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.

Martin Sibileau