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