Please, click here to read this article in pdf format: march-15-2011

We are back from the 2011 Austrians Scholars Conference, at the Ludwig Von Mises Institute, in the USA, where we were exposed to an incredible diversity of people and ideas. We highly recommend!

During our time at the conference, two main, market driving events, took place. The first one, of course, was the earthquake in Japan. On this matter, all we can say is that in no way, besides the terrible human loss, this can be considered bullish. The reconstruction of the areas hit is only catastrophic and cannot be positively construed (here is another example of how Keynesianism taken to the extreme is nothing short of absurd). The strength seen in the Yen is driven by the repatriation of capital, required to assist with the reconstruction efforts. It remains to be seen how much weight this situation poses on global markets. It would seem that given the acknowledged danger posed by nuclear reactors, from now on, alternative energy sources will be demanded in higher quantity in Japan. But all this belongs to the sphere of long-term speculation. Right now, Japanese risk is selling off, as the damages are reassessed by the hour.

The second event takes us back to the European Union, where we have been placing our focus since late January. It was on January 28th that we wrote a letter titled: “Why the Euro could rise even higher (and gold fall even lower)”. The main thesis here was that if the European Financial Stability Facility, a special-purpose vehicle (“EFSF”) that issues Aaa/AAA debt guaranteed collectively by all the EU-zone members, was used to repurchase EU sovereign bonds in the secondary market, the Euro would strengthen considerably (at approx. $1.50 USD), within a win-win situation for the European Central Bank, the EU banks and sovereigns.

During the weekend, an agreement was reached at the summit of the European Monetary Union council, where we understand the EFSF has been allowed to increase to EUR440BN (from EUR260BN) and if used to purchase sovereign debt, under exceptional circumstances (from countries with ongoing adjustment programmes), the purchases will take place in the primary, not the secondary, market (i.e. directly from governments). In addition, Greece has been granted a maturity extension to 7.5 years and 100bps reduction in the interest the EU/IMF charges on its loans, in exchange for a commitment to accelerate privatizations to raise EUR50BN. We will not discuss the political background here, which is complex (i.e. Ireland, for instance, got nothing, apparently due to its resistance to increase its corporate tax rate still at 12.5%). But what we can say is that this is a missed opportunity and leaves little room to be fixed on the final meeting of the EU Council, on March 24-25.

Indeed, the use of the EFSF to directly finance liquidity needs does nothing to solve the institutional problem affecting the EU, which is the lack of a unified bond market. This approach finances flows (i.e. deficits), instead of stocks (i.e. secondary market bond inventory), and that is almost always a bad thing. When stocks are financed (i.e. the Fed’s MBS purchases, not QE2), a quantity known ex-ante to investors is dealt with. Investors know how much will be purchased, within a certain period, and can make a reasonable calculation of the impact it will have on the market and market constituents (i.e. EU banks). When flows are financed however, quantities are by nature only known ex-post, after the deficits are disclosed and expectations reassessed. This keeps uncertainty alive and uncertainty is expensive.

With reason, it seems this decision was against the ECB, as M. Trichet seems to have pushed to allow the EFSF to intervene in the secondary market. This was our position in January and the confirmation of the ECB’s alignment with it is to us understandable. If we thought that intervention was capable of strengthening the Euro to $1.50 USD, now we know it should not reach that level. If we thought that it would strengthen the capital of EU banks, now we know it should not. If thought it would establish a proto federalist base off which federal taxation would eventually be born, now we know it should not. Most importantly, if we thought it would weaken gold, now we know it should not!

The result of this agreement will only be an agonizing wait until unavoidable sovereign defaults must be again confronted. In the meantime, in our view, this context should be bearish of stocks, neutral-to-bullish of gold, bearish of sovereign risk and neutral-to-bullish of corporate credit.

Martin Sibileau