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.

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

(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

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

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

We are back from a relaxing vacation and strangely glad to see that not much has happened since we last wrote. Indeed, the markets bounced from the lows we went through earlier this month, and we were stopped out on our short positions, as we invest on fundamentals, but trade like technicians.

Why do we insist that nothing really changed?
We have not witnessed a single catalyst on the Greek/Euro-zone situation. In the US, Bernanke only continued to confirm the Fed’s view of a weak recovery but recovery at last, while at the same time, he asked Congress to think about a fiscal exit strategy. China continues to expand output on its pegged currency and commodities, in our view, are starting to price unavoidable currency collapses.

We believe that by now, it is self-evident that the world has lost one of the most important functions money provides: Its use as a unit of account. Please, take a moment to think about this, but not in the standard way you have been taught to. Do not think of the USD as a unit of account. Do not think of the EUR for the same reason, or any other currency. Why? Because production, distribution, sales, collections, etc. today are global processes. If you don’t believe this, just look around you. Look at where your watch was manufactured and think of all the different components that had to be assembled, the raw materials that had to be used, where they came from, how they were purchased, paid for and, as important, think about what each of the entrepreneurs responsible for these operations did with their respective profits. What currency did they invest them in? What was the volatility of those profits, after adjusting them for their currency crosses (inputs vs. output)?
If the world wants to continue growing, it will need a strong reserve currency. There is no such a thing today. Yes, the USD continues to be the world’s reserve currency, but by default. And this does not and will not foster economic growth. Hence, our bearish outlook.

We recommend the reader to watch a recent interview (Feb. 21st) with Greece’s Prime Minister George Papandreou, by Andre Marr, at: http://www.youtube.com/watch?v=EJP1Z85Hs9g . This interview painfully reminded us of Argentina’s Plan Blindaje, in 2000-01, when it was announced by the then President De La Rua. We wrote before that Greece’ situation is not comparable with Argentina (refer: www.sibileau.com/martin/2009/12/17 ), but the similarities are striking.

This brings us to our final point. We read today’s Morgan Stanley’s Global Monetary Analyst research note titled “Default or Inflate or…”. In this note, Morgan Stanley’s Global Economics Team suggests that neither defaults nor inflation are likely or even optimal for sovereigns. There are many reasons for this conclusion, which we will not deal with here. However, because of this conclusion, the authors of the note propose that governments in developed countries will push banks to purchase and hold their upcoming debt issuances, “as a prudential measure”. This did actually occur in Argentina and it was precisely what led to the financial collapse of 2001. We admit we had thought about this many times before in 2008. We even thought that the US ownership of banks after their respective bailouts had no other final purpose but to later have the power to steer their portfolio allocation decisions. In particular, we thought that by owning Citi, the US government could raise deposits outside the US to buy Treasuries. Call us crazy, but stranger things have happened…

However, we believe there is merit to this suggestion, although it is a bit early to worry. Under this scenario, there are two issues that concern us. First, this would have an immediate and meaningful crowding-out effect on the private sector. If this was the case, we would even consider another jump in default rates, particularly in the high yield space, which according to Bank Of America (“HY Maturity Wall – How big a Worry”, in “Situation Room” Report, Feb. 23rd , 2010) will see over 85% of all loans outstanding mature between 2012 and 2014. Second, we are concerned about the sovereign credit default swap market, which we think is the real weapon of mass destruction. Strangely enough, no regulator has set its eyes upon it yet and honestly, we don’t think they ever will. It is in the sovereigns best interest, as issuers, to ensure that investors buy their issuances comfortably, under the misleading belief that the systemic risk entailed in such purchases is hedged away with these swaps.  But we ask who in his/her right mind would feel safe buying sovereign risk protection from banks that a few months ago could only obtain liquidity under the guarantee of the same sovereigns they now sell protection on, banks which would be forced to invest up to a considerable percentage of their portfolios in sovereign debt? Is this not as crazy as having children sell insurance on their parents’ financial risk?

Martin Sibileau

(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)

The statement released by European authorities yesterday was a mere expression of support for Greece, explicitly denying a request by Greece, for financial aid. The markets accordingly sold all things European, including and in particular Spanish financials. The picture does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.

What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for $16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended 4bps steeper at 285bps. The Czech Republic was also deceived when it raised 15-yr debt on Wednesday and Greek banks seem to be facing funding problems. We also face significant uncertainty with the latest developments in Iran.  But on the other hand, the markets received some “optimistic” releases too. Continuing job claims in the US kept their downward trend, Australia also saw an improvement in its labour market and the CPI reading in China was stronger than expected.

Briefly, of one thing we may be certain: Capital is flowing out of the Eurozone and into the rest of the world. But at the same time, capital seemed yesterday to also be preferring commodities and basic materials, which puzzles us, because the macroeconomic backdrop is bearish for us.

In our view, we should not see yesterday’s rally in North American stocks and credit, as well as in crude and oil, as a bullish signal, after the EU meeting’s statement. Why? Because for this rally to be interpreted as bullish, the Euro should have rallied as well! It didn’t and in fact plunged from a tall cliff, specially against the Canadian dollar. A reduction in the purchasing power of the Eurozone should not be seen as something positive for global growth (= for oil demand and hence for the Canadian market!)

Interestingly enough, Freddie Mac yesterday announced that it will buy practically all 120+days delinquent mortgage loans from its fixed rate and adjustable rate mortgage Participation Certificate securities. We had foreseen a move of this type and discussed it in December and on our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:

“…As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity. In December, I associated this process with USD strength. Now, I am not so sure. Since my 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 me that the USD strength will be only a relative notion in 2010. I 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)…”

Back to the impressive strength shown yesterday by the Canadian Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At close, 1.05 were enough. The CAD was even stronger of course vs. the Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted such a move?  In our view, the strength in the CAD was not fully reflected in the stocks market (TSX 60), which closed +1.32% higher, at 11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.

Martin Sibileau

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau

We’re back and still concerned about the situation the capital markets face and will continue to face. Essentially, (we differ with the mainstream view and) we stand by our interpretation that Europe does not face a short-term liquidity crisis, but an institutional crisis. Institutional economics is one of those underappreciated and misunderstood branches of Economics (in our view, if economists had properly read Von Mises’ “Human Action”, Institutional Economics or Behavioural Economics would have never taken off as disciplines. Perhaps the best known economist within the Institutional tradition is James Buchanan (1986 Nobel Memorial Prize), but we also enjoyed very much and recommend reading the works of Peruvian economist Hernando De Soto).

The institutional economist asks the following question: “If the European Union is actually not a Union, but a Confederation, why should Euros be held as the world’s alternative reserve currency, instead of Canadian Dollars or Australian Dollars or Swiss Francs?” We think this is a valid question and a question markets are asking as we write. But first, let’s briefly describe what a Confederation and a Union are:
Confederations are alliances of sovereign states. “…In a Confederation, the links among members are weaker. The legal instrument of the alliance is a “treaty”. The purpose of a Confederation is economic integration and military assistance among members. Member states remain sovereign and as such, keep the powers of self-determination. Confederated states reserve the right to nullify, reject legislation and eventually, of secession. They may issue currency, keep customs and sustain armed forces. They lack a strong common government, although they may unify their foreign policy.
In a Union, the links among member states are more vigorous. In a Union, one finds a definitive purpose to integrate the states. There is a sovereign federal government, while the states are autonomous. The states can govern themselves, have their own legislation, but these acts are subordinated to the Union’s constitution and federal laws. Secession is not allowed, although member states conserve those rights that they did not delegate to the federal government, when the Union was established….” (our translation from “Curso de Derecho Político”, H. Sanguinetti, 4th Edition, 2000)

As investors, what should we interpret as a catalyst, as a defining moment?  Here’s our view: If the IMF has to intervene, the European Union will definitely be a Confederation. This is unfortunately the path of least resistance. This is the easiest and less painful path.  If the IMF is engaged, the Euro will no longer be considered an alternative global reserve currency and the bid that there was under such belief will no longer be there. We shall be sellers of Euros under this scenario. This is the worst-case scenario, for if the EU citizens lose purchasing power, the global recovery will become a long-term dream. Note that we don’t care about Debt/GDP ratios or other metrics. The relevant issue here is that on the margin, the Euro would no longer offer more safety than other strong, healthy currencies. In fact, its complex institutional framework would be a burden, compared to other ones, simpler to understand.

In the world of corporate credit, when lenders are not satisfied with the credit quality of borrowing subsidiaries, they may demand cross-guarantees, in addition to an irrevocable guarantee of the parent. Unfortunately, this cannot happen with sovereign debt. The more difficult and painful path for the European Union is to stand up to the challenge and lay the ground for a stronger integration, under a central government that can provide legally and operationally a guarantee for not just the debt of Greece, but of any other state under stress (i.e. Portugal, Spain, Ireland).

Such integration demands political will and time. Unfortunately, the world lacks both. Therefore, we were very suspicious, when at 12:19pm yesterday, Bloomberg announced that Germany was considering assisting Greece. In fact, we smelled something wrong earlier, when after 10am, the Canadian dollar broke its correlation with oil (chart above, source: Bloomberg).

At 11am, it was clear that the source was the cross with the Euro. Somebody knew something that the rest of us ignored (chart below, Eur/USD, source: Bloomberg). And then, the rumor was officially out at 12:19pm, that a member of the German’s Christian Democratic Union had said Germany was considering assisting Greece. The Euro had gained 1% and profits were immediately taken!

We are of the view that the market sold into this strength, for if it the rumor had had real merit, the bounce should have been way stronger. However, we are also concerned about the existing misinformation. As we write (11pm ET), the “Frankfurter Allgemeine” (at 11:02pm ET) reports Mr. Joaquín Almunia (ex-economy commissioner, since Feb 10th, according to Bloomberg) to have only expressed that the European Union should promise protection to Greece. However, Madrid’s “El País” reports that the European Union and Germany are preparing a package for Greece. Le Monde and Financial Times back the latter interpretation.

All we are certain of is that a European plan should put the IMF alternative farther rather than closer, and that’s a good thing. However, a plan for Greece is hardly going to solve the situation, for it is the European Union that is in crisis, not just Greece. And the upcoming strike of public employees in Greece is not going to make life simpler.

Martin Sibileau