(Click here: May 21 2012 , to read this article in pdf format)

According to Wikipedia, the expression “Elephant in the room” is an English metaphorical idiom for an obvious truth that is being ignored or goes unaddressed. The idiomatic expression also applies to an obvious problem or risk no one wants to discuss. With the ongoing sell off in all markets, except for precious metals lately, we think that liquidity has been the elephant in the room.

It would seem that we are in a liquidity trap or even worse: The traditional metrics, prices for liquidity are no longer relevant. In the face of widespread bank downgrades in Italy and Spain, the news of billion in losses from credit derivatives positions by a global bank, political uncertainty in Greece, negative fiscal data out Spain and negative jobs and activity data out of the US, the sell off in risk is very understandable….But, what about liquidity? In a not so distant past, every time this sort of events took place, they were accompanied by a violent increase in the cost of liquidity. That was a good thing, apparently, because it made things easy for central banks: All they had to do was to supply that expensive liquidity and its cost would come down, triggering a rally in risk assets. This is precisely what occurred in December 2011, when the Fed extended currency swaps and the European Central Bank released its first Long-Term Refinancing Operation (LTRO).

Since December, however, the cost of liquidity, regardless of the performance of risk assets, has done nothing but fall. The chart below (source: Bloomberg), shows how this has occurred in the case of liquidity in US dollars (3-month Libor – Overnight Index Swap spread). This suggests that Quantitative Easing 3 would be of little use:

The same can be said, counter intuitively, about the cost of liquidity in Euros. The chart below (source: Bloomberg), shows that (3-month Euribor – Overnight Index Swap spread), which indicates that a new LTRO would be of little help:

And what could be said of the cost of converting swapping Euros to US dollars, in the context of a possible break-up of the Euro zone? The chart below (source: Bloomberg) shows the price of the 3-month Euro-USD swap basis. It is clear that this basis is at levels outside any crisis…and yet, we have one. There is no need for another currency swap:

All this makes us think that liquidity has indeed been the elephant in the room so far. What can central banks do now, should they want to keep this current crisis in control? Quantitative easing, Long-term refinancing operations and currency swaps would not do anything, we think, to address the current sell off in risk.

Now, suppose policy makers allowed the sell off to continue, until it reaches a self-clearing point. After that, however, fiscal deficits would continue to be the norm, either in theUSor the Euro zone. Would investors then still hold US Treasuries, for instance? Or German Bunds? (Remember that the main assumption here is that the market reaches a floor). It would seem to us that the answer is a big “No!”.

Furthermore, if the cost of liquidity never climbed and the risk asset prices reached a floor….what will happen to all that liquidity currently being hoarded by investors? We think the case is very bullish of precious metals and commodities. However, given the obscene and absurd manipulation via high-frequency trading in these markets, we should be ready for an awful dose of volatility and financial repression of unimaginable proportions.

We want to make one last point about liquidity and related to the recent announcement that a major global bank (we cannot single out companies at “A View from the Trenches”, but we guess readers understand who we refer to) lost billions in a derivatives position. It is difficult to believe the demagogic explanation that this bank got itself in trouble because their derivatives traders were greedy and wanted to manipulate the market. Yes, it could be an easy explanation but we doubt it would make the right explanation.

This bank began to buy protection in the IG9 (i.e. investment grade series 9) index to protect its loan portfolio from systemic risk. The problem was that this systemic risk was greatly sedated with the morphine the Fed gave markets, when it established the currency swaps in December 2011. We were perhaps the only ones to make the point that this tool was actually not decoupling the USfrom Europe, but doing the opposite (refer: “There is no decoupling”, January 16^th, 2012).

Indeed, as correlations weakened again (as explained in our Jan 16^th, 2012 letter), this bank was forced to sell IG9 protection, to unwind the previous trade. But as it did (and perhaps still does, it brought the market against itself. We can make the following conclusion: Either the credit market became too big to be hedged in the credit derivatives market or the credit derivatives market was greatly reduced by regulations or financial repression, to support the credit market.

We think both things have occurred simultaneously: The printing of money by central banks have created an overextended credit market and the financial repression (think for instance of the debt swap ofGreecedebt) has made the credit derivatives market illiquid. The problem is that we still have a problem: What do we do about all the risk in credit that is still outstanding out there? It cannot be hedged….

Martin Sibileau