The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps.
This is our first letter of 2012. The year started with a mini rally that every analyst out there attributes to something called “decoupling”. Why? Because the strength in asset inflation, although global in nature, is particularly more solid in the US.
The oddity appears to be higher asset prices, in spite of a weaker Euro, in a Eurozone whose main problems remain unsolved. Correlations are breaking! say analysts, at every opportunity they have to speak to the media.
We want to start the year tackling this issue, which we feel is very important to understand. Without mincing words, we will say that the concept of “decoupling” is completely wrong and if followed, it will lead to wrong conclusions and horrible investment decisions.
The fall in asset prices during the last quarter of 2011 was triggered by a run for liquidity, typical of fiat currency systems or systems with leverage. Euro zone banks had to sell USD denominated assets to raise liquidity, lifting the price of the USD and putting pressure on the rest of the risk asset spectrum. This was addressed in November, when the Fed confirmed its commitment to continue extending USD swaps to other central banks, at a reduced price of 50bps. At “A View from the Trenches”, not only have we dealt extensively with the mechanics and implications of currency swaps but also, we believe we would not be mistaken if we said that we were the first and only ones to point to its relevance, way before anyone else in the market. For instance, in February 2010 (almost two years ago!), we warned:
“…that France did the same (in the 1920s) that we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment…” (refer: www.sibileau.com/martin/2010/02/26 )
How relevant was this action taken in November? The chart below (source: Bloomberg) shows us how the price of the 3-month EURUSD swap reverted after November 30th:
How consequential was the amount of swaps extended by the Fed? The next chart (source: Bloomberg)gives some perspective, showing what the Fed extended in 2008, vs. what occurred last November:
The spike is certainly visible. Back in 2008, the deleveraging was just starting, so it would seem unlikely to us to see those levels again. However, we must not underestimate the magnitudes seen in November and the sovereign problem ahead, particularly if it threatens to break the Euro zone. In light of all this, it is clear to us (and not to the rest, apparently) that rather than a decoupling, we are seeing a huge coupling. In fact, we are witnessing the mother of all couplings! As we explained on December 12th, the Fed is bailing out the European Central Bank, because without US dollars, the run for liquidity in Europe would result in a general run against the ECB. But since December, the ECB is now also financing on a 3-yr basis, the liquidity, in Euros, of the Eurozone banks. There is plenty of speculation as to what the Euro zone banks do with that money but we think it is safe to say that at least, they are not forced to liquidate assets. On the accounting analysis of the 3-yr financing, we found a very interesting article, by Izabella Kaminska, at FT Alphaville, named “The curious case of ECB deposits”.
In summary, the mother of all couplings consists in linking the balance sheet of Euro zone banks indirectly with the Fed: The Euro zone banks get cheap liquidity from the ECB in Euros, supported by the US dollars provided by the Fed to the ECB. Asset are not sold now and in fact, they could actually be purchased later, if the sovereign crisis in Europe was to be addressed.
What does this all mean? Well, as we explained on December 12th, this printing of billions of US dollars by the Fed to back the ECB means that Americans need not to save any extra, to bail out Europe. This is what puzzles mainstream economists, who refer to this “oddity” as a “break in correlations”. The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps. Such a sell off would bring down the price of every single asset vs. the US dollar.
Now that we have clarified this point, we must ask ourselves how this should impact gold. On this point, we must say we are now in uncharted waters. Yes, the swaps are nothing new, but the context in which they unfold is. With this in mind, we think that the rhythm in 2012 will be marked the evolution of the fiscal situation in the Euro zone. On Friday, we saw a massive downgrade in sovereign risk by S&P that was fairly priced in by the market. Going forward, further deterioration or default surprises will accelerate the pressure on Euro banks, which in turn will force the Fed to become more coupled and to print more US dollars. We think that in this context the volatility and the bull trend in gold should both increase.
Why would we not also want to buy stocks? Because we follow the view of Friedrich Von Hayek: We believe that this process is also affecting relative prices everywhere and when relative prices are distorted, in the long term, production falls and we end with a higher amount of money in circulation, available to purchase a smaller amount of goods. Inflation, in the long term, always bankrupts producers and benefits the holder of products. If you don’t believe us, ask gold miners how they feel about the performance of their stocks vs. that of gold bullion.
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