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

Please, click here to read this article in pdf format: november-21-2011

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

Please, click here to read this article in pdf format: november-10-2011

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

Click here to read this article in pdf format:november-7-2011

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

Click here to read this article in pdf format: october-27-2011

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