Click here to read this article in pdf format:  August 6 2012

Today is a holiday in Canada and our letter is published later than usual. We will make a few comments on what we believe were the most relevant events impacting capital markets (do these still exist, by the way?) last week:

No news on monetary policy

During the past week, both the Fed and the European Central Bank had the opportunity to execute on new policies, be it price or volume driven. As we anticipated in our last letter, these banks decided to past on such an opportunity. There is really nothing else they can effectively do, except explicitly monetize sovereign debt. If they opt for unconventional policies, the medicine will have a worse effect than the sickness, although we want to make this clear: Monetizing sovereign debt is also not the solution. However, it buys time and is the less distorting of all available measures. Having said this, if we are right, the rally we saw in the Euro was only short-covering and soon, we will have to enter a new downward leg.

Relevering of corporate balance sheets: Rich shareholders, poor corporations

A few months ago, we warned that: “…in the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?

I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place…”

This trend is increasingly becoming more evident, as new multi-billion shares-buyback programs and dividend raises are announced every week. Who’s financing this? Banks mostly and they will be sorry for it by the time interest rates (i.e. real interest rates go up). In the meantime, let’s enjoy the party!

Reconsidering our last comments on the repo market: Why we may be proven wrong

At the end of our letter on June 25^th, we brought up what we thought was a sharp comment from Murray Rothbard, in his book “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard told us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”

We concluded therefore that this crisis has to end with a rigorous deflation or liquidation of liabilities, which must be expressed in terms of a new standard. In the ‘30s, the US dollar was still backed by gold and gold was the Fed’s asset. Today, the US dollar is backed by US Treasuries. Therefore, we concluded, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. On July 2^nd, we made the case that such a repudiation was going to take the form of lower volumes in the repo market. By that, we meant illiquidity in the repo market. The same was going to make harder to short commodities naked, brining eventually one net short position in the futures markets to bankruptcy. In the process, counterparty risk would rise exponentially endangering the respective clearinghouse and forcing the Fed to intervene. The key conclusion here was that from that point on, spot prices of commodities were no longer going to be manipulated, given the broken futures markets, opening the door to high inflation.

As the title of this paragraph suggests, we may be wrong in this analysis. What makes us think so? New information: Namely, the potential massive use of floating rate notes (FRNs) by the US Treasury, starting 2013. We want clarify this: The introduction of FRNs will not suppress the process described above. It will only delay it and make the fall even more catastrophic.

The new information came to us upon reflection, based on a series of anonymous articles published on Zerohedge.com, regarding the upcoming change in the funding policy of the US Treasury. Please, find the links to these articles below. Give yourselves some time to read them carefully. They are worth it. We present them in chronological order:

1. www.zerohedge.com/print/446207
2. www.zerohedge.com/print/446655
3. www.zerohedge.com/print/447068
4. www.zerohedge.com/print/447126
5. www.zerohedge.com/print/452769

Floating Rate Notes are variable rate notes. If you hold them and rates increase, for instance, you don’t suffer a capital loss. Since the beginning of the crisis, the US Treasury has basically issued fixed rate debt. The long term portion of it, courtesy of Operation Twist, is being massively bought by the Fed. The short end, is accumulating in the balance sheets of the primary dealers. If interest rates were to rise, these dealers would suffer untold capital losses, and it would be politically difficult to bail them out. Therefore, the same dealers are pushing the US Treasury to slowly start refinancing this short-term fixed rate notes in their inventory with floating rate notes. That way, by the time interest rates rise, the problem will have already been transferred to the US taxpayer, who will be in a deeper hole.

What does all this have to do with our previous analysis of the repo market? Well, if floating rate notes are issued, they will have a strong bid from money market funds and liquidity will be enhanced in the repo market, which would continue funding the commodity futures markets.

However, with the US Treasury facing a higher fiscal cliff, the Fed would be forced to intervene buying not only the long-term, but the also short-term debt, to ensure that inflation transforms these higher nominal short-term rates into lower “real” rates. The Fed would not do this only to save the US Treasury, but also the private sector. Why? As short-term liquidity shifts from commercial paper to government-issued floating rate notes, levered companies (and we just said companies are pushing leverage) would have a hard time finding short-term working capital funding. Potentially, and only years ahead, this could well end in situations seen in Latin America, where banks offered weekly or weekend guaranteed investment certificates at high rates. Gold, again, would end up being “the” store of value. But this, this is years ahead and in the making.

The consequences of high frequency trading and the myth that it is needed to bring liquidity to markets

High frequency trading was brought back to light in the past week, after the tremendous losses suffered by the Knight Capital Group. We don’t have much time but want to simply say this: The whole idea that high frequency trading brings liquidity to markets is born out of a misconception of liquidity. And here, we go with the Austrian school: Liquidity is not and should never be intrinsic to an asset, but is the result of preference by acting men.

Secondly, High frequency trading does not even provide liquidity. It just plays the operational weaknesses of markets. In a casino, when the croupier says “rien ne va plus”, all the real bids are locked. In a stock exchange, it appears that this doesn’t happen, allowing high frequency traders to introduce false signals to trigger stop losses or profit taking. If that is liquidity, our markets are broken. It is another Ponzi scheme, with no real cash at the end, played within mili-seconds.

But the underlying point here is that we should not force liquidity into all stocks. If some are not liquid, it is for a reason and providing fake demand via high-frequency trading is an expensive mistake. If the world allows high frequency trading to continue, it will end, paradoxically, in illiquid markets. The real money will leave markets and flow to real assets, because if liquidity means being exposed to the manipulation of high frequency trading….why pay a premium to be liquid?

Martin Sibileau