Today, we think it would be important to leave the analysis of the latest news aside (including the negotiations on Greece’s debt) and instead, to present a theoretical framework that may allow us to understand the ongoing rally and what may develop during 2012 and beyond. There is nothing more practical than a good theory and a good theory is indeed what we are looking for this morning.

Let’s first examine what we are witnessing today, namely the financing by the Fed and the European Central Bank (“ECB”), of the Eurozone financial system. Below, we describe how it works and we carry the analysis to the extreme. We like challenging models to their extreme implications, because this aprioristic deductive exercise forces us to identify what mainstream economists, many months later than us, usually end up calling “tail risks”.

In step 1 above, we see the first pillar of the EU financial system bailout: The Fed extending US dollar swaps to the ECB, at below market rates. As can be seen, these swaps are an asset of the Fed and a liability to the ECB, which receives US dollars in exchange. With these US dollars, as we explained on December 12th, the Fed avoids a liquidation of US denominated assets by EU banks and the resulting increase in the cost of US dollar funding as well as in counterparty risk, for US financial institutions. These swaps can therefore be seen as vendor financing in favor of US banks, at the expense of American taxpayers and anyone who invests their savings in US dollars (i.e. US banks, via the Fed, provide cheap financing to their trading counterparties, all paid for by a devaluation in the purchasing power of the US dollar. On this matter, please refer our comments on September 12^th, 2011).

However, the extension of USD swaps is not enough to save the status quo. The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB, as shown on step 2. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits. That is shown, as step 3.

On step 3 too, we see that these funds keep open the window for depositors in weak banks to continue the liquidation of their deposits, in exchange of fresh cash. On the other hand, once the governments sell their bonds to the banks, they distribute the Euros issued by the ECB across the Eurozone.

Finally, on step 4, we see the conversion of these Euros by EU depositors and corporations, into US dollars (or Swiss Francs or gold), as a way to protect their savings from the unsustainable status quo: They know that the EU fiscal deficits will remain alive and have uncertainty on the future of the monetary system. Who provides them with the window of opportunity to exchange their Euros for US dollars? Ultimately, the Fed, with the provision of cheap US dollars to the ECB, via swaps.

This circular process, in extremis, brings us to the final line in the graph above, where we show the balance sheets of the Fed, the ECB, the EU banks and the EU depositors & Non-financials. The Fed will own US swaps against which US dollars will have been printed. Yes, printed! This had occurred in the 1920’s and 1930’s, but at least back then, those US dollars were somehow backed by gold reserves. Today, that’s no longer the case. Who will have the US dollars owed to the Fed? Not the EU banks nor the ECB, but the EU depositors & Non-financials! In summary, the people of the Eurozone!

In extremis too, the balance sheet of the ECB will look like that of a middle man. As assets, it will carry long-term refinancings. As liabilities, it will have the US swaps, that it extended to the EU banks. These EU banks however used the euros to buy sovereign debt, which is now their asset, and owe euros (i.e. LTROs) to the ECB. This is a very unstable situation, because if the fiscal situation of the Euro zone does not improve, these sovereign bonds in possession by the EU banks will remain driving capital losses.

This analytical framework leaves us with questions:

If the Fed ends up being the creditor of the EU depositors and corporations…how will it ever get its money back? What will be needed to repatriate these US dollars? We think there are only two ways to solve this problem. The best case and least likely is to see an improvement in the fiscal situation of the Euro zone. If deficits were stabilized or even reduced, the sovereign bonds held by the EU banks would drive capital gains, euros would flow back again to the EU banks in the periphery and US dollars would have to be sold in exchange, to buy these Euros. The EU banks would be then in a position to both return the LTROs and the US dollars to the ECB. The worst case occurs if the Fed implements an exit strategy, raising US dollar interest rates and US dollars flow back to the US. This is also not likely, at least in the short-to-near term, in our view. This would require, a priori, a strong economic recovery.

Another interesting question is related to the Euros in circulation, supplied by the LTROs: What happened to them? In extremis, we see that the EU depositors and Non-financials first took these Euros from the EU banks and later exchanged them for US dollars. Were they taken out of circulation? No, but the velocity of circulation increased, from the ECB to the banks, to the people, and back to the ECB. This is consistent with the monetization of sovereign debt and a context of high inflation. Once again, we note that this analysis is in extremis…For now, we can see it as a natural logical consequence. To mainstream analysts, this is a “tail risk”. The reader is of course free to take a view on this matter.

Please, note that this analysis implies the survival of the Eurozone with the liquidation of sovereign debts via inflation.

Is this status quo sustainable? If not, what will accelerate its demise? How will gold and the rest of the risky asset spectrum behave? Below, we present a flow chart, where we seek to summarize this process.

As we can see, as backdrop to the process described above, the Euro zone today is crowding out private investments, given the high cost of sovereign debt. In addition, it has and continues to implement higher tax rates and further interventionism and financial repression. With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unadressed. All these factors only contribute to prolong the recession and a high unemployment rate.

The flow chart is clear: As long as the people of the EU put up with this situation and the EU Council, chaired by Mr. Herman Van Rompuy effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain. If people revolt and the EU breaks up or if the Fed is no longer politically strong enough to force these swaps, the status quo will collapse.

Contrary to popular belief, this status quo is based on the “coupling” and not “decoupling” of the Fed with the ECB. This coupling relaxes correlations, because the US dollars sent by the Fed to the ECB were printed and nobody in the US feels the immediate pain. Hence, we have the rally in stocks and gold, without any correction in the US Treasuries market.

Whenever the political sustainability of the EU is challenged, we will see a run for liquidity. And 2012 will have many of these panic situations, affecting any late longs in gold or stocks.

Finally, when the “decoupling” takes place, the US dollar can only remain strong if the fiscal situation of the US permits. But we fear that the Fed will embark on interest rate targeting. This is a story for another letter…

The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo.

Martin Sibileau

This is our first letter of 2012. The year started with a mini rally that every analyst out there attributes to something called “decoupling”. Why? Because the strength in asset inflation, although global in nature, is particularly more solid in the US.

The oddity appears to be higher asset prices, in spite of a weaker Euro, in a Eurozone whose main problems remain unsolved. Correlations are breaking! say analysts, at every opportunity they have to speak to the media.

We want to start the year tackling this issue, which we feel is very important to understand. Without mincing words, we will say that the concept of “decoupling” is completely wrong and if followed, it will lead to wrong conclusions and horrible investment decisions.

The fall in asset prices during the last quarter of 2011 was triggered by a run for liquidity, typical of fiat currency systems or systems with leverage. Euro zone banks had to sell USD denominated assets to raise liquidity, lifting the price of the USD and putting pressure on the rest of the risk asset spectrum. This was addressed in November, when the Fed confirmed its commitment to continue extending USD swaps to other central banks, at a reduced price of 50bps. At “A View from the Trenches”, not only have we dealt extensively with the mechanics and implications of currency swaps but also, we believe we would not be mistaken if we said that we were the first and only ones to point to its relevance, way before anyone else in the market. For instance, in February 2010 (almost two years ago!), we warned:

“…that France did the same (in the 1920s) that we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment…” (refer: www.sibileau.com/martin/2010/02/26 )

How relevant was this action taken in November? The chart below (source: Bloomberg) shows us how the price of the 3-month EURUSD swap reverted after November 30^th:

How consequential was the amount of swaps extended by the Fed? The next chart (source: Bloomberg)gives some perspective, showing what the Fed extended in 2008, vs. what occurred last November:

The spike is certainly visible. Back in 2008, the deleveraging was just starting, so it would seem unlikely to us to see those levels again. However, we must not underestimate the magnitudes seen in November and the sovereign problem ahead, particularly if it threatens to break the Euro zone. In light of all this, it is clear to us (and not to the rest, apparently) that rather than a decoupling, we are seeing a huge coupling. In fact, we are witnessing the mother of all couplings! As we explained on December 12^th, the Fed is bailing out the European Central Bank, because without US dollars, the run for liquidity in Europe would result in a general run against the ECB. But since December, the ECB is now also financing on a 3-yr basis, the liquidity, in Euros, of the Eurozone banks. There is plenty of speculation as to what the Euro zone banks do with that money but we think it is safe to say that at least, they are not forced to liquidate assets. On the accounting analysis of the 3-yr financing, we found a very interesting article, by Izabella Kaminska, at FT Alphaville, named “The curious case of ECB deposits”.

In summary, the mother of all couplings consists in linking the balance sheet of Euro zone banks indirectly with the Fed: The Euro zone banks get cheap liquidity from the ECB in Euros, supported by the US dollars provided by the Fed to the ECB. Asset are not sold now and in fact, they could actually be purchased later, if the sovereign crisis in Europe was to be addressed.

What does this all mean? Well, as we explained on December 12^th, this printing of billions of US dollars by the Fed to back the ECB means that Americans need not to save any extra, to bail out Europe. This is what puzzles mainstream economists, who refer to this “oddity” as a “break in correlations”. The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps. Such a sell off would bring down the price of every single asset vs. the US dollar.

Now that we have clarified this point, we must ask ourselves how this should impact gold. On this point, we must say we are now in uncharted waters. Yes, the swaps are nothing new, but the context in which they unfold is. With this in mind, we think that the rhythm in 2012 will be marked the evolution of the fiscal situation in the Euro zone. On Friday, we saw a massive downgrade in sovereign risk by S&P that was fairly priced in by the market. Going forward, further deterioration or default surprises will accelerate the pressure on Euro banks, which in turn will force the Fed to become more coupled and to print more US dollars. We think that in this context the volatility and the bull trend in gold should both increase.

Why would we not also want to buy stocks? Because we follow the view of Friedrich Von Hayek: We believe that this process is also affecting relative prices everywhere and when relative prices are distorted, in the long term, production falls and we end with a higher amount of money in circulation, available to purchase a smaller amount of goods. Inflation, in the long term, always bankrupts producers and benefits the holder of products. If you don’t believe us, ask gold miners how they feel about the performance of their stocks vs. that of gold bullion.

Martin Sibileau

Please, click here to read this article in pdf format:december-22-2011

In the absence of further meaningful events, this will probably be our last letter of the year. Reflecting on our main macro thesis, things have played out the way we thought they would. Not from the beginning of 2011, but from the beginning of 2010. That’s right, already back in 2010 (refer for instance our letter from May 3^rd 2010: www.sibileau.com/martin/2010/05/03 ) we envisaged a scenario exactly like the one we’re facing today. Back then we wrote:

“….It has become clear and public that European sovereign debt is being and will continue to be bought by European banks backed by the ECB, making the sovereign risk contagion back to the financial system a done deal. Therefore, how safe are those who bought sovereign credit default swaps (“cds”) from banks that are now exposed by the sovereigns?…We have mentioned this ignored side of sovereign cds in previous letters (for instance, refer: www.sibileau.com/martin/2010/03/01 ). How this issue is not discussed while every regulator in the world is still looking for ways to reduce systemic risk is beyond our understanding.

If sovereign jump-to-default risk increased, the ECB would most likely monetize sovereign debt (actually, the ECB is already doing it), further devaluing the Euro. But as long as no sovereign defaults, things will be under control. However, if a Eurozone sovereign ended in a credit event triggering the cds contract…How bad would the run for liquidity to the USD be? CDS contracts on European sovereigns trade in USD.

How much would counterparty risk (=risk between the banks that traded the cds) jump? Is the size of outstanding sovereign debt and that of the cds net notial useful to assess the impact? We think not and we guess that anyone downplaying this issue based on the size of Greece’s cds net notional outstanding doesn’t understand the leveraged nature of capital markets. Are Greece’s funding needs in 2010 not minimal compared to the impact they are causing?

The next question is whether gold would rally or fall. To answer it, we have to speculate on whether the Fed would or not extend currency swaps to the ECB to avoid the collapse of the Euro. The Fed did so in Sep/Oct-08, upon the Lehman event, and we believe the Fed would so again, which brings us to the another point… What is riskier?:

a) To have the Fed extend currency swaps to the ECB to provide liquidity to the financial system for clearing purposes (as in post-Lehman) or…..

b) to have the Fed extend currency swaps to the ECB, as a ultimate back-up on liquidity on sovereign debt?

In the first scenario, should gold not sell? (It did). In the second, should gold not rally, as a sovereign default causes the collapse of the Euro (our base case assumption here)? Would American taxpayers ever get their monies back if the Fed extended those swaps to the ECB under the second scenario?…”

What we did not anticipate is that it was possible to start in scenario (a) above, and as we think will occur during 2012, transition to scenario (b). It may now be possible that these scenarios be not mutually exclusive, as we imagined then 19 months ago, but linked with one preceding the other.

Recapping the year, we should say we had a bit of cautious optimism, back in January, when we thought there would be agreement to use the EFSF to purchase sovereign debt in the secondary market. In perspective, we realize that the refusal to go this path by Germany in March, marked the death sentence of the Euro as we know it.

The debt ceiling negotiations in the US, including its sovereign risk downgrade by S&P, and the latest drop in reserve requirements in China are symbolic of what we will see in 2012.

The view from the rest of the world is also murky. In 2011, we witnessed the fall of dictatorships in the Arab world, without any clarity on what will follow. The same applies to North Korea. South America is divided into a right-leaning block (Chile, Perú, Colombia) and a left-leaning one (Venezuela, Ecuador, Bolivia, Argentina), with Brazil still trying to figure out which way it will go. We believe it will go left. It’s the path of least resistance.

Overall, there has been disintegration in global trade, with the irony of a convergence in risk, between the developed and the emerging world. The first are being downgraded, while the second have been upgraded.

What next?

We think 2012 will see a rebellion of the people. On the economic front, they will likely repudiate the financial status quo, with an increasing run on deposits, perhaps even at a worldwide scale. On the political front, we will see a fight to retake democracy. In Europe, that may mean not just the fall of the Euro but also of the European Union. In the US, the rise of Ron Paul and if not him, his ideas, may create a serious schism in the Republican Party, in favour of Obama’s re-election. In China, the rebellion should proceed at a slower pace, but steady nonetheless, as prices increase.

Back to a shorter term view, as the reader is already aware, yesterday the long term (3 year) refinancing operation resulted in almost Eur489 billion being borrowed by 523 banks. A lot has been said and written. All we want to add here today is this: We must keep in mind that all this does is to prevent the further sale of assets (sovereign) by Euro banks. Nothing else. If sovereign ratings are further downgraded, the respective losses will still have an impact. If fiscal deficits persist in the Eurozone, the value of the sovereign debt will fall and will still have an impact. If investors are further affected by the Greek situation, the value of sovereign debt will fall and will still have an impact. As you see, the substance of the problem remains alive. All eyes will be on the Fed, which will have no alternative but to remain financing the rest of the world via currency swaps.

This situation however leaves us with uncertainty and uncertainty breeds volatility. Gold and the rest of the risky assets will have a hard time.

We wish you all a prosperous 2012!

All the best,

Martin Sibileau

Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

Martin Sibileau

]]> http://sibileau.com/martin/2011/12/12/the-fed-already-started-qe3-but-in-the-eurozone/feed/ http://sibileau.com/martin/2011/12/05/the-detail-nobody-talks-about/ http://sibileau.com/martin/2011/12/05/the-detail-nobody-talks-about/#comments Mon, 05 Dec 2011 04:00:11 +0000 Martin Sibileau http://sibileau.com/martin/?p=1892

Click here to read this article in pdf format: december-5-2011

Today we want to write a few comments on the news last week, of the IMF receiving loans from central banks from the Eurozone, to buy EU sovereign debt. We certainly don’t know if this will work out or not and by the amounts that were speculated (EUR200BN or more). But there is merit to make a few observations at this point:

1.-We think the most interesting detail here, to which we believe little attention was paid, is that it will “apparently” be national central banks and not the ECB, that will lend the funds to the IMF, to purchase sovereign debt (“apparently” being the operative word here). Why do you think this would be relevant? It would not, if you were not considering an eventual break up of the Eurozone. But if that scenario plays out, the clearing of sovereign debt will be much easier. In other words: this way of monetizing sovereign debt eventually allows an orderly dissolution of the Eurozone.

2.-As usual, it will be interesting to see whether the funds are used to buy in the primary market (i.e. direct funding of governments) or in the secondary market (i.e. funding to bondholders). We suspect that given the limitations in size and the level of yields the Euro zone is facing, the funds will be exclusively used in the primary market. This has a negative impact on the pricing discovery process. We may see a funding stress on the existing bondholders, impacting the USD funding market and eventually leading to USD swaps at cero cost from the Fed. In summary, we would see more “inelasticity” from the markets (refer our last letter), with apparently sustainable high yields in sovereign debt. These situations very often lead to frustrated policymakers, who see no alternative but to increase the level of financial repression.

3.-If the IMF buys debt from governments, and the banks who hold past issues of government debt face funding problems, we assume the banks will still need liquidity lines from the ECB. Should we not see a transfer of these liquidity lines to national central banks? Which banks would benefit? Which ones would lose?

4.- What will occur with the sovereign debt that the ECB has already purchased since May 2010, through the Securities Markets Program? Will it also be transferred to national central banks?

5.- Will points 3 and 4 be contemplated in the next EU summits, when fiscal integration is discussed? How would the markets take the news, if they actually are?

Needless to say, lending printed money to the IMF to buy sovereign debt is to simply leverage the problem, without addressing its root. While every analyst dismissed the Greek problem at the beginning of 2010, saying that it was only a liquidity issue, we were the first and perhaps only ones to go on record saying that the Eurozone did not face a liquidity or solvency problem, but an institutional problem (See our letter from February 8^th and 10^th, 2010: www.sibileau.com/martin/2010/02/08 and www.sibileau.com/martin/2010/02/10)

On February 10^th, we wrote: “…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…”

What could save the Euro? A real fiscal integration. By this we mean a structure where a EU wide federal tax is charged to all the Eurozone citizens, to allow transfers to countries in trouble. If this worked, this federal institution could issue its own bonds, Eurobonds, that would later be swapped to the IMF, in exchange for the national sovereign bonds that the IMF would purchase. This is the only way to save the Euro, and we think it is already too late to implement.

Martin Sibileau

Please, click here to read this article in pdf format: december-1-2011

The coordinated action of central banks yesterday changed our short-term view. We had written in our last letter that we expected the fragile global financial system to collapse, with people taking matters into their own hands and, as Murray Rothbard once described: “…insisting 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…”

Until Tuesday, we were certainly in that direction. But the announcement of cheaper US swaps from the Fed to the European Central Bank (“ECB”) has now lengthened the day of reckoning. What makes us think that we were right about the direction? Over the last two weeks, the Eurozone banks kept steadily increasing the utilization of liquidity lines provided by the ECB, the Euro/USD swap basis (i.e. the price that the Fed precisely wants to keep under control) continued to widen to 165bps, and lastly, on Tuesday, the ECB failed to sterilize all the money they printed to buy EU sovereign bonds.

Therefore, as we can see, the markets had become “inelastic” to prices, in their demand for liquidity. They kept bidding for it were it was supplied, they paid for it way above the “official” price (100bps was the “official” cost of a EU/USD swap and the LIBO rate did and does not represent the true cost of funding) and they did not find the price offered by the ECB good enough to let liquidity go back home (i.e the central bank). This last point, the failure to sterilize, is important.

As per the figure below, to keep the quantity of Euros printed to buy debt unchanged (Step 1), the ECB immediately issues short-term debt, which the banks, which had sold that toxic debt, buy. When they buy the short-term debt, they give their euros back to the ECB.

This worked well since May 2010, when it was first implemented, until last Tuesday. This week, the banks did not purchase all of the ECB debt. Why? Was the yield offered by the ECB not good enough? No. The problem is that you can’t pay EU banks enough to let those hard earned Euros go. Why? Because these banks were already beginning to see deposit withdrawals. All these signals confirmed to us that the endgame was near and that it was the collapse of the Eurozone.

But yesterday’s announcement of cheaper EUR/USD swaps starting December 5^th kicks the proverbial can down the road…again! Now, at “A View from the Trenches”, we have shown leadership in communicating to readers what a disgrace these swaps are. They transformed the recession of 1930 into the Great Depression, as Jacques Rueff documented in his book “The Monetary Sin of the West”.

With this move, Germany, who resisted the pressure to allow the ECB to monetize sovereign debt purchases, got the rest of the world to finance the deficits of the Eurozone. In particular, they got American taxpayers and everyone else in this planet who keeps his/her savings in US dollars, to finance them. Germany held the world hostage and Germany won!

Rather than liquidate those banks that were forced to hold sovereign debt (yes, forced!), generating a formidable credit crunch, the big global banks that had these unfortunate banks as counterparties, successfully lobbied the Fed to extend a blank cheque to them (i.e. the unfortunate banks), so that they do not go bankrupt. Was it for free? Or is there a commitment from the EU to also embark in monetization, in December? We don’t know, but we suspect that the Fed would have not risked this move without some sort of compensation from the EU. Therefore, although money is not necessarily being created, the fact is that USD denominated assets that would have had to be sold by EU banks to shore liquidity, no longer need to be sold on the margin. This was a real transfer from Americans, who saw their purchasing power devalued immediately with the news, to the Eurozone banks, and the shareholders of those global banks who have them as counterparties.

The last aspect we want to remind the reader of is that through these swaps, the Fed is indirectly exposed to the future defaults in the Eurozone. Given their view on the problem, it is only logical to expect the Fed to push US dollar liquidity to extremes, as the root of the problem, the Euro deficits, remains in place. At the end of this much delayed story, the only winner will be gold. This monetary policy can never result in genuine growth but in inflation and we know that with inflation productivity falls.

Martin Sibileau

At this point, we would like to take the time to summarize a few ideas and to provide more clarity on where we have stood and continue to stand. Revisiting what we wrote on May 2010, at the time when the first bailout package for Greece was put in place, we see that almost everything we forecast then is unfolding now before our eyes. The reader only needs to click here (refer to scenario 2: “ECB sterilizes PIGS debt purchases issuing short-term debt”) verify. The main points were:

“…there cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system:

a) What if the so-called “short-term” ECB debt backing deposits is indefinitely rolled over and depositors see the risk and decide not to renew deposits?

b) If the ECB becomes a riskier bank, its currency will (actually is) no longer be considered an alternative reserve asset and the propensity to exchange it for gold or USDs will increase exponentially. If so, what was the wisdom behind Sunday’s decision by the central banks of the USA , Canada , UK , Switzerland and Japan to provide currency swaps to the ECB? Are currency swaps all of a sudden a “free lunch”? What for were the balance sheets of these institutions compromised? Who pays for it? Should the senior management of those central banks not be audited for decisions of this sort? Who is accountable?

This analysis suggests there could be a generalized run against the Euro as a currency…(…)

Another aspect here is that as this process takes place, the credit quality of the loans held in the Euro-zone banks would quickly deteriorate, further weakening the ECB position.

Would this lead the world to the end of paper money?

We have written many times before, that we were amazed by the fact that regulators did not understand the systemic nature of sovereign credit default swaps. These swaps, which in the case of Euro-zone sovereigns are denominated in US dollars would be the link here, connecting US financial institutions with Euro liquidity problems.

The Fed last Sunday already extended currency swaps to the ECB in a very murky way, which even caused a heated debate in the US Senate. What do you think would happen under a terminal situation, where the European banks’ risk as counterparties would jump exponentially?

And then, friends, would you hold US dollars as a reserve asset, knowing that they are thrown into a hole to fight the last battle? Doesn’t this actually make gold look like a bargain at $1,240/oz?…”

All of these concerns/predictions have materialized the way we imagined them. The last act here is to see the systemic implosion of the sovereign credit default swaps. When we finally see the respective defaults, we will realize the severity of it.

There is however one side to this story that we have overestimated. We thought that with the USD swaps extended by the Fed to the ECB, the pain, the cost of USD liquidity would be contained. What we see today, a EURUSD swap basis of more than 125bps and comparable to 2008, is not what we had in mind. But if so, can’t we say that gold at $1,724/oz is resilient?

To summarize, since May 2010:

-Our predictions on the dynamics in the Eurozone have proved correct

-We have not yet seen the unfolding of the systemic risk hidden behind sovereign credit default swaps

-We wrote that eventually the Fed would step in to provide USD liquidity, but we overestimated its impact. So far, the markets are shrugging it off.

This last point is connected to our last two letters, which put us on the contrarian side. Why? We clarify below:

-What the market collectively believes:

The market at this point seems to believe that the ECB still has time to step in, buy unlimited amounts of peripheral sovereign debt and, in so doing, avoid the collapse of the Euro zone.

-What we believe:

We believe that even if the ECB stepped in, the collapse at this point is unavoidable. And as we wrote on November 7^th, ten days before the controversy between France and Germany would become public (see: http://www.bloomberg.com/news/2011-11-17/france-renews-pressure-for-ecb-to-finance-euro-bailout-fund-as-yields-rise.html# ), we think the break up is most likely to be triggered by France leaving the Euro zone. On November 7^th, we wrote:

“…the increase in Italian sovereign risk will affect French banks more than German banks. The endgame here is France leaving the Eurozone, as it becomes evident that the German lobby on the ECB forces France to recapitalize its financial system at a prohibitively high cost. France would be better off recapitalizing/nationalizing its system in French Francs. But if France leaves, there is no Eurozone…”

Now, our pessimism on this issue has increased over the past week. Why? Because of two things:

-Thing 1:

We were reading Murray Rothbard’s “America’s Great Depression” (www.mises.org/rothbard/agd.pdf ), which according to the famous British historian Paul Johnson, “…brings the world of economic history (…) vividly to life, and which contain so many cogent lessons, still valid in our own day…”. In his chapter 12, under the title “The Attack on property rights: The final currency failure”, we have a vivid description of the year 1933, when American depositors ran for liquidity in different states. The Fed provided all the liquidity necessary, just like politicians outside Germany are demanding that the ECB do, but even then, Mr. Rothbard tells 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. The reaction to this growing insistence of the people on claiming their rightful, legally-owned property, was a series of vigorous attacks on property right by state after state. One by one, states imposed “bank holidays” by fiat, thus permitting the banks to stay in business while refusing to pay virtually all of the just claims of their depositors…”

Unfortunately, we think this is the most likely scenario in the coming weeks/months: People will take matters into their own hands! This scenario is consistent with the indifference we see today in the USD liquidity market, vis-à-vis the swaps extended by the Fed. The market doesn’t care! Policymakers, take notice: A rigorous testing of the global baking system is underway!

-Thing 2:

Thinking on the necessary conditions to break the Euro zone in an orderly fashion, we concluded that it is an unfeasible task. If it breaks up, it will be amidst chaos. Given its complexity, we will not address this now, but can say this: An orderly break up of the Euro zone would require a SIMULTANEOUS Euro-wide bank holiday (a week-long), after which the following would have to emerge: a) new national banks backing their respective currencies with a common denominator: gold and a basket of foreign exchange reserves, b) credits from different former EMU nations against the equity of EMU-wide recapitalized banks would have to be cleared, and c) the value of the local currencies against gold and the foreign exchange would have to be flexible, allowing capital flows and the testing (by the market) of the new national banks’ solvency.

Under the existing political conditions in Europe, we are not even close to seeing this. We fear chaos of the worst order awaits (and we haven’t even begun to analyze the US deficit dealings by the Super Committee).

Martin Sibileau

The events triggered during the last 24 hours warrant a short update on our last letter. As we noted then, we could either assume that (a) the ECB (i.e. European Central Bank) holds the line with sovereign bond purchases or (b) on the contrary, it accelerates them.

Please, please, pay attention to the following: When you think about (a) or (b), you further assume that there exists indeed an entity named “ECB” or European Central Bank. This should be rather obvious except that yesterday, “…EU sources told Reuters that German and French officials had discussed plans for a radical overhaul of the European Union that would involve establishing a more integrated and potentially smaller euro zone…” (refer: http://www.reuters.com/article/2011/11/10/us-eurozone-idUSTRE7A831520111110 ).

Now…this changes everything! This, if it is not seriously denied, will trigger a run against banks in the Euro periphery. This is in our view the most unfortunate move any policymaker should have made. They made it because they wrongly think they are still in control. They are not, so there is no upside in telling the market that they consider a break up. The market will tell them when and how!

Until yesterday, policymakers could have still managed to “do something”, even if that something was nothing else but to monetize sovereign debt. With this news, which we think was released in the European afternoon, we expect deposits not to be renewed in the EU periphery banks and an exponential increase in withdrawals from chequing accounts.

One thing is to have the options (a) or (b) above, with regards to the speed at which sovereign debt is monetized. An entirely different one is to be forced to act as lender of last resort for banks which face a run, precisely because the notion of the ECB as lender of last resort is challenged.

If you are a Spanish depositor, would you not withdraw your savings, in Euros, from a local bank? Why would you transfer them to, say a German bank, if you don’t even know what currency Germany will have? Yes, you can assume it will be a stronger currency, but still…why take chances? Why not buy certainty? Why not buy an existing currency, outside the Euro zone? At the same time, if that Spanish bank seeks a liquidity line from the ECB, what incentive would Germany or France have to support it and inherit their share of this headache, when they actually intend to break up? None, we suspect, which brings us to our most important point: If the Euro zone breaks and the ECB is liquidated… How can Ben Bernanke justify rolling over the existing currency swaps to provide USD funding to the ECB, a central bank in the process of being liquidated? He can’t!!!! He has the whole opposition spectrum, from Ron Paul to Mitt Romney, every night on TV shows explaining how they plan to audit the Fed if they get to power. The Fed can only keep its currency swaps outstanding as long as there is an institution called European Central Bank. Otherwise, the swaps will have to be called.

This is very serious. On September 5^th, we wrote: “…AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER…”

Well, the market is in control now, folks. The game is over and policymakers have lost it. Whether the break up is disorderly or not, remains to be seen. Personally, we prefer to watch from the sidelines.

Martin Sibileau

The events that took place last week will be consequential. In our last letter, we made the case that even without further details, the measures at the EU summit only showed an impressive lack of common sense.

Last week, EU leaders agreed on three fundamental measures: (a) To leverage the EFSF (European Financial Stability Facility), under a first-loss insurance scheme that would cover the initial losses on newly issued debt of EU sovereigns; (b) Greece’s sovereign debt will be “voluntarily” restructured without triggering a credit event. The eventual haircut (i.e. discount) on Greek debt will be significant (approximately 50%), or at least higher than 20% for the purpose of our discussion; and (c) EU banks will have to raise more capital by 30 June 2012. As we explained, these three measures constitute an inconsistent system, which will leave the European Monetary Union in worse shape.

By now, the market seems to share our view. Italy’s sovereign 10-yr yield broke the 6% mark from below and on Thursday, the EFSF decided to postpone a $3BN pre-funding issue, blaming market conditions. How could they do that? Is the EFSF not supposed to raise money for sovereigns in distress precisely when market conditions are not optimal?

The whole exercise of saving Greece is exposing one of the biggest Ponzi schemes ever (the record in Ponzi schemes is still proudly held by the US Treasury). Shamelessly, the goal of the G-20 meeting last week was disclosed as nothing else but one more layer in the game, where EU banks finance sovereigns, sovereigns and the ECB (i.e. European Central Bank) finance banks, the EFSF finances the sovereigns and now probably, the rest of the world would finance the EFSF. But it is too late. The crack is out there for everyone to see and Italy is screaming the word “contagion” so loud that even amid a severe volatility, gold managed to end the week higher, even in USDs (i.e. the case for higher Gold/Euro is obviously clear at this point).

But if it is that clear that all measures so far are not going to solve the problem, why is the Euro still so strong? Why have we not seen a major sell off? We think the answer lies in the interest rate cut the ECB offered on Thursday. The market knows that the only way out now, if any, is to monetize sovereign debt and wants to believe that Draghi’s (i.e Mario Draghi, the current President of the European Central Bank) move last week was a signal of support in that direction. We think it is a bit too optimistic but acknowledge that monetization will arrive at the last hour.

What would that last hour look like? What would precipitate it? We have been discussing this point with an old friend and reader who shall remain anonymous. Here’s our thoughts:

It is now clear that Greece is no longer the problem. Greece has already been discounted and the market, as always, is now looking into the future. It looks grim. Contagion is already spreading and cannot be denied. Portugal? Spain? Ireland? No, those countries had been accounted for. The problem now is Italy and the upcoming arbitrage of banking jurisdictions, in the face of the Eurozone breakup. As the last day approaches, deposits in the periphery of the EU will not be renewed and, if money is not held under the mattress, it will make its way into deposits at German/EU core banks.

This jurisdictional arbitrage within the Eurozone, will grow exponentially intolerable. Banks in the periphery will increasingly use the ECB liquidity lines, including USD loans facilitated by the Fed through cross-currency swaps, to meet the run for liquidity facing them. The ECB will have to accumulate collateral against these lines and the money redirected to core banks will sit as reserves, generating a credit contraction in the EU. Some will feel the pain more than others. None of the countries that face rising yields today will be in a position to address their ever growing deficits, as their tax revenue collapses.

Where it will be particularly felt, in our view, will be Italy. Until this point, we can either assume (a) that the ECB holds the line with sovereign bond purchases or (b) on the contrary, it accelerates them. If it holds it, then the increase in Italian sovereign risk will affect French banks more than German banks. The endgame here is France leaving the Eurozone, as it becomes evident that the German lobby on the ECB forces France to recapitalize its financial system at a prohibitively high cost. France would be better off recapitalizing/nationalizing its system in French Francs. But if France leaves, there is no Eurozone and Germany is left without the benefit of its pan-European reserve currency. The negotiations leading to this result would be very interesting, full of volatility and we don’t know what would happen to the value of gold here. Indeed, gold should find a strong bid, but at the same time, one has to believe that the Fed would find it very, very difficult to justify renewing USD swaps to a central bank (the ECB) in the process of being liquidated. This is true particularly in the following months, as a cornerstone of the Republican Party is the promise to closely audit the Fed. In this case, the cost of USD funding would shoot exponentially and margin calls would crush the price gold and the rest of the risky asset spectrum.

If, on the contrary, under Mr. Draghi, the ECB accelerates sovereign bond purchases, the Euro would embark on a devaluing road and gold would steadily rise against ALL currencies, as the Fed would extend a hand to the ECB, in the belief that the Eurozone can survive, albeit at the expense of losing purchasing power and perhaps too, the dream of ever challenging the US dollar as the world’s reserve currency.

In this scenario, the devaluing game would continue as long as the German public tolerates the resulting inflation. This scenario could easily include the separation of Greece and Portugal from the Eurozone, while Spain makes progress with its fiscal program and Italy wins time to restructure. This is the can-kicking option, with no guaranteed results. But it buys time and perhaps ends in some sort of federal tax structure. If inflation picked up significantly, this scenario could potentially end with Germany leaving the Eurozone, particularly if no advance is made towards a pan-European fiscal integration.

We think therefore that this last option (ECB accelerates sovereign bond purchases) is the most likely and see brighter days for gold.

Martin Sibileau

As we write these comments, no concrete proposal for the European Financial Stability Facility (EFSF) has been presented after the summit that took place yesterday, among leaders of the European Union (EU). However, markets seem to consider as highly likely that three fundamental decisions will be made:

1.-The EFSF will be leveraged, under a first-loss insurance scheme, to cover the initial losses on newly issued debt of EU sovereigns.

2.-Greece’s sovereign debt will be restructured without triggering a credit event.

3.-The eventual haircut (i.e. discount) on Greek debt will be significant (approximately 50%) , higher than 20% for the purpose of our discussion below.

Together, these three measures, if implemented, would generate an inconsistent system, leaving the European Monetary Union in worse shape.

The current limit on the European Financial Stability Facility is EUR440BN. If we subtract the existing commitments to fund the Irish, Portuguese and Greek programmes, we are left with approximately EUR200BN. If these were pledged to cover, say the first 20% of newly issued sovereign debt of EU members, we would have about a trillion Euros, 20% insured (i.e. Eur200BN/0.2 = Eur1 trillion). This would mean that investors of the first trillion Euros in sovereign debt would only suffer losses, if these surpass 20% of their investments.

How can we tell investors they will be safe enough with a 20% cushion, if they simultaneously see a haircut on the Greek debt in the order of 50%? To make matters worse, if existing hedged (with credit default swaps) investors of other EU peripherals sovereign debt see that no credit event is triggered (i.e. default is not acknowledged) in the Greek case, why would they keep paying to insure their bond holdings with credit default swaps? After all, those who thought were properly hedged on their Greek debt holdings would now see that the insurance premiums they bought are useless.

The consequence of these last two measures would generate a sell off in sovereign credit default swaps, eventually taking liquidity from this market, and in the process, likely increasing the cost of owning the newly issued debt that the leverage EFSF initially sought to cheapen, by providing a 20% first-loss insurance.

Lastly, as a structured credit product, the senior tranche owned by investors (the EFSF would have a subordinated tranche of 0-20% in losses, investors would be senior, with exposure to losses above 20%) will be negatively impacted if the contagion (i.e. correlation of defaults) spreads (i.e. increases) within the European Monetary Union. Think of this example: suppose that a veterinarian sold a farmer an insurance contract where the first 20% of the cattle covered by the contract would be refunded, if it catches a certain disease. As long as that disease is contained, the insurance contract provides the farmer with peace of mind. It is clear then that if the disease becomes epidemic, the farmer will find himself in a more compromised position.

Investors of EU sovereign debt are actually in a position weaker than that of our hypothetical farmer. The same sellers of the insurance, by forcing haircuts bigger than the loss they insure and without triggering a credit event would actually be increasing the likelihood that the default contagion within the region spreads. Bondholders without a proper hedge may fire sell their investments, raising the cost of the newly issued debt, further threatening the position of the EU banks, which are currently asked to increase their capital.

This could indeed end in a vicious circle that would dangerously spiral, for if we are correct…the next logical step would be to ask who would reinsure the insurers, as a region-wide collapse is on the horizon. As we saw in the US with mortgage insurers, that person was the Fed. Will that be the fate of the European Central Bank as well? The recent rally in gold seems to tell us the answer.

Martin Sibileau