Click here to read this article in pdf format: July 30 2012

Besides the 2012 Olympics (Go Canada!), last week, we had two main drivers of markets, at a macro level, of course. The first was the hope that there will be a final intervention by the European Central Bank, plainly monetizing sovereign debt. The second, the expectation that the Federal Reserve, next week, will announce some sort of monetary easing.

Both are simply unrealistic. With regards to the situation in Europe, where it is now clear that whatever the austerity program, if actually implemented, got whichever sovereign nowhere, the rumour was that the European Central Bank is willing to do whatever it takes to save the currency. Be careful what you wish for, because so far, they have not saved it and in the process they ensured that the Euro zone no longer has a solvent banking system, reliable capital markets and even money market funds. There was no news of any impending resolution towards fiscal union to begin with and that, to us, says it all. Now, if you disagreed with our conclusion here, you must explain how, if there was some truth in all this, WTI oil could not break above $90.5/barrel or gold its key $1,643/oz level. News of this sort, if true, would have truly shaken markets. The rally that took the EURUSD above 1.23 was therefore simple short covering and the smart money faded it.

With regards to the Fed, we heard and read many perspectives. What really troubled us was that absolutely all of these analysts base their expectations of monetary policy on activity data of the private sector. What we mean is this: They look at the housing market, orders, employment data, consumption, inflation, etc., to determine whether the Fed will or not keep printing money via US sovereign debt purchases. Are they naïve or are they colluding to sell you a fantasy?

Let’s get this clear: The US runs a fiscal deficit of over 120 billion per month. This is as much what the Spaniards said they needed to bail out their banks. This happens every month. The US Treasury must therefore sell debt to pay for this deficit and the question is: Who buys it? The last time we checked, under Operation Twist, the Fed had purchased 91% of long-dated issuances…91%!!! The rest? Other central banks? Most likely, which tells us that genuine demand is well below 10% of issuance…

Now, if you still think that that the Fed looks at data from the private sector to decide whether it will or not monetize US sovereign debt, please, stop reading. Otherwise, share with us our awe: How is it that nobody, nobody ever discusses QE3 or any other prospective monetary policy looking at the fiscal gap? How? we wonder… Coming from Argentina, we remember that any serious discussion on monetary policy was always, regardless of the political backdrop, closely tied to an analysis of the fiscal situation of the sovereign and its future cash needs. Yet, here in the first world, the fiscal gap seems to be totally independent of the Fed’s actions. We believe this situation, by the end of the year, will have been amended.

By the end of 2012, we expect to see the fate of the Euro zone decided: Either for better or for worse. But it will be decided. And then, the world will turn its sights onto the US fiscal situation. Will we then see, for instance, the markets fade employment data on Thursdays at 8:30am ET and instead react on news of fiscal performance?

It is exactly because of this reason, that we also believe that the Fed, contrary to what some expect, will not announce next week a reduction in the interest paid on excess reserves. The European Central Bank did so in its last rate meeting and that was the kiss of death to the Euro money market. The US cannot afford to do this, because the US dollar is still the world’s reserve currency and if the US money market is destroyed, the repo market dies with it. This market (i.e the repo market) finances the Ponzi scheme in the futures and commodity markets and endangering it would seriously threaten the status of the US dollar in the world. The Fed knows this and therefore, all it will try to do, we think, is to talk markets up. We will not listen.

Martin Sibileau

Click here to read this article in pdf format: July 23 2012

We have not written for the past two weeks. We were vacationing but at the same time, nothing really changed a single dot of the macro picture. Perhaps the main development has been the collective (but still minimal) realization that markets are being manipulated either by governments or banks. The starting line, it seems, is the manipulation of the London Interbank Offered Rate (LIBOR). We are not going to add to this. We expressed our comments in our last letter. Those interested in following the issue can do so at Zerohedge.com.

The relative calm therefore affords us the opportunity to reflect upon a topic that has and continues to personally bother us, with respect to the comprehension of the ongoing crisis. We are referring to the circular reasoning behind every proposed solution to this crisis.

We remember affectionately the first time we were confronted with circular reasoning. It was courtesy of Antoine de Saint Exupéry’s famous book, “The Little Prince”. In its chapter 12, the Little Prince meets a tippler, a drunkard (original drawing from the author, below), and the dialogue goes like this:

“What are you doing there?” he said to the tippler, whom he found settled down in silence before a collection of empty bottles and also a collection of full bottles.

“I am drinking,” replied the tippler, with a lugubrious air.

“Why are you drinking?” demanded the little prince.

“So that I may forget,” replied the tippler.

“Forget what?” inquired the little prince, who already was sorry for him.

“Forget that I am ashamed,” the tippler confessed, hanging his head.

“Ashamed of what?” insisted the little prince, who wanted to help him.

“Ashamed of drinking!” The tippler brought his speech to an end, and shut himself up in an impregnable silence. And the little prince went away, puzzled.

“The grown-ups are certainly very, very odd,” he said to himself, as he continued on his journey

Later in life, we also faced (but don’t remember so affectionately) other circularities: The logics of the US immigration system (where one needs to have a visa to work, but needs to have a work offer to apply for a visa) or the beginnings of our career, when it was difficult to land our first job because we had no previous work experience…

The most damaging of all circularities however, can be found in the policies undertaken by central banks, regulators and governments in general, worldwide. Where to begin? Since we are deductive, let’s start at the core of the problem, which is the way macroeconomics is conceived by the establishment:

In the minds of those who lead the world (at central banks, finance ministries, regulatory agencies and business schools), markets, at one starting point, are in equilibrium. A shock (in today’s case, of a financial nature) shakes the status quo and it is commonly perceived that it’s the governments’ duty to restore equilibrium. The shock, of course, they think is exogenous: it came from outside the system, could not be forecast in advance, but can be prevented in the future, with more regulation.

The first mistake here is to believe in the existence of equilibrium. We will not say more about this (but there are entire books available on this topic). Humans are constantly acting, trading, and they do this based on price signals. Profit and loss therefore are essential features in the system, that tell us whether what we do is indeed of value to the market or not. As long as we leave profit and losses unrepressed to guide us, we will get as close to that elusive equilibrium as we can possibly get. Why?  If  we do something of value for the market, the market will tell us to do more of that: How? By making us profitable. If we don’t, the market will tell us to stop and to rather allocate the resources we used, including our mental capital, to better uses. How? By making us unprofitable. If we insist with the wrong course, we will go bankrupt. Paraphrasing Gordon Gekko: Bankruptcy, for lack of a better word, is good for the system!

Having said this, we acknowledge, financial shocks are caused by market bubbles. All asset price bubbles were the deliberate (not coincidental) result of some sort of signal suppression, price suppression. All of them. But to begin with, the worst price suppression we have today is in the banking system, where loans, which are multiple times the actual value of deposits, are not marked to market, but carried on an accrual basis. The Euro zone is learning right now about the consequences of this, as their banks carry depreciating sovereign debt. The system there has fallen into the vicious circularity of governments guaranteeing or capitalizing these institutions that go bankrupt precisely because they are creditors of the same who provide the guarantees or equity injections.

But the story doesn’t end here. Leaders conclude that the bubbles were caused not by the suppression of prices but by irrational behaviour. This idea has become so popular that during the 20^th century we have seen the birth of a new branch in economics: Behavioural Economics. The whole notion has become so ridiculous that in 2002, Dr. Daniel Kahneman received the Nobel Memorial Prize in Economics, despite being a research psychologist, for his work in Prospect theory! None of this would be really needed, if we understood that failures and losses are a good thing because in the “system”, they mend mistakes before they reach systemic proportions. The regulations proposed to mitigate irrational behaviour therefore do nothing but to exponentially increase systemic problems, exposing us to another circularity.

Take for instance the insistence imposed upon banks worldwide, that in times of stress, their creditors be converted to equity holders, to strengthen the capital structure of these institutions. This policy is also an exercise in circular reasoning: It leaves banks without access to credit (either senior or subordinated, unsecured or ultimately secured) and with worthless equity. The only ones holding the bag are depositors which, as in the Euro zone, end up demanding unconditional guarantees of their governments and even after getting these, they withdraw their monies (i.e.Spain). Therefore, governments end up trapped in the circularity of causing bank runs by their own policies.

There is another circularity, which is perhaps the least understood. The Fed and a myriad of other central banks have not only a mandate on inflation but also on maintaining a target level of activity, or employment. These central banks therefore focus on the so-called excess capacity of their respective currency zones to reach a decision on their benchmark interest rates.  We will show that this is circular reasoning in hiding, because it makes no sense to think that a company that produces, say, 10,000 cars per month but has the capacity to be producing 15,000 should be producing those 15,000 cars per month.  However, given the cost structure and prices the company gets for its produce, the optimal amount they choose to produce is 10,000. Period. Because if they produce more, they may incur into a loss and may even go bankrupt. Think about it in your own terms…At the given income you earn…would you work and additional half-time, for no other reason that if you “invest” in doing so, you will simply earn the same per hour of work or less? Clearly you wouldn’t, unless your marginal salary rises. So, why would the rest of the world do so?

The key thing is then to ask: What set of relative prices were present back at the time when the company decided to invest to have a capacity to produce 15,000 cars per month? Who created those artificial relative prices? Could we not say that the 0% interest rate imposed by a central bank is one of those artificial prices? But if we are right, is it not clear that there is a circularity when a central bank sets a rate following data on capacity? After all, the additional unused capacity was driven by a low interest rate policy and encouraging the build up of more capacity only exacerbates the problem.

At the heart of all these circularities is the fact that the world has fiat currencies and the world’s reserve currency is used to support a Ponzi scheme, where the US Treasury gets into debt to repay the outstanding debt and its interest. Like all lies, this one will be exposed when the fact is confronted with the story. Today, the story is still winning over the fact, thanks to the existence of futures markets, through which commodity spot prices are manipulated (think oil, gold).

Why? Because, central planners believe in managing expectations. Remember, they think that markets act irrationally and if one can manage expectations, as in the case of inflation expectations, one can get away with printing money. They believe that the prices of commodities are one of the main drivers of inflation expectations and by maintaining these prices suppressed, people will not think the current policies will end up in high inflation.

How is this done? The existence of futures markets allows big players to set big naked shorts, which means that huge short positions, driving the spot prices down, are created without the seller actually owning the commodity. The underlying risk is obviously systemic, because once one of these sellers is exposed naked, the house of cards clearinghouse falls. The futures markets are the Achilles tendon of this big house of cards we live in. As long as they exist, we will not see parabolic increases in the price of precious metals and once they cease to exist, capital controls will be overwhelming. Pick your poison…

 

Martin Sibileau

Click here to read this article in pdf format: July 9 2012

Markets had a quiet week, with a holiday in Canada and another in the United States. We will therefore be brief today.

In our last letter, we presented how we think, the end of this crisis will be brought about: With the collapse of the futures markets. It is important that these markets really break because they are the ones used to manipulate commodity prices (not just gold) and as long as commodity prices can be controlled, the flight from fiat money to real assets will not be triggered and the global depression will stay with us. We know that, “they” know that and that’s why when that critical moment approaches, the repression to avoid it will be phenomenal, of a kind nobody in the developed world has ever witnessed. We leave it here…

Last week, the central bank of Argentina declared that at least 5% percent, we understand, of deposits held by local banks “must” be lent to businesses. Everyone laughed at this ridiculous measure. Everyone knows that it is useless and that the government of that country can do nothing to prevent their eventual fall. Last week too, the central bank of the European Union declared that it will pay nothing, (zero percent rate) on deposits from Euro zone banks. Yet nobody laughed at this measure and still… it is nothing else but a twisted version of what the Argentines did. It is as ridiculous and it will be met with the same answer: Less lending and more recession.

As we wrote months ago, in order to save their currency, the Euro zone destroyed its banks. And with this last measure, it will have ended its money market. For all practical purposes, the European Central bank made sure that its liabilities, the Euro, will never be able to reach a global reserve status. The damage these irresponsible central bankers are doing is immense because until now, Euro banks were not lending to each other for a genuine reason: Very high counterpart risk within a currency zone that is falling apart. They were taking heavy capital losses on the sovereign debt holdings they had been coerced to invest their funds in but, at least, they were able to earn 25bps on immobilized monies. Now, they won’t even have this “risk-free” income, a situation that actually enhances counterpart risk, as solvency is further crushed.

At the same time, if the banks cannot afford to have funds immobilized, they will discourage the growth of deposits in the Euro zone, precisely when they are most needed. The way markets welcomed this measure shows we are not alone with this view.

On another note, last week too, Robert Diamond, ex-CEO of Barclays was called a criminal during a testimony before the British Parliament. The reason? His former employer was accused of manipulating the London inter-bank offered rate (LIBOR). We can only ask this: Why are bankers called criminal when interacting in the market to get a price for their product, while central banks, who actually “set” the rates….are not? Who is the criminal? After all, would any other business not try to move a price to its benefit? If it is successful, it’s because the demand for that product is there. The point is: They were not, which is why Libor, after all, has become an irrelevant rate. Was that criminal? Did bankers really ever force other banks or businesses to borrow by way of bank debt, rather than bonds or raising equity? Yet, central banks do actually impose rates on the market, regardless of demand. Who is the criminal? Who is it?, we ask…

Lastly, in our letter of June 25^th, we argued that it was now conceivable to see Germany leave the Euro zone first. We think that the latest actions, both by the central bank and the Euro Summit, make this outcome increasingly likely.

Martin Sibileau

Click here to read this article in pdf format: July 2 2012

Today is a holiday in Canada. Yesterday was Canada Day, and the birth of the Confederation (in 1867) is celebrated. In an unusual way, we will dedicate a few “non-market” comments to the popular context within which this celebration takes place.

On this particular Canada Day, we also commemorate the bicentennial of the war of 1812, which is wrongly understood in terms of United States vs. Canada (for instance, check here). We view that interpretation as simple and cheap nationalism –which is not surprising during these times of global economic depression- but what is worse is that it totally misses the point.

There were two civil wars inNorth America. Two, not one. The first war was the so-called (by the Americans) Revolutionary War. It started in 1775, but remained unresolved and delayed by the French Revolution and Napoleonic Wars. Once the uncertainty was cleared in Europe, the war resumed and the end was decided in 1812.

Like Korea in the 20^th century, North America finished splitting as well: One North America in the North, and the other in the South. It was a process that lasted decades, during which innocent lives, fortunes and dreams were crushed by a war fought on ideals and driven by material factors. Unlike the current division between the two Koreas, that of British North America and the United States relied on much “grayer” differences: To live peacefully but under authority or to search freedom (both economic and political) under the very serious risk of ending in anarchy. Both propositions were valid at the time and are valid today. Other countries, likeFrance in the 1780’s faced the same dilemma, but could not sort it out and anarchy trumped freedom. It is because of this, in our view, that the history ofNorth America is so interesting: It constitutes a unique and successful story, which was not exempt from violence and suffering. And it is with these considerations that we remember, on Canada Day, the achievements of a great nation: Happy Canada Day!

On a different note and back to the 21^st century, the news out of the EU summit on Friday lifted risk assets across all classes and geographies. But we will discuss this, albeit briefly, further below. Today, we want to continue with a topic we left unfinished, in our last letter: The repudiation of the US treasuries and its consequences. Why do we think we should be discussing this? Because that repudiation will be the final outcome of this crisis and although we are likely years away from it, we must be prepared to understand what will drive it, how it will impact and, why not, how to profit from this long-term view.

We will not define here what particular event will trigger that repudiation. We don’t know it. As a friend once told us, “revolutions always start with the hanging of a baker at the public square”. Hence, we just know there will be a baker somewhere who will be hanged, but we still don’t know who that baker is. The only known underlying factor is not an event, but a “flow”: The US fiscal deficit. We think that once the course of the European Monetary Union is decided (not necessarily solved, but at least decided), markets will turn their attention, after the US presidential election, to the solvency of the US.

Once this repudiation starts, it will indeed affect all asset classes. What matters to us today are the futures, commodities and repo markets. They are interrelated, because in the repo market, players in the futures markets can get the equivalent of secured borrowing to short commodity futures. We explain how this works below:

Repo is short form for “repurchase agreement”. In this agreement, a party sells securities (usually US Treasuries, our case today) and agrees to buy them back at a later date. The repurchase price should be higher, with the difference between the initial and the final repurchase price representing an interest rate (the repo rate). For all purposes, through this agreement, an outright purchase and an outright sale have taken place and the party buying the US Treasuries (the lender) has to mark to market them.

In our example, the seller of the US Treasuries (who will buy them back at a higher price), uses the cash to short commodities, say gold, in the futures market. Basically and without confusing the reader with the particularities of the transaction, the underlying situation is that this party uses the borrowed cash to buy gold today, sell it, and commit to buy it back at a later date. The party is now short a futures contract in gold. At expiry, gold will be bought back and the securities used initially to secure the funds will be repurchased too.

This transaction is profitable if in the future, when the party buys back the gold, he/she does so at a price low enough to make a profit that will cover the repo rate (the difference between sale and repurchase price of the security).

Like in any other transaction, this one is also full of risk and that risk affects all parties. Let’s examine this under the assumption that US Treasuries are deemed riskier and their price begins to fall, as markets worry about the unsustainable growth path of the US fiscal deficit.

The buyer of the US Treasuries does not want to hold them for long (they are a depreciating asset) unless the repo rate compensates him/her for the risk. And if it does, as the repo rate increases, the buyer will grow concerned that his counterpart, the original seller of the Treasuries, will be insolvent at the time of the repurchase. As a result, if the price of Treasuries falls, the buyer will trigger margin calls on the seller.

The seller of the US Treasuries, who shorted gold in the futures market, will now be “hoping” that the spot price of gold, in the future, will have fallen enough to compensate for the loss he/she will incur, when he/she repurchases the Treasuries at a much higher price than they trade in the market.

And now….most importantly, those sourcing physical gold to clear transactions in the futures market, will be concerned that the speculators who shorted it, will be insolvent by the time they need to buy it back. They will demand a higher price to compensate for the counterpart risk or even worse: They will withdraw the commodity from the market because they don’t feel safe.

If you think that this situation is uncommon, we want to show you the chart below (source: Bloomberg):

In the chart above, you can see that the curve of the 3-month repo-rate, in Euros, has sharply inverted. This chart corresponds to June 28^th and helps to visualize the state of secured lending in the European Union these days…The security, European sovereign debt, as in our main assumption with US Treasuries, has continued to fall in price as the solvency of the Euro members is put in question.  Basically, transactions, if carried out, are on an overnight basis. The trust is gone not only in the unsecured, but the secured market and with it, the value of the currency has fallen against the US dollar. It is easy to see now how a similar situation can take place with the US repo market and the value of the US dollar, in terms of gold.

Once we have understood the micro details of this dynamic, we can proceed to see the big picture. The chart below seeks to depict it:

Our scenario will not be exempt from financial repression and in fact, it will be made possible thanks to it. Because we expect panic right after the repudiation begins, we can foresee that theUSgovernment will impose that US Treasuries be marked to model in the repo market. But as we all know, if a price is imposed upon the market, the market will still manage to respond with volume. A lower amount of commodities will either be made available to clear the futures market or their physical/spot price will increase.

Governments will respond lowering required margins, pumping liquidity and threatening those commodity “speculators”. As the pressure heats up, counterparty/systemic risk will rise until at one point, it shoots exponentially, when a big player in the market suffers an historical short squeeze.

At that point, we can see central banks pumping even more liquidity to avoid the collapse of the futures markets, which they have been using until then to manipulate prices. Commodity (i.e. gold) holdings will be taxed, together with commodity producers. Holdings can even be outright confiscated, in the name of national interest. All these actions will do nothing but accelerate the transition from inflation to high inflation.

 It is a vicious spiralling situation, where US financial institutions will be forced to hold US Treasuries at 0% risk weight (i.e. at a masked loss), forcing them to raise capital, and likely undergoing the same path European banks underwent. And of course, interest rates, at least nominally, will spike. It is a scenario where the US housing market is negatively affected, corporates default and investment collapses, raising unemployment with productivity falling. This will not happen tomorrow, but it will happen sooner than most want to imagine.

Finally, we want to leave today with a few comments on the Euro summit of last week. We think that nothing has really changed, except that the door has been opened to the possibility of lending non-existent funds to euro banks directly and without seniority over existing lenders. With no new funds and no monetization of existing debts, the pain on the austerity has only been distributed: Less for the periphery, more to Germany, as the chart below (source: Bloomberg) shows how simultaneously, on the announcements, the price of Germany’s sovereign debt (to the right) dropped, while that of Spain (to the left) rose.

Having said this, in our view there is a chance however that going forward, the pressure on the European Central Bank will also be shared: While Germany had not been pressing for debt monetization in the past, if the yields on their debt began to raise to dangerous levels, they would be confronted with the dilemma of leaving the Union or pressing the central bank. By that time, Germany may be deep, deep inside their contribution hole and their reasoning may become more “reasonable”. Will this event resolve the fate of the Union and mark the start of the repudiation of US Treasuries? Or will the repudiation get delayed, because Germany leaves first the Union?

Martin Sibileau