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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…

Martin Sibileau