Please, click here to read this article in pdf format:december-22-2011

In the absence of further meaningful events, this will probably be our last letter of the year. Reflecting on our main macro thesis, things have played out the way we thought they would. Not from the beginning of 2011, but from the beginning of 2010. That’s right, already back in 2010 (refer for instance our letter from May 3^rd 2010: www.sibileau.com/martin/2010/05/03 ) we envisaged a scenario exactly like the one we’re facing today. Back then we wrote:

“….It has become clear and public that European sovereign debt is being and will continue to be bought by European banks backed by the ECB, making the sovereign risk contagion back to the financial system a done deal. Therefore, how safe are those who bought sovereign credit default swaps (“cds”) from banks that are now exposed by the sovereigns?…We have mentioned this ignored side of sovereign cds in previous letters (for instance, refer: www.sibileau.com/martin/2010/03/01 ). How this issue is not discussed while every regulator in the world is still looking for ways to reduce systemic risk is beyond our understanding.

If sovereign jump-to-default risk increased, the ECB would most likely monetize sovereign debt (actually, the ECB is already doing it), further devaluing the Euro. But as long as no sovereign defaults, things will be under control. However, if a Eurozone sovereign ended in a credit event triggering the cds contract…How bad would the run for liquidity to the USD be? CDS contracts on European sovereigns trade in USD.

How much would counterparty risk (=risk between the banks that traded the cds) jump? Is the size of outstanding sovereign debt and that of the cds net notial useful to assess the impact? We think not and we guess that anyone downplaying this issue based on the size of Greece’s cds net notional outstanding doesn’t understand the leveraged nature of capital markets. Are Greece’s funding needs in 2010 not minimal compared to the impact they are causing?

The next question is whether gold would rally or fall. To answer it, we have to speculate on whether the Fed would or not extend currency swaps to the ECB to avoid the collapse of the Euro. The Fed did so in Sep/Oct-08, upon the Lehman event, and we believe the Fed would so again, which brings us to the another point… What is riskier?:

a) To have the Fed extend currency swaps to the ECB to provide liquidity to the financial system for clearing purposes (as in post-Lehman) or…..

b) to have the Fed extend currency swaps to the ECB, as a ultimate back-up on liquidity on sovereign debt?

In the first scenario, should gold not sell? (It did). In the second, should gold not rally, as a sovereign default causes the collapse of the Euro (our base case assumption here)? Would American taxpayers ever get their monies back if the Fed extended those swaps to the ECB under the second scenario?…”

What we did not anticipate is that it was possible to start in scenario (a) above, and as we think will occur during 2012, transition to scenario (b). It may now be possible that these scenarios be not mutually exclusive, as we imagined then 19 months ago, but linked with one preceding the other.

Recapping the year, we should say we had a bit of cautious optimism, back in January, when we thought there would be agreement to use the EFSF to purchase sovereign debt in the secondary market. In perspective, we realize that the refusal to go this path by Germany in March, marked the death sentence of the Euro as we know it.

The debt ceiling negotiations in the US, including its sovereign risk downgrade by S&P, and the latest drop in reserve requirements in China are symbolic of what we will see in 2012.

The view from the rest of the world is also murky. In 2011, we witnessed the fall of dictatorships in the Arab world, without any clarity on what will follow. The same applies to North Korea. South America is divided into a right-leaning block (Chile, Perú, Colombia) and a left-leaning one (Venezuela, Ecuador, Bolivia, Argentina), with Brazil still trying to figure out which way it will go. We believe it will go left. It’s the path of least resistance.

Overall, there has been disintegration in global trade, with the irony of a convergence in risk, between the developed and the emerging world. The first are being downgraded, while the second have been upgraded.

What next?

We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy. In Europe, that may mean not just the fall of the Euro but also of the European Union. In the US, the rise of Ron Paul and if not him, his ideas, may create a serious schism in the Republican Party, in favour of Obama’s re-election. In China, the rebellion should proceed at a slower pace, but steady nonetheless, as prices increase.

Back to a shorter term view, as the reader is already aware, yesterday the long term (3 year) refinancing operation resulted in almost Eur489 billion being borrowed by 523 banks. A lot has been said and written. All we want to add here today is this: We must keep in mind that all this does is to prevent the further sale of assets (sovereign) by Euro banks. Nothing else. If sovereign ratings are further downgraded, the respective losses will still have an impact. If fiscal deficits persist in the Eurozone, the value of the sovereign debt will fall and will still have an impact. If investors are further affected by the Greek situation, the value of sovereign debt will fall and will still have an impact. As you see, the substance of the problem remains alive. All eyes will be on the Fed, which will have no alternative but to remain financing the rest of the world via currency swaps.

This situation however leaves us with uncertainty and uncertainty breeds volatility. Gold and the rest of the risky assets will have a hard time.

We wish you all a prosperous 2012!

All the best,

Martin Sibileau

Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

Martin Sibileau

Click here to read this article in pdf format: december-5-2011

Today we want to write a few comments on the news last week, of the IMF receiving loans from central banks from the Eurozone, to buy EU sovereign debt. We certainly don’t know if this will work out or not and by the amounts that were speculated (EUR200BN or more). But there is merit to make a few observations at this point:

1.-We think the most interesting detail here, to which we believe little attention was paid, is that it will “apparently” be national central banks and not the ECB, that will lend the funds to the IMF, to purchase sovereign debt (“apparently” being the operative word here). Why do you think this would be relevant? It would not, if you were not considering an eventual break up of the Eurozone. But if that scenario plays out, the clearing of sovereign debt will be much easier. In other words: this way of monetizing sovereign debt eventually allows an orderly dissolution of the Eurozone.

2.-As usual, it will be interesting to see whether the funds are used to buy in the primary market (i.e. direct funding of governments) or in the secondary market (i.e. funding to bondholders). We suspect that given the limitations in size and the level of yields the Euro zone is facing, the funds will be exclusively used in the primary market. This has a negative impact on the pricing discovery process. We may see a funding stress on the existing bondholders, impacting the USD funding market and eventually leading to USD swaps at cero cost from the Fed. In summary, we would see more “inelasticity” from the markets (refer our last letter), with apparently sustainable high yields in sovereign debt. These situations very often lead to frustrated policymakers, who see no alternative but to increase the level of financial repression.

3.-If the IMF buys debt from governments, and the banks who hold past issues of government debt face funding problems, we assume the banks will still need liquidity lines from the ECB. Should we not see a transfer of these liquidity lines to national central banks? Which banks would benefit? Which ones would lose?

4.- What will occur with the sovereign debt that the ECB has already purchased since May 2010, through the Securities Markets Program? Will it also be transferred to national central banks?

5.- Will points 3 and 4 be contemplated in the next EU summits, when fiscal integration is discussed? How would the markets take the news, if they actually are?

Needless to say, lending printed money to the IMF to buy sovereign debt is to simply leverage the problem, without addressing its root. While every analyst dismissed the Greek problem at the beginning of 2010, saying that it was only a liquidity issue, we were the first and perhaps only ones to go on record saying that the Eurozone did not face a liquidity or solvency problem, but an institutional problem (See our letter from February 8^th and 10^th, 2010: www.sibileau.com/martin/2010/02/08 and www.sibileau.com/martin/2010/02/10)

On February 10^th, we wrote: “…As investors, what should we interpret as a catalyst, as a defining moment?  Here’s our view: If the IMF has to intervene, the European Union will definitely be a Confederation. This is unfortunately the path of least resistance. This is the easiest and less painful path.  If the IMF is engaged, the Euro will no longer be considered an alternative global reserve currency and the bid that there was under such belief will no longer be there. We shall be sellers of Euros under this scenario. This is the worst-case scenario, for if the EU citizens lose purchasing power, the global recovery will become a long-term dream. Note that we don’t care about Debt/GDP ratios or other metrics. The relevant issue here is that on the margin, the Euro would no longer offer more safety than other strong, healthy currencies. In fact, its complex institutional framework would be a burden, compared to other ones, simpler to understand…”

What could save the Euro? A real fiscal integration. By this we mean a structure where a EU wide federal tax is charged to all the Eurozone citizens, to allow transfers to countries in trouble. If this worked, this federal institution could issue its own bonds, Eurobonds, that would later be swapped to the IMF, in exchange for the national sovereign bonds that the IMF would purchase. This is the only way to save the Euro, and we think it is already too late to implement.

Martin Sibileau

Please, click here to read this article in pdf format: december-1-2011

The coordinated action of central banks yesterday changed our short-term view. We had written in our last letter that we expected the fragile global financial system to collapse, with people taking matters into their own hands and, as Murray Rothbard once described: “…insisting upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”

Until Tuesday, we were certainly in that direction. But the announcement of cheaper US swaps from the Fed to the European Central Bank (“ECB”) has now lengthened the day of reckoning. What makes us think that we were right about the direction? Over the last two weeks, the Eurozone banks kept steadily increasing the utilization of liquidity lines provided by the ECB, the Euro/USD swap basis (i.e. the price that the Fed precisely wants to keep under control) continued to widen to 165bps, and lastly, on Tuesday, the ECB failed to sterilize all the money they printed to buy EU sovereign bonds.

Therefore, as we can see, the markets had become “inelastic” to prices, in their demand for liquidity. They kept bidding for it were it was supplied, they paid for it way above the “official” price (100bps was the “official” cost of a EU/USD swap and the LIBO rate did and does not represent the true cost of funding) and they did not find the price offered by the ECB good enough to let liquidity go back home (i.e the central bank). This last point, the failure to sterilize, is important.

As per the figure below, to keep the quantity of Euros printed to buy debt unchanged (Step 1), the ECB immediately issues short-term debt, which the banks, which had sold that toxic debt, buy. When they buy the short-term debt, they give their euros back to the ECB.

This worked well since May 2010, when it was first implemented, until last Tuesday. This week, the banks did not purchase all of the ECB debt. Why? Was the yield offered by the ECB not good enough? No. The problem is that you can’t pay EU banks enough to let those hard earned Euros go. Why? Because these banks were already beginning to see deposit withdrawals. All these signals confirmed to us that the endgame was near and that it was the collapse of the Eurozone.

But yesterday’s announcement of cheaper EUR/USD swaps starting December 5^th kicks the proverbial can down the road…again! Now, at “A View from the Trenches”, we have shown leadership in communicating to readers what a disgrace these swaps are. They transformed the recession of 1930 into the Great Depression, as Jacques Rueff documented in his book “The Monetary Sin of the West”.

With this move, Germany, who resisted the pressure to allow the ECB to monetize sovereign debt purchases, got the rest of the world to finance the deficits of the Eurozone. In particular, they got American taxpayers and everyone else in this planet who keeps his/her savings in US dollars, to finance them. Germany held the world hostage and Germany won!

Rather than liquidate those banks that were forced to hold sovereign debt (yes, forced!), generating a formidable credit crunch, the big global banks that had these unfortunate banks as counterparties, successfully lobbied the Fed to extend a blank cheque to them (i.e. the unfortunate banks), so that they do not go bankrupt. Was it for free? Or is there a commitment from the EU to also embark in monetization, in December? We don’t know, but we suspect that the Fed would have not risked this move without some sort of compensation from the EU. Therefore, although money is not necessarily being created, the fact is that USD denominated assets that would have had to be sold by EU banks to shore liquidity, no longer need to be sold on the margin. This was a real transfer from Americans, who saw their purchasing power devalued immediately with the news, to the Eurozone banks, and the shareholders of those global banks who have them as counterparties.

The last aspect we want to remind the reader of is that through these swaps, the Fed is indirectly exposed to the future defaults in the Eurozone. Given their view on the problem, it is only logical to expect the Fed to push US dollar liquidity to extremes, as the root of the problem, the Euro deficits, remains in place. At the end of this much delayed story, the only winner will be gold. This monetary policy can never result in genuine growth but in inflation and we know that with inflation productivity falls.

Martin Sibileau