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