Archive of May, 2011
Published on May 30th 2011
Please, click here to read this article in pdf format:may-30-2011 At the beginning of May, we thought we were facing a textbook run for liquidity triggered fundamentally by the sovereign crisis in the European Union and the higher than expected unemployment rate in the US (besides low activity and housing data). Technically, of course, the [...]
Please, click here to read this article in pdf format:may-30-2011
At the beginning of May, we thought we were facing a textbook run for liquidity triggered fundamentally by the sovereign crisis in the European Union and the higher than expected unemployment rate in the US (besides low activity and housing data). Technically, of course, the run started with M. Trichet’s dovish announcement on EU rates, combined with an oversold position in the US dollar.
In the past two weeks however, since our last letter, we notice that that run for liquidity has not materialized yet. The fundamentals described above have not only been confirmed, but also proved to be worse than most of us thought. Is there anything wrong with this picture? Not if you think that easy monetary conditions will remain untouched, unlike what many analysts believe.
In our past letter, we wrote that it was not unthinkable to see US sovereign debt being monetized while the Fed at the same time raises rates. The trick, we wrote, would be done like most nations who are in trouble do: Infecting their financial system with sovereign risk. The push by new regulations (see our last letter) to hold Treasuries as collateral is one way.
Ironically, the world may now see certainty in the collapse of sovereign debt from peripheral countries in the EU and uncertainty around the future of US risk. This, added to the general rise in interest rates by emerging markets (= repudiation of QE2), might trigger another round of weakness for the US dollar. That would be evidenced by the sudden strength of gold, now in USD terms. If this thesis is correct, our thought of May 9th, should still be valid: We must see further deleveraging, before any serious inflationary threat becomes a reality. This means to us that volatility should not decrease.
Personally, in volatile times, we search for classics. We seek in the pages of economic history the clues that will make that volatility look like what it is: Only one more period in a bigger chart. We think we have found that in Jesús Huerta de Soto’s “Money, Bank, Credit and Economic Cycles”, 2nd edition, 2009. Huerta de Soto starts this opus magnus with a legal, moral and historical review of the fractional reserve system. In chapter II, there’s a section titled “ Banking in Greece and Rome”, where we learn that the same concerns we have today on risk management by banks were documented no less than twenty four centuries ago; that back then bank debt holders were as uncertain about their privileges as Euro senior financial bondholders are today and that just like governments today, Ptolemaic Egypt, in Alexandria, sought to control banking to the point where the crowding out was total, through government-owned institutions. In light of all this, how could we now be surprised when Basel III is indefinitely postponed or evaded? How can we doubt that the end game here is global monetization of sovereign liabilities? Indeed, we cannot.
Published on May 16th 2011
Please, click here to read this article in pdf format: may-16-2011 A week later, the sell off in commodities has continued, due to the global deleveraging that is taking place. It has been so serious that the media everywhere is almost calling the commodity rally dead. All sorts of explanations, most of superstitious nature, are [...]
Please, click here to read this article in pdf format: may-16-2011
A week later, the sell off in commodities has continued, due to the global deleveraging that is taking place. It has been so serious that the media everywhere is almost calling the commodity rally dead. All sorts of explanations, most of superstitious nature, are given. We have even read an analyst suggest that in general, all rallies last about 115 to 130 months…therefore, the rally in gold is finished!
Last week we noted that: “…In this context, it may no longer be wise to trade long risk (i.e. commodities, stocks), but on a hedged basis (i.e. short Euro), to address the many deleveraging bouts that we will experience…” Below, we show the long gold/short euro trade, expressed in US dollars, via two ETFs (DGP: 2x long gold and EUO: 2x short Euro), which yielded a 1.83% return for the week (= [3.35% + 0.31%] / 2) , way better (more profitable and less volatile) than to be long gold in US dollars.
Should this performance of commodities, in currencies other than the US dollar, signal that the rally is not dead? Does it indeed have legs? Whenever we ask this ourselves, we answer with another question: “What makes you think interest rates will rise?”
On this point, we like Peter Schiff’s view (watch: http://youtu.be/4bZglexQk4o ). Peter says that the Fed will not raise rates because it will make it very expensive for the US Treasury to service its debt. He also thinks that QE2 was not to “support” growth, but to finance the US Treasury. Although this makes sense to us, we fear that it may not necessarily hold true.
We think the Fed could find ways to raise the policy rate, without impacting the US Treasury debt servicing capability. At least in the short term, and we at least, live in the short term. This perspective is consistent with what the European Central Bank has done, under the so called “separation principle”. The ECB has raised rates and at the same time, it has considerably deteriorated the quality of its assets, extending liquidity lines to weak financial institutions and indirectly, to peripheral governments. This has of course weighted on the Euro, but it has so far worked. Can it work forever? No, it cannot. But it serves as an example.
On this line, we learned from a note by the Bank of America, that proposed margining rules under the derivatives reform provisions of the Dodd-Frank act may be passed requiring financial institutions in the US to raise collateral on their derivatives positions in the form of US Treasuries (refer: “Dodd-Frank Collateral Rules Implements QE3”, Credit Derivatives Strategist, May 11th, 2011) . If passed, Bank of America estimates this could coerce the purchase of sums comparable to those of QE2, effectively establishing another wave of government debt monetization. The important thing here is that this could take place in 2012 simultaneously with an increase in interest rates, without impairing the US Treasury. The overall effect would be a formidable crowding out of the private sector from the debt market. Gold bugs be warned!
Published on May 9th 2011
Please, click here to read this article in pdf format: may-9-2011 About two months ago, at the Austrian Scholars Conference of the Ludwig Von Mises Institute, a few asked us what it was like to live under hyperinflation, when they learned of our Argentine background. We responded that it was not so bad, because hyperinflation [...]
Please, click here to read this article in pdf format: may-9-2011
About two months ago, at the Austrian Scholars Conference of the Ludwig Von Mises Institute, a few asked us what it was like to live under hyperinflation, when they learned of our Argentine background. We responded that it was not so bad, because hyperinflation is really the last stage of a currency crisis. At that point, the depreciation of the currency, the repudiation of the currency goes parabolic and “money dies”. It can last only a few weeks, months, until looting, social unrest takes over, the government collapses and you have a new government and a new currency, backed by something different than government liabilities. We really prefer that scenario to decades of light inflation.
However, given our age, we were only able to witness the inflationary processes of the ‘80s. We missed all the “preparation”, all the mise-en-scène of the ‘70s in Argentina. What do we mean? Hyperinflations can only take place after credit collapses. Not before. That is what happened in Argentina during the ‘70s, which allowed the acceleration of the ‘80s.
Why must credit first collapse? Because to reach hyperinflation, which is the ultimate repudiation of a currency, deleveraging must have run its course. Not by debt repayment, but by the massive devaluation of debts, taking all credit “supply” (not demand) off the table. When that process is done, it is only natural (in the absence of a banking system in local currency) to get to the next stage, whereby the currency is destroyed. Having said this, we can now turn to our point today.
The world certainly does not face hyperinflation yet which implies that if our view is correct, the pain will continue. Pain takes the form of deleveraging, like the one we witnessed last week in the commodities space. This deleveraging is counterintuitive, because as systemic risk increases as it did last week (first with the transmission of the sell off in silver to all the commodities space and second with the dovish stand by the European Central Bank), risk trades are unwound and capital must find its way back to its funding currencies: the US dollar and the Yen. Yet, it is these two currencies which clearly stand out as the most likely candidates to face hyperinflation in the future…How close is that future?
The answer to this question depends again on how much longer credit can remain alive. Unfortunately for our taste, we think credit could remain in ample supply for a lot longer than most think. The real catalyst to start its shrinkage will be a wave of defaults.
In the US, these defaults would have to come from the private sector, because the Fed will continue buying government debt. However, the maturity wall of the private sector is at least two years ahead of us. In Japan, this is a non-starter, given the ample level of domestic savings. In China, where markets are totally controlled by the government, this defaults also unlikely to be triggered and if they were, the People’s Bank of China, in our view, would be in a position to deal with them, particularly given the current high level of reserve requirements. In other emerging markets, deleveraging in their local currencies would not begin until deleveraging in US dollars begins. Therefore, where else can we see a threat of defaults?
The obvious answer is in the European Union. Perhaps, this is what was behind the second sell-off of the Euro that took place on Friday, when Der Spiegel first published a note online, suggesting that Greece’s exit from the Union would be discussed at a secret meeting during this weekend. The Euro fell to the high 1.43s from 1.45 on this, dragging all the commodities complex along. Defaults within the European Union are most likely than elsewhere, because they can either be triggered by sovereigns or by the private sector which is being asphyxiated by both the European Central Bank and the sovereigns.
In this context, it may no longer be wise to trade long risk (i.e. commodities, stocks), but on a hedged basis (i.e. short Euro), to address the many deleveraging bouts that we will experience, until credit is off the table and the doors are open to hyperinflation. From this, it should be clear that we do not share the view that last week’s sell-off in commodities was of a technical nature, namely that the USD had been oversold, but of a more fundamental one.
Published on May 2nd 2011
Please, click here to read this article in pdf format: may-2-2011 Today we could discuss the most important developments that have unfolded since we last wrote on April 18th. We could discuss the rationale of Greece’s debt restructuring, the monetary policy of the ECB going forward, the slow acknowledgement that Spain will not be spared, [...]
Please, click here to read this article in pdf format: may-2-2011
Today we could discuss the most important developments that have unfolded since we last wrote on April 18th. We could discuss the rationale of Greece’s debt restructuring, the monetary policy of the ECB going forward, the slow acknowledgement that Spain will not be spared, the weakness of the USD or its counterparty, the unstoppable rise of gold. Our readers know that we warned about some of these issues (Spain, gold, stagflation) with fortunate timing and our thoughts on why the Euro has risen or why we are facing stagflation (i.e. jobless claims have suddenly began to stabilize and rise, GDP change has not met expectations) are on record for anyone to see. This morning however, we want to dig deeper. We don’t want to discuss things you may already know, but want to suggest why mainstream economists, like Ben Bernanke, continue to believe (unlike us) that this crisis can be fixed. We think (unlike them) this crisis ends in a currency crisis of a magnitude never seen before, with a transfer wealth of unthinkable proportions.
When Ben Bernanke gave his press conference last Wednesday, he labeled the increase in commodity prices of a temporary nature and dismissed his responsibility in the depreciation of the USD. The Chairman of the Fed reiterated the Fed’s mandate, as a natural way to shield himself from unwelcome questions. This mandate is dual, seeking to maximize employment, providing price stability. There is a popular perspective of this dual mandate, which is expressed in what is known as Taylor rule. The rule seeks to find an approximation to the changes in policy rate, driven by the rate of inflation and the level of activity (i.e. the other side of the unemployment coin) in a currency zone. The equation is written:
Or: Target short term nominal interest rate = Rate of inflation + equilibrium real interest rate + coeff a * (gap between current rate of inflation and target rate of inflation) + coeff. b* (gap between current GDP and potential GDP).
As you can see, mainstream economists (including Mr. Bernanke) believe that there exists: (1) a “target” rate of inflation, (2) an equilibrium real interest rate, and (3) a potential GDP.
However, none of these three concepts exists. They are only the mental tools of economic planning. When you think that there is a “target” rate of inflation, you assume that you can control the inflationary process and furthermore, it shows that you don’t understand what inflation is. Why? Because inflation is nothing else than the non-neutrality of money expansion at work. Not all prices rise or fall at the same time. It is relative prices that changed, with QE1 or QE2. To believe that one can target a rate of inflation is to believe that one can manipulate this non-neutrality of money. This is false and absurd. Ignoring this point explains why Bernanke believes that the price in commodities is of a temporary nature. In his mind, inflation can be targeted.
The next misleading concept is that of the existence of an equilibrium rate of interest. We believe this is self-explanatory, for there isn’t a single rate of interest, let alone equilibrium. If there was one, there would be no need for money as a medium of indirect exchange. This point was thoroughly addressed by Don Patinkin (ref. “The Indeterminacy of Absolute Prices in Classical Economic Theory”, 1949, Econometrica)
The last error lies in believing that there is a known potential GDP. This is a mechanic, Marxist, view of human action. It ignores the role of relative prices. Does anyone believe that a firm will hold inventory or work below capacity at a loss, just out of stubbornness? When a firm decides to lower output, or the use of resources, that decision is rationally driven, to remain profitable. The relative prices between inputs (and only one of which is capital) and output tells the entrepreneur that the apparently under-potential output is the profitable choice at hand. A potential higher output represents a potential loss.
In summary, the dual mandate of the Fed assumes the correctness of the price level doctrine. But in fact the whole mode of reasoning behind the Taylor rule is a typical case of arguing in circle. Its equation already involves the assumption which it tries to prove. It is essentially nothing but a mathematical expression of the untenable belief that there is proportionality in the movements of prices, unemployment and interest rates.