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.

Martin Sibileau