Archive of January, 2011
Published on January 28th 2011
Please, click here to read this article in pdf format: january-28-2011 We were as surprised as many others when the lows of $1325/oz were taken yesterday and gold made it all the way down to $1,310/oz, after the previous post-FOMC rally. We were the more surprised to see this drop without major movements in rates [...]
Please, click here to read this article in pdf format: january-28-2011
We were as surprised as many others when the lows of $1325/oz were taken yesterday and gold made it all the way down to $1,310/oz, after the previous post-FOMC rally. We were the more surprised to see this drop without major movements in rates or anything else that would have explained the “testing” of the gold-as-reserve-currency thesis.
So…what was that? We began our last letter saying that “…we think that the lower commodity prices we are testing this week are driven by the developments in Europe…”. We will try to explain ourselves better this time. Since last year, but specifically since early January of 2011, politicians and central bankers in the European Union have been hinting at the possibility of using the funds raised by the European Financial Stability Facility to repurchase outstanding sovereign debt of peripheral EU governments, rather than to finance such governments’ deficits.
Today, we want to examine what this repurchase transaction means in terms of macroeconomic variables, but we anticipate the following: A higher Euro, possibly a lower price of gold and a higher valuation in Euro bank stocks. There are many risks to this view, but we believe that the mere possibility of this transaction can move markets. In fact, we think that the late weakness in gold, strength in Euro and Euro bank stocks is driven by this speculation. Let’s see why:
In the figure below, we show the aggregate balance sheet of EU peripheral governments (“EU Sovs”), the European Central Bank (“ECB”), Euro-zone banks (“EU Banks”) and the European Financial Stability Facility, a special-purpose vehicle (“EFSF”) that issues Aaa/AAA debt guaranteed collectively by all the EU-zone members:
In step 1 above, the EFSF issues EFSF bonds, at a yield lower than that at which the EU sovs would be able to. The EFSF increases its liabilities in exchange of Euros, provided by the EU Banks. The EU Banks keep the EFSF bonds as assets. In step 2, the EFSF uses the Euros to purchase Sov Bonds held as assets by the EU banks. In the end, as shown on step 3, the EFSF holds Sov bonds as assets, matched by EFSF Bonds. The EU Banks effectively exchanged Sov Bonds for EFSF bonds, of higher rating, at no cost. They keep the same amount of Euros they had before the exercise. Therefore, the EU Banks have had a capital gain. Do we think that this is what has been driving the outperformance of Euro bank stocks lately? Interestingly enough, the MSCI Europe Financials Sector Index Fund (ticker: EUFN) has risen on significant volume since January 10th, when the possibility of carrying out sov debt purchases with the EFSF began to be taken seriously. Below, we show the corresponding chart (source: Bloomberg):
Was this a coincidence on the back of “good earnings”? How would EU leaders, who take pleasure in blaming greedy bankers for this crisis, explain this transfer of wealth, from the EU taxpayers to the EU Banks shareholders?
But this is not all. As the EFSF buys this outstanding debt, if the purchases surpass the 2011 net issuance of EU sovs, the supply of EU sov bonds falls, and their price rises. This is a virtuous cycle through which EU sovs are able to raise funds at lower yields, the debt remaining in the asset side of the EU banks’ balance sheets appreciates and the EFSF vehicle produces a capital gain (the value of the assets, EU sov bonds increases, while their liabilities remain unchanged):
Now, as you can see from steps 1 to 3 above, until here, the European Central Bank has not been involved, which means that their options are open….Open to what?, you may ask…
As we explained on May 13th of 2010, since the European Central Bank got itself fully involved in the bailout of peripherals, it has been buying and holding EU sov bonds (EUR77BN at Jan 26th) and sterilizing these purchases via the so-called Securities Market Program.
Now, the virtuous cycle by which EU sov bonds rise in value also affects the balance sheet of the ECB, producing a capital gain. As the supply of EU sov bonds in circulation decreases with the EFSF purchases, the ECB can, but may choose not to, sell back the EU sov bonds it had bought to the banks, returning their supply to the previous “equilibrium” amount:
As we show in step 4 below, if the ECB did sell the EU sov bonds it holds, the respective amount of Euros raised by the sale would be taken out of circulation (i.e. there would be a decrease in the liabilities of the ECB):
Why would the ECB want to sell back to the market the sovereign debt it bought? Simply put, to fight upcoming inflation. If they could “pull this one”, they would be simultaneously avoiding the default of EU peripheral debt, decreasing the yields the EU zone pays, strengthening their financial system and stabilizing prices.
Now, if this scenario took place and the Euro strengthened, on the margin, the demand for gold as an alternative reserve asset would necessarily have to fall. Have we not exactly seen a drop in gold with the strengthening of the Euro, also since January 10th? The chart below (source: Bloomberg, Euro shown in orange, gold in white) shows our point. It also shows how in the summer of 2010 too, when the ECB proved the solvency of the EU financial system, gold suffered a major correction. This would explain why gold in January has been falling without major increases in yields:
How sure are we that the scenario we just described can take place? We are not, but we are inclined to believe that it may happen. It has its costs though, for as the Euro strengthens, the competitiveness of the Euro zone falls in the short-term, affecting employment both in core Europe, which will have to pay the bill, and in peripheral Europe, where cost cutting will have to continue, to rein fiscal deficits. Remember that this is only provisory, for as step 5 shows below, in the end, the Euro banks end up holding both EU sov bonds and EFSF bonds. If the risk of these is seen to increase as the Euro strengthens, the ECB will be under a lot of political pressure.
Are we too late to trade this thesis? We don’t think so, because investors in EU bank bonds still see a relevant political risk in the conversion of senior debt to contingent capital. This explains why credit spreads in EU financials have only tightened little, underperforming stocks. But once clarity is gained on this issue and on a positive note, the trade (long Euro, long EU banks stocks/credit, short gold) could find another leg upwards.
Published on January 26th 2011
Please, click here to read this article in pdf format: january-26-2011 This is a week during which the global markets’ tectonic plates are shifting, and the shift is not too quiet. Our letter today will sound more like a monologue rather than a well laid-out explanation of what we think is occurring. The reason is [...]
Please, click here to read this article in pdf format: january-26-2011
This is a week during which the global markets’ tectonic plates are shifting, and the shift is not too quiet. Our letter today will sound more like a monologue rather than a well laid-out explanation of what we think is occurring. The reason is simple: We are uncertain. We can however throw a few suggestions to understand the recent and potentially future action.
To begin, we think that the lower commodity prices we are testing this week are driven by the developments in Europe, rather than in the USA or China. Here, we see ourselves far from the common view that blames profit-taking or the possibility of higher rates in China for the drop in prices. We were one of the first to suggest, back in November 24th and 29th that the European Union’s efforts were being underestimated, while the US slept on the cushion provided by the new deficit monetization program of $600BN. Precisely yesterday, two months later, an event of historical proportions took place: The first truly “European” bond issuance was born under the European Financial Stability Facility (EFSF). Take a look (you may also save the image. Perhaps one day it will be of historical interest. Source: Bloomberg):
Here are a few comments: With this 5-yr EUR5BN bond at a 2.75% coupon, sovereign EU peripheral credit default swaps traded wider, and we understand that investors have shifted away from EU sovereign risk to EU corporate. We also understand that regardless of this reaction, and even in light of the horrible GDP release in the UK, more than EUR45BN were chasing this auction, with approximately 38% of the demand coming from Asia. Coincidentally yesterday, the US Treasury was scheduled to auction $35bn in 5s. The bid-cover ratio for US treasuries had been declining, with foreign investor allocation falling from 36% in the Sep/10 to 15% in December. But with the positive expectations set on fiscal policy (i.e. State of the Union speech), the was awarded at 0.650%, with no surprises.
Now, as a friend wrote to us today, it is clear that the Fed is not buying Treasuries to keep rates low long enough to sustain a recovery in the US private sector. That recovery is already taking place in spite of the Fed. The Fed is simply financing the US fiscal deficit. Yesterday’s EFSF issuance was guaranteed on a pro-rata basis by the EU members, but the demand came from the private sector and if the European Central Bank buys sovereign debt, it sterilizes it. In other words, in Europe, after a year, we are faced with a central bank subsidizing the financial sector with liquidity lines. But governments are slowly cutting spending and have proved that they have access to the markets. The problem with the EU, as we pointed out, was institutional. Yesterday’s issuance was an “institutional” innovation may allow Greece, whose debt is rated as junk, to avoid default. The missing piece for the EU now is to prove investors that during this year, EU periphery banks will be able to survive without liquidity lines. If they do so, the EUR should trade towards $1.50, all else equal, in our view.
If the Euro strengthens, that void that had been filled by gold as a reserve of value, will shrink. As the Euro strengthens too, relative prices within the EU will have to adjust, slowing activity temporarily, for core Europe will be saving for the periphery. That, all else equal, should temporarily affect the bull run in commodities. But if we are correct, how can we explain gold falling in value in USD terms? We can see it happening in Euros, but why does it also happen in USD?
When we say “all else equal”, we assume a state of affairs where China survives another year without addressing its imbalances, that the US shows (although painfully) to the world that it is serious about its fiscal deficit and that the municipal debt space is not challenged.
Published on January 21st 2011
Please, click here to read this article in pdf format:january-21-20111 We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key [...]
Please, click here to read this article in pdf format:january-21-20111
We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key assumptions for 2011 that we presented in our last letter are weak at best…Well….think again.
Has anything happened this week that may challenge the assumption of further consolidation in Europe? No. In fact, we have heard and read many times about Spain’s resolution to inject more capital to its savings banks (i.e. “cajas”) and Ireland may end up paying a lower interest rate on the bailout fund. In the US, the weekly jobless claims data showed that at least, they did not increase. Anecdotally also, the S&P National AMT-Free Municipal Bond Index has withstood the sell-off in risk. Existing home sales data also surprised with a stronger than expected rise. The Philly Fed manufacturing survey remained strong, and leading economic also provided positive news. However too, a weak TIPS auction shadowed the UST market.
Ah, but of course, it seems that the main concern comes from China. Apparently, given the last release of activity data, China is growing even in the face of incipient inflation (officially gauged at around 5%) and investors fear that an interest rate increase is on the works…Who spread this rumor? Why was it spread coincidentally with China’s Jintao visit to the US? We have no idea. Has China not been increasing interest rates unsuccessfully? Yes, they have. Has China not just manipulated the cost of capital (i.e. rates) but also its quantity via increases in the reserve ratio requirements (RRR)? Yes, they have.
Any basic textbook of macroeconomics will teach us that when a country decides to fix the value of its currency, it loses control over interest rates. At least the “real” interest rates…The same applies to credit controls. History shows they have always, always failed. Why would China ignore these facts? Because they have nothing to lose with trying. Because they seek to delay the inevitable. However, today we want to show that these manipulations can actually have the opposite effect, if they are abused. For instance, let’s take their policy of increasing RRR to the extreme. Below, we show the balance sheets of the People’s Bank of China (PBOC) and the Yuan banking system, in a very stylized way. On the asset side of the PBOC’s balance sheet, we find mostly US Treasuries backing the Yuan. On the liabilities’ side, banks’ reserves. On the asset side of the banks’ balance sheet, we find reserves and interest-bearing assets (loans). On the liabilities’ side, deposits and their net worth.
We have divided the process of taking the reserves requirement ratio to 100%, in three stages. In the second one we can see that as loans mature, their net issuance decreases, to boost reserves. We assume here that the process is neutral: Higher funding costs have no effect on defaults and the banks’ aggregate net worth does not need to change. The overall impact is simply a change in the composition of the banks’ asset side of their balance sheet.
As aggregate leverage decreases to the extreme, as we can see in stage 3, the PBOC is simply left with US sovereign debt fully backing reserves. Effectively, all deposits have been invested in these securities. The financial savings of the Chinese people have been coercively “loaned” to the US sovereign. With this extreme example, you start to realize the folly of this monetary policy.
Implicitly, once leverage is taken out of the picture, the PBOC is irrelevant. Legally, it continues to serve as a lender of last resort, but China is left entirely at the mercy of the US Treasury. As the US approaches default, the value of its debt will collapse…and so will the value of the deposits of Chinese citizens! The irony here is that a run against China’s financial system would not be triggered by an internal development. Nevertheless, if the PBOC had to bail out a financial institution in this context (by extending loans and/or decreasing reserve requirements), the increase in money supply would be felt much more than if there was leverage. For on the margin, the new quantity of Yuan being printed by the PBOC would truly stand out.
Therefore, the Yuan would depreciate and it would do so at the worst time, exactly when the world would need a strong reserve currency. The contagion from the US to the rest of the world would be widespread and more violently than necessary.
How would the rest of the world sort this out? Gold would have to fill the void, which is why the recent weakness represents an opportunity to us.
Published on January 17th 2011
Please, click here to read this article in pdf format: january-17-2011 After almost a month, the most part of which we spent traveling in Argentina, we resume our publication with the first letter of 2011. A few weeks into the year and we don’t see but the continuation of themes we singled out at the [...]
Please, click here to read this article in pdf format: january-17-2011
After almost a month, the most part of which we spent traveling in Argentina, we resume our publication with the first letter of 2011. A few weeks into the year and we don’t see but the continuation of themes we singled out at the end of 2010.
More than a month ago, on December 14th, we wrote that: “…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…”. In hindsight, we were right to shift away from gold into US stocks (long 2x Nasdaq, more specifically) and in early January, we decided to further reduce our position in gold (do less of that which doesn’t work, to do more of that which does!).
To the risk of sounding like a broken record, we will repeat the 2010 themes that we think will further develop this year:
-Further consolidation of the European Union:
In 2010, we were the first to openly say that the EU’s problem was of an institutional nature (see: “An institutional perspective on the Euro”, February 10th, 2010). While everyone discussed Greece’s weakness in terms of solvency, we challenged the mainstream view with our perspective. Nowadays, everyone on the street is discussing the federalization of Europe.
On this point too, on November 24th, we changed our view. Until then, we had thought that Germany’s leadership would not be able to stand fully behind the EU. But on the 23rd, we had happened to read a Bloomberg report that had taken Ms. Merkel out of context. Ms. Merkel had been reported saying that the situation (i.e. of EU) was “extraordinarily serious” and the market began to sell the Euro, in full herd-like behaviour. As we happen to speak German and were surprised by the herd reaction, we went to the source (video link below) and concluded that for an unknown reason, Ms. Merkel’s speech had been fully misinterpreted. That was when we changed our view on the Euro, from bearish to neutral, for it became clear to us then, that Germany would move the EU in full force away from dissolution towards a proto-federal framework. We offer here again the speech (summarized) that changed our view: Click here
Where does this leave us? The European Central Bank has been buying and will continue to buy sovereign debt. But unlike the Fed, the ECB has not yet monetized it. Until now, that debt has been sterilized by issuing ECB debt, driving Euro liquidity rates higher than USD ones, thereby contributing to put a floor to the Euro (for an explanation of this process, see our letter of May 13th and December 2nd ) . In other words, the ECB still has a lot of firepower to save the monetary union and although they are now showing themselves as anti-inflationary, a good sell-off of sovereign or Euro-bank debt will change their minds quickly. In the meantime, the clock will be ticking for the Fed, which brings us to our next point:
-Further deterioration of US risk:
It is now very clear that after the extension of tax cuts in December, the US has not done anything yet to address its fiscal situation (see: “Europe is proving it…what about the US?”, November 29th, 2010). The tipping point on this issue, we think will prove to be a wave of failed auctions in municipal/state debt. This is beginning to show its ugly head, as we saw last week with the debt auction of the Port Authority of New York and New Jersey. Everybody in Wall Street will tell you this is not a serious problem. Everybody will downplay it. We understand why. What we have trouble understanding is how the only ETF we know to short municipal debt is actually “down”, in the last month!!! (ticker: NYSE:SMB) If any reader understands it, please, we welcome your feedback.
Now, as we wrote on December 6th: “…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…”
This outlook make us think gold is still to make higher highs in 2011 in spite of the temporary pullback we’re seeing now. Would this be consistent with higher stock prices? Yes, as long as a true sovereign crisis does not unfold. Such crisis is not our base case.
-Further price controls in China:
We think that China will continue to sustain its peg to the USD by enforcing even stricter price/quantity controls. This is a key assumption, for it means that the US Treasury market, particularly if the US shows at least a weak recovery, will keep a buyer. Will reserve requirements keep increasing? They will. Will credit controls pop out of nowhere? They will. Will the Chinese people seek to invest in gold or any other asset that serves them as an escape valve? They will. Please, note that we do not say this situation is sustainable. We just say it can remain another year without being solved.
What does this all mean?
If the three key assumptions play out, in 2011 we should see high volatility but higher stock prices worldwide, the Euro not making lower lows (i.e. not falling below 1.18USD), higher commodity prices and higher CAD/AUD/NZD dollars, higher interest rates, slow growth and steady unemployment.