Please, click here to read this article in pdf format: march-11-2010
In the past days, the world seems to have embarked on to another leg of a rally, with equities trying to set the stage for higher highs. Volume is reduced though and you may ask yourselves why we are not as bullish as we were last year, after all the evidence in favor of a nascent recovery. Is it because the recovery is weak? Is it because unemployment remains high? Is it because consumer spending looks low? No, no, no…We wrote before anyone, back at the beginning of 2009, that we expected unemployment to be high and that we did not expect any growth, but agony.
The main reason we were bullish then was that the stimulus programs, the quantitative easing was well underway. That is no longer the case. Is that all? Should we no longer be bullish just because stimulus programs are unwound? No, there is another element to it. The same countries that claim to be unwinding these programs are running unsustainable fiscal deficits and absolutely no serious and credible action is taken. That, to us, is enough to worry. Are we short the markets? No, we were stopped weeks ago, because we can no longer take the pain of even a 1.5% loss…

Consistent with this sentiment, some analysts deem the credit (not yield) curve in investment grade space (CDX IG13 index) to currently be to steep in the front end, suggesting that the implicit default rate is too high. What is the analysis based on? Simple, descriptive statistics, going back to 1970. We wonder what period in history, back to 1970, was ever similar to the outlook we’re facing? When was there monetary coordination? When did the world fall since 1970 into a liquidity crisis with stimulus programs of the size and geographic reach seen today? Furthermore, we ask ourselves how is it that so much research is currently being done on the defaults outlook, without anyone taking a closer look at the maturities concentration the world faces in high yield, between 2013 and 2015? When did a scenario of so close a maturity front together with increasing interest rates not demand a steep credit curve? Hence our not so bullish stance here, as discussed above.

On another topic, we are finally seeing some long overdue concern of politicians on sovereign credit default swaps. Particularly in Europe. As we wrote on March 1st (refer: www.sibileau.com/martin/2010/03/01 ): “…politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons…”. Regulators are wrong in seeking to prohibit these instruments, blaming them for their problems to issue debt. By the same token, regulators are ignoring the true problem of these contracts, which is the fact that any counterparty selling them does so on leverage. If a sovereign in Europe or the US was to fall, the implicit guarantees that these institutions selling sovereign credit default swaps have would be worthless and they would be undercapitalized, at exactly the same time everyone rushes to the liquidity door.

Finally, we refer to our previous letter, where we challenged the notion of Canadian markets strength based on commodities performance or even growth expectations. As you can see in the charts below (source: Bloomberg), the exodus to Canada is a process that started long before Parliament discussed the 2010 budget last week. It began in November, and took off in earnest with the Dubai credit event. The Canadian “thesis” worked against the Australian dollar, a commodity currency which has increased policy rates (below left) and extremely steadily vs. the Euro (below right). The foreign exchange market never lies.

(”A View from Trenches” is temporarily no longer published on a daily basis. Over the past year, we enjoyed writing every day. However, we are very busy of late, undertaking another project that hopefully will be finished by next Fall. We will write as often as possible, but not on a daily basis. Thank you so much for your support and understanding)

Since our last letter, the markets have continued to rally, on the assumption that Greece’s fiscal problems will not spill over to other peripherals mainly, but on the more broad based belief that global activity will continue to recover. Hence, as expected, gold is underperforming, the USD is being sold together with Treasuries and oil and equities rally. In our last letter too, we had explained why we favored Canadian equities over gold. We disagree with the general notion, the true vox populi that the not-so-crazy fiscal budget for 2010 plus rising commodity prices are lifting the CAD. In our view, the CAD is being lifted by default, by Canada’s historical inertia, which in a moment of global volatility, looks like a safe island in a brave ocean. It is true, that inertia is the result of a relatively stronger fiscal position, but it is also apparent to us that smart beats strong, and a smart government that truly opened this country’s economy and financial system to foreign investment could run a wider fiscal deficit (if it so wished), with a still stronger CAD.

In Europe, on the other hand, we do not think fiscal problems will just vanish, and we see the proposal by Germany’s Finance Minister Schaeuble to create a fund similar to the International Monetary Fund, but for the Euro region (as reported by Financial Times Deutschland) as ridiculous. However, we respect one of Denis Gartman’s rules of trading (rule no. 8 ) and think like fundamentalists, while we trade like technicians. Therefore, we are enjoying the recent ride on Canadian stocks.

What perhaps may have gone unnoticed yesterday was the New York Fed’s announcement that will use money market funds as counterparties in its reverse repurchase agreements, to add capacity to drain reserves. We had initially alerted of this on Sept 30/09 (www.sibileau.com/martin/2009/09/30 ), which (for the sake of intellectual honesty) we first learned about from Bank of America’s Global Rate Focus report, on Sep 25/09. Later on Oct 21/09, we wrote:

“…the Fed will eventually need to take liquidity off the market. One of the tools to achieve this is the reverse repos, where the Fed exchanges Treasuries in its balance sheet for cash (that leaves the market). The problem with this is that the volume required is so huge, that the current dealer infrastructure is not enough. Thus, money market funds, for instance, would have to participate in the effort. But if money market funds were to hold these Treasuries, the crowding out effect on the commercial paper market would be significant, affecting rates…” (refer: www.sibileau.com/martin/2009/10/21 )

On this news, Bloomberg reported yesterday too, that there is currently a shift out of Municipal debt, and in favor of Treasuries (i.e. Federal debt). The same has and continues to happen with European peripherals’ debt in favor of German bunds. But given the institutional differences of one currency zone and the other, in the US the currency is not affected. It took the US a four-year civil war to define itself as a Union, finally in 1864. We certainly hope Europeans figure that one out faster and peacefully!

In the meantime, as the Fed starts engaging money market funds, we fear that problems will pile up. Here’s a potentially challenging scenario:

Some municipal issuers will have difficulty accessing the commercial paper market and may draw from liquidity lines that banks extended to back such commercial paper. Would banks in the US dare to show a strong hand against governmental entities in financial trouble? I don’t think so. Who’s going to end up footing the bill, then? Corporate issuers, as liquidity dries. Simultaneously, if this crowding out process unfolds, the credit quality of municipal issuers will be affected, increasing capital requirements of financial institutions. Under this scenario, if the US Federal government shows a sustainable fix to this problem, the USD will strengthen and gold will continue to drop. Otherwise, if the problem gets out of hand, we will get inflationary signals, with the both interest rates increasing and the USD depreciating. Please, keep in mind that this is a long term view, so typical of “A View from the Trenches”. In the meantime, our view is that in the absence of further volatility in sovereign risk (very unlikely), the other asset classes will see slight pricing revisions, consistent with a more sustainable fiscal path. Relative value and curve trades are in full fashion these days…

Martin Sibileau

Please, click here to read this article in pdf format: march-4-2010

(A brief announcement before we start with our comments today: Going forward, “A View from Trenches” will not be published on a daily basis. Over the past year, we enjoyed writing every day. However, we are very busy of late, undertaking another project that hopefully will end by next Fall. We will write as often as possible, but not on a daily basis. Thank you so much for your support and understanding)

Since our last comments on Tuesday, we have had a few updates on policy. The most important indeed is Greece’s announcement of revenue-raising and budget-cutting measures . Since last week, the 5-yr unsecured sovereign credit default swap spread has dropped dramatically, from 400bps to 294bps (at close). If this issue was, as Mr. Jeffrey Rosenberg sustains, a short liquidity problem, things should be left there, with us waiting for the results yielded by the budget plan. But as we clearly made the case before, this problem goes beyond the sphere of liquidity. It is an institutional problem, and as such, we will have to follow Germany’s reaction vis a vis Greece’s initiatives. So far, Prime Minister Merkel made it clear yesterday that the next meeting this Friday will not be about aid commitments.

In our view, these budget announcements have no purpose but to set the necessary conditions towards a more sustainable institutional framework, where either or both Germany and France guarantee Greek issuances. However, an impressive opposition is growing in Germany against this move. On this issue, Mr. Otmar Issing (Economist, former member of the board of the Deutsche Bundesbank (1990–1998) and of the Executive Board of the European Central Bank (1998–2006) couldn’t have been more explicit: “Garantien für die Käufer griechischer Anleihen durch die bundeseigene Förderbankgruppe KfW kommen überhaupt nicht in Frage”, reported the online edition of Frankfurter Allgemeine (Our translation: Guarantees for the buyers of Greek liabilities through a KfW Bank Group are out of the question).

On a separate but related note, we have not been bullish of gold lately. In our opinion, gold in terms of Canadian dollars was a poor investment decision. In hindsight, we believe this was a correct view. And looking forward, we maintain such view. In Chart 1 below (source: Bloomberg), we show the ETF “XIU.TO”, that tracks the S&P TSX 60 composite (white) vs. the ETF “IGT.TO”, which tracks the price of gold, in Canadian dollars. As can be seen, since Feb. 8th, when sovereign risk out of Europe escalated, gold has barely risen, vs. the S&P TSX 60. Why take the risk of a single asset vs. the Canadian equity market?

Chart 1

Furthermore, February 8th would seem to be a relevant date. Thus we take a look from a different market, the FX market (which never lies). This time, we wanted to look at the EUR/CAD cross. Indeed, this cross moved significantly in CAD’s favor since February 8th , as shown in Chart 2 below (source: Bloomberg):

Chart 2

But Chart 3 below (source: Bloomberg) provides us with a more fertile conclusion. It shows the EUR/CAD cross (orange) vs. the CAD/USD (white). It is very apparent to us that the shift out of the Euro and into the CAD started at the end of November, immediately after the Dubai credit event, and as rumors on Greece’s fiscal weakness were starting. This move out of the Euro and into the CAD has been slow but sure! The CAD/USD has been visibly more volatile, almost breaking the trend (remember the resistance at 1.075 CAD/USD?)

Chart 3

We have consistently held that the strength in the CAD did not spill over to Canadian assets, suggesting that it was driven by central banks’ reserve purchases. We believe this is now clearer than ever. Yesterday also, with bearish oil inventory data, the Canadian dollar kept its strength intact, touching 1.0275 CAD/USD intraday.

What to make of this?

Canada is receiving an important flow of capital. Going forward, those mainstream economists (which we could also fairly brand as “mercantilists”) that focus on commodities performance based on the global recovery path to understand the Canadian story will be disappointed. In our view, Canada is no longer just a commodity exporter. Canada is now starting to export “peace of mind”, which the world seems unable to find elsewhere. We made this prediction long ago, when on June 2nd , 2009 wrote:

“… The Canadian dollar should remain within a free and flexible exchange regime (including no further regulation on Canadian banks)”. The stronger the intervention is, the weaker the Canadian dollar ends. (…) Canadian stocks will not rise (as in the US), if the Bank of Canada relaxes its monetary policy…Canadian stocks are rising because foreign money is flowing in! And for foreign money to keep flowing in, Canada must show it can provide a stable currency. The world is starving for stability! All Canada needs to do is to remain quiet, while the rest of the world misbehaves and voices its anti capitalistic rhetoric.  In the world of the blind, the one-eyed country gets the big bucks!…” (“Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 )

We think this process in favor of Canada is in full force, unless Parliament Hill derails it, which is always, always possible. Two days ago, the Bank of Canada made clear (at least to us) that at the end of its conditional commitment period, in June 2010, an upward revision of policy rates will follow. This does nothing else but reinforce the appreciation of things Canadian.
With these winds, we fail to see weakness in Canada’s real estate sector and we want to be long Canadian equities, as they are driven by mining in precious metals, basic resources and boring banks.  Our propensity to fear that slack in global growth will indirectly punish Canadian valuations via lower commodities prices, is lower and lower, as the world comes to Canada to deposit their savings in a safe place.

Martin Sibileau

Please, click here to read this article in pdf format: march-2-2010

We will be brief today, for nothing of macroeconomic consequence has taken place in the past 24hrs. The action that caught our attention yesterday was in the foreign exchange market (the market that never lies). In particular, we refer to the action in the Canadian dollar. The cross with the Euro gained (i.e. the CAD rose against the Euro) 2.3 cents intraday, and although (or because) the TSX composite closed +0.85% higher, we can only deduct that the demand for Canadian dollars did not reflect a pari-passu demand for Canadian assets. Therefore, our intuition is that with yesterday’s calm, the demand for Canadian dollars that did not end in assets was a demand for reserve purposes, at a central bank. We are open to alternative suggestions to explain this phenomenon but any of these explanations would also have to address how the Canadian dollar did so perform on a day where neither oil nor gold rallied.

Was the CAD rally based on the news that the Canadian economy expanded at a 5%  annualized rate in the fourth quarter (faster than forecasted by the Bank of Canada)? We doubt it because a) the CAD’s sensitivity to interest rate gap (i.e. with the higher than expected growth rate the market revises its forecast on policy rates) has been low, and b) the strength was not uniform but clearly against the Euro.

On another note, in an interesting report, Bank of America estimated yesterday that approximately $160BN will flow to private investors by the end of 2010, as a result of the buyout of delinquent mortgage loans by Fannie Mae and Freddie Mac (refer: “The long and short of delinquency buyouts”, in Situation Room, Bank of America Merrill Lynch Credit Strategy, March 1, 2010). At “A View from the Trenches” we had anticipated the consequences of this operation back on January 4th, when we wrote:

“ …Since (our) last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells (us) that the USD strength will be only a relative notion in 2010. (We) say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)… “

We stand by these comments and the market is proving us right. What we did not grasp back then was the magnitude of this operation ($160BN of private liquidity) under certain loan delinquency level assumptions that can further deteriorate, if the recovery process disappoints. We invite readers to closely monitor activity in the GSE market for this is serious enough to keep the dream of asset inflation alive.

(Note: Mainstream economists use the term “asset inflation” to refer to bubbles, because their theory of inflation is wrongfully based on the non-neutrality of money, as implied by the exchange equation: M*V = P*Q. Therefore, they treat bubbles as an aberration that can only be addressed with regulation)

Martin Sibileau

Please, click here to read this article in pdf format: march-1-2010

Over the weekend, we came across an article from U.S. Congressman and former Presidential Candidate Ron Paul, with whom we sympathize (refer: www.ronpaul.com ). The article was titled “Are U.S. taxpayers bailing out Greece?” and published on February 16th (refer: http://www.ronpaul.com/2010-02-16/ron-paul-are-us-taxpayers-bailing-out-greece/ ).
Briefly, Mr. Paul wrote: “…Is it possible that our Federal Reserve has had some hand in bailing out Greece? The fact is, we don’t know(…)Unless laws are changed to allow a complete and meaningful audit of the Federal Reserve, including its agreements with foreign central banks, we might never know if this is occurring or not…”
Mr. Paul left us thinking, and after careful consideration, we realized that the implication of this exercise may (or not) be in contradiction with what we wrote on Friday. Let us explain:

To begin with, we believe that indeed, there would be a cost to U.S. taxpayers, if Greece defaulted. We don’t think Greece will default, at least not in the near term, but there would be a cost nevertheless. The cost is not explicit and it would show its ugly face if a credit event was triggered under a sovereign (i.e. Greece’s) credit default swap.

Why?

Any US financial institution with a net long exposure to Greece’s sovereign credit default swaps would face an immediate funding problem. Therefore, the Fed would be pressed to rescue such institutions, while at the same time, it would have to provide currency swap lines to the European Central Bank, to avoid a collapse of the Eurodollar market.

The cost regarding the financial rescue would be on US taxpayers. This would be an unnecessary and most disappointing cost. After so much “quatsch” on regulation, how would the current US Administration justify having missed a flag as big as that of sovereign credit default swaps. There is currently a lot of quatsch about sovereign credit default swaps, but all superficial. The economic ignorance of politicians prevents them from understanding what these derivatives really imply. As we wrote earlier, under a system of fiat currency, allowing banks to sell insurance on sovereign debt is no different than allowing children to sell insurance on the financial risk of their parents. But politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons. If somebody bought credit insurance on the parents of the seller of that insurance, be it the most educated, hardworking or honest kid, he or she would still be dreadfully misled by the formal aspects of the contract, which lacks any solid content. The solution does not reside in prohibiting them, but in requiring that collateral on such trades, at least on non-Emerging markets credit default swaps, be posted in gold. (Note: Why do you think I believe that a commodity collateral would not be required on credit default swaps on emerging market countries?)

On the other hand, the cost needed to save the Eurodollar market would be global. The global feature of this cost is driven by the violent foreign exchange volatility the world would have to bear, where the notion of a global reserve currency would be clearly challenged. This brings us back to the point made last Friday, when we wrote that a sovereign credit event would be deflationary, and that liquidity preference, in particular a strong demand for USD, would challenge the value of gold.

We kept and keep thinking about this one. Given the hypothetical nature of this event, we can only speculate as to what conditions would be necessary for gold to rally. The first one that comes to mind is a catastrophic situation, where the Fed actually bails both the financial institutions and the Euro market but the market no longer trusts monetary authorities and every USD facilitated by currency swap lines is swiftly bought with Euros and immediately exchanged for gold.

If you think this twice, you will acknowledge it would not be the first time a flight to safety of this nature takes place. In fact, it would make sense. But again, this should occur under a total lack of monetary policy coordination and something else: The firm conviction that stimuli programs are useless. This would be a true capitulation. What is the probability for this scenario? Not too high for now, but not too low either, in our view.

Martin Sibileau