal deficit. If at current deficit levels Helicopter Ben had to pull out QE2…what do you think will be his reaction if the deficit increases? How can the US dollar be stronger then? Because Treasuries’ yields increase?
US yields no longer, in our view, reflect anything. They are being completely manipulated, curve wide, by the Fed. So, when Treasuries sell off, we don’t seek to explain them in terms of changes in expectations vis-à-vis future FOMC’s decisions. We are simple: If the market sells, all we care is that it disagrees with the Fed’s manipulation. If it buys, it agrees. We think we don’t need to look any further than that, given the obscene level of manipulation, which begins with the Fed’s purchases and ends with the absurd regulation called Basel III and its risk weightings scale, which assigns zero risk to sovereign debt.
To be fair, the only time we witnessed a stronger currency and a sovereign bond sell off was in 1995, in Argentina, at the time of the Tequila’s shock (i.e. the Mexican’s debt crisis). However, back then Argentina’s rates jumped under a convertibility system, which meant that the Argentine peso was 100% backed by FX reserves, being totally isolated from the fiscal side of the equation. The situation in the USA is hardly similar to that one. Those who bought the peso back then were wise to do so.
Lastly, a potential source of US dollar strength (or gold weakness) may be provided by the appointment of Congressman Ron Paul, to chair the House Domestic Monetary Policy Subcommittee, overseeing the Fed. We read yesterday’s Bloomberg’s report on a survey that found most American’s wanting to rein in or abolish the Fed. We wish Mr. Paul well on his new role and believe he fully deserves that place. But we also fear that his actions may end up being counterproductive. Mr. Paul or the Tea Party may wish to end the Fed, but they have no alternative plan, let alone clarity on how to unwind it. We will elaborate further on this in future letters.
Published on December 6th 2010
Please, click here to read this article in pdf format: december-6-2010 When last Friday gold jumped to $1,400s/oz post announcement of the employment data in the US, we were not surprised at all. What surprised us was the strength in oil and other commodities. Had we not seen it coming? Of course we did, for [...]
Please, click here to read this article in pdf format: december-6-2010
When last Friday gold jumped to $1,400s/oz post announcement of the employment data in the US, we were not surprised at all. What surprised us was the strength in oil and other commodities. Had we not seen it coming? Of course we did, for we have been forecasting stagflation since early 2009, as those who have followed us know. However, we stood in awe on the reaction. Late on Friday, we did some research to get a sense of what others’ thoughts were on this and we came across Peter Schiff’s comments on gold, in his “Schiff report”, suggesting that we are now, for the first time, perhaps witnessing the beginning of a bubble in gold…Why now? Mr. Schiff’s criteria lies in the performance between gold stocks and gold, and last week we saw a much stronger performance in gold stocks.
Last week ended therefore with a few expectations. From the European Union, markets expect either an increasing role from the ECB as lender of last resort and potentially a bigger bailout fund, as it is clear that the Union itself is being challenged. With respect to the ECB’s role in particular, it is obvious that liquidity programs and sovereign bond purchases must continue, either directly or indirectly, from banks. What the ECB is trying to keep is the sterilization of those purchases, but we think that sooner rather than later, that will not be possible. This is consistent with our fundamental change of opinion from November 24th, when we anticipated that the market had underestimated the EU’s intentions. The Euro shorts ended the week on tears…
In terms of a bigger bailout, well… that will depend on the negotiations among core Europe and the periphery. But the important thing here is that the option has been mentioned for the first time.
We repeat: we think we are witnessing the very transformation of the EU into a proto-federal institution. This would not be the first time something of the sort happens. Political unification is always taking place somewhere in the world, although not at the scale and degree of diversity that the EU confronts.
As an analogy, we offer the case of Argentina. When Spain under and after Napoleon’s rule could no longer hold its possessions in America, Argentina fragmented into a group of territories in complete anarchy. Some of these territories quickly became independent countries, like Bolivia, Uruguay and Paraguay. But the rest of them, which later would become provinces, actually forced Buenos Aires to join a Union, which first was known as the Provincias Unidas del Rio de la Plata and later, simply Argentina. Why do we bring this up today? Because we think it is interesting to see how different this case was from what we see in Europe today. It would seem that today, it is core Europe that is interested in sustaining the Union, rather than the periphery…Why? Because they seek to force their currency (i.e. credit) on them. If the Union used gold as currency, that is to say, if there was no central, monopolic paper currency, perhaps we would see in Europe the same dynamics that we saw in the territories of Argentina in the nineteenth century: The periphery, not the core, would seek the unification.
What does this all mean? It means simply that for the unification to further in Europe, the core will have to compromise on monetary policy, while the periphery will need to do the same with their fiscal policy. It also means a weaker Euro and a long-term bid on gold.
Having said this, we now turn to the US. On Friday too, we read a few articles and listened to media comments that speculated on the possibility that the Fed buy not just Treasuries (i.e. federal debt) but also state and municipal debt. We have no idea whether they will or not, but we can advance the following analysis, if they end up doing so.
We think that monetizing state or municipal debt would be counterproductive for the Fed, because the market would realize that the issuers all depend on the same purchaser, and the market would level down, following the proverbial path of least resistance. The reasoning would be this: Muni debt, just like Federal debt, depends on the Fed = Muni investors leave and those in the Treasury market trigger an arbitrage, whereby they seek higher yield for the same risk. Therefore, the yields in Treasuries and Munis would converge (i.e. higher Treasury yields), forcing the Fed to buy even more Treasuries (i.e. QE3). This would all create more inflation, hurting municipal and state revenue in the process, as the stagflation grows.