Please, click here to read this article in pdf format: august-12-2010

In our last comments, (ref: www.sibileau.com/martin/2010/08/10), we suggested that the relationship between the cost of liquidity in the Euro and USD currency zones and the Euro was breaking and signaling a reversal, together with the widening of Euro sovereign spreads. The mystery was disclosed on Tuesday by the Fed and with it, the whole macro backdrop has changed, rather violently.

The thesis we suggested last Thursday (www.sibileau.com/martin/2010/08/05 ) is totally outdated. The rules of the game have changed dramatically and, in our opinion, for the worse. The Fed’s announcement, explicitly saying that they will target the size of their balance sheet, surprised us, deceived us. Simply, the Fed decided that instead of allowing its balance sheet to shrink, as the mortgage backed securities and agency debt it holds are repaid, it will reinvest those amounts (which are not minor, estimated at $200BNover the next 12 months) back into the Treasuries market.  We understand it will target purchases in the 2-7yrs range, which caused the 10-30yr to steepen sharply in the last two sessions. The spread between costs of liquidity in the Euro and USD currency zones, discussed a week ago, continued to widen also for this same reason, but the sensitivity of risk assets to it reversed. Another thing to keep in mind: If the Fed purchases Treasuries directly from the Treasury, it will not only be keeping the size of liquidity available in the system steady but also, it will be monetizing fiscal deficits.  The street is watching…

One of the first rules any student of Economics learns is that if a monopoly controls quantities, it cannot control prices and vice versa, if it controls prices, it cannot control quantities. Until Tuesday, the Fed was targeting the price of its liabilities. It was concerned with the so called general price level. Since Tuesday, it is concerned with their quantity. Yes, we are aware that this is consistent with Keynes’ idea, which we have so often quoted here, that:

“…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…” (Chapter 13th, “General Theory”)

Output and asset prices have indeed increased since 2009 and the Fed’s effort is exactly directed towards maintaining a given rate of interest. The problem of this perspective is that it is not dynamic. Once the market has incorporated that monetary growth in its expectations, it will demand that growth to remain in place. It’s plain addiction.
On the other hand, we disagree with the popular view that there will be no growth in the supply of money. We think there is in the sense that instead of having a Fed’s balance sheet that shrinks, we have a constant one.  To illustrate our point, let:

Mt = Money supply at time t, measured in months

b= Average mortgage-backed securities and agency debt paydowns, per month

Therefore, before Tuesday, we had:  (1) Mt = Mt-1 – b* t,  

which meant that the money supply on month t equaled that of the previous month, less proceeds from average paydowns that the Fed withdrew from circulation.

Since Tuesday, we have :   (2) Mt = Mt-1 , which means that the money supply on month t will equal that of the previous month. Money supply remains constant.

If we take the difference between (2) and (1), that is to say, if we see what has occurred since Tuesday on the margin, we will see that:  (2) – (1) = Mt-1 – [Mt-1 – b* t]  = (b * t), where (b * t) >0.

Therefore, we think that there is growth now vs. before, which brings us to the next question: why did the market sell off today?
We see the sell off as the market’s way of forcing the hand of the Fed. As we wrote before, the street knows that until asset prices fall more, the Fed will not engage in active quantitative easing. The rational thing to do therefore is to sell before everyone else does so.  If you notice smoke in a room and hear the firemen approaching…why wait? Why not rush to the exits before they get clogged?

From now on, we will need to get to that critical level. Is it a S&P500 at 850pts? Who knows…But once we reach that level, we will have lower activity or a lower amount of goods being produced, but being chased by a market with a higher amount of fiat currency. In other words, we will have stagflation. 

Martin Sibileau

Please, click here to read this article in pdf format:august-10-2010

In our last letter, we had suggested that:

“…in the absence of any catalyst for a further widening of the 3-mo Euribor-OIS spread vs. 3-mo Libor – OIS spread, the risk rally (i.e. gold, stocks, oil, credit, Euro) that we have witnessed in the last weeks should remain range bound…”

Well, the European “recovery” should be a catalyst in itself. As the system recovers, so do financials, lessening their dependence on liquidity lines from the European Central Bank and driving Euribor higher. This provided support to the recent Euro rally, when USD weakness widened the interest rates differential between currency zones. As the chart below shows (source: Bloomberg), the spread  3-mo Euribor-EONIA and 3-mo Libor – OIS continued to widen yesterday. Yet, the Euro after having topped just above 1.33, steadily dropped during the session.

Have we found a reversal in the Euro? It maybe early to tell, but the fact that it dropped with the rates spread widening caught our attention. We are aware some will suggest that it was a mere correction within a consolidation. After all, the currency has been enjoying a relentless ride. Also, it has not even touched its support at 1.3130. However, yesterday was also a day of widening in Euro zone sovereign spreads. All this, with stocks closing higher.

Dos this make sense?

The market is completely focused on the FOMC meeting taking place tomorrow. Essentially, the Fed can hint that they will somehow (via reinvesting in mortgages or bills) increase the supply of liquidity or…not. We think nothing will be hinted tomorrow and in the absence of further news, the market may refocus on the unsolved problems in the Euro zone, which may be behind the performance of the Euro and sovereign credit default swaps yesterday. As we wrote before, we can’t see a rationale for the Fed to buy the securities that the market is already buying and stocks and commodities are not dropping. Perhaps, we suggest the Fed should even begin to think about how to further tighten, before it is too late.

In the meantime, things in Europe have not really improved. Yes, everyone tells us that the stress tests provided more transparency, but that is a polite way to say we were told that which we knew. One thing that caught our interest is the fact that on August 5th, the Greek government announced EUR25BN in guarantees for Greek banks. In total, Greek banks now count with EUR55BN in government guarantees.

What are these guarantees for? For Greek banks to be able to raise money!

From the market? No, from the European Central Bank, with the guarantees as collateral!

What is the liquidity being raised for? To further lend to the government!

Then why does the European Central Bank not buy Greek government bonds directly? Because this way there’s a shortcut for the Central Bank to avoid having to sterilize the purchases.

Why? To not drive refinancing , EONIA and Euribor rates higher…

Martin Sibileau

Please, click here to read this article in pdf format: august-5-2010

Liquidity won, fundamentals lost. This should summarize the action this week. The question now is how much longer this picture is going to last. If we take the demand side of liquidity off the picture for a moment, assuming it remains relatively constant, and focus on the supply side, we can think in terms of two main suppliers, namely the Fed and the European Central Bank. We thought the chart below would be very illustrative (source: Bloomberg). It compares the 3-mo Euribor-OIS (or Euribor-EONIA) spread vs. the 3-mo  Libor-OIS spread . In other words, we can see the relative cost of liquidity in USD vs. Euro (for a discussion of 3-mo Libor-OIS, refer our letter of Dec 1st, 2009: www.sibileau.com/martin/2009/12/01 ):

As we can see, at the top left, the cost of liquidity in USDs dropped dramatically in March 2009, when the Fed put its quantitative easing program in place. By mid-May 2009, this cost was below that of Euro liquidity and with this interest rate differential, the 2009 rally sustained itself at the expense of the USD value. As long as that spread differential was wide, stocks, credit and commodities rallied, and volatility declined.

This rate differential began its narrowing trend in the wake of the Euro zone institutional crisis and it inverted at its worst point, the week after the European Monetary Union announced the EUR750BN bailout. The fall of the S&P500 below its 200-day moving average coincides with this point in time. It took place precisely in that infamous week of May. The price of gold also tracks the evolution of the rate differential (not shown in chart).

Now, at the far right, we can see that the differential is expanding again, with 3-mo Euribor-OIS currently at 32.95bps vs. 3-mo Libor-OIS at 24.45bps.

Is the widening sustainable? Please, note that I am not asking if the spread is sustainable, but if the widening in spreads is sustainable. If it is, we think the Euro rally should continue, along with higher stocks and tighter credit. Gold should not outperform stocks, but the trend from the bottom left to the top right would of course remain intact.

In 2009 the widening was sustainable because the Fed could trigger its quantitative easing program, while the European Central Bank (ECB) maintained its anti-inflationary stance. In 2009, there was a reason for the Fed to undertake quantitative easing. The assets that the Fed purchased directly or indirectly (i.e. funding the Treasury) were assets that the market despised, namely mortgages. That made sense. What may not make sense now is to think that the Fed would keep buying them, as many analysts suggest, after Fed’s Bullard’s speech on this point. Are Treasuries not at record low yields? Are mortgage spreads not at record lows? Is credit not tightening? Why therefore would the Fed rush to buy that which everyone else is buying? Where is the need?

If we look closer to chart above, you will notice that the reversion in the interest rates differential started right after the July 1st refinancing of the EUR442BN 1-yr Long Term Repo Operation (LTRO) by the ECB. This transaction was a success, as it withdrew liquidity from the Euro zone. The volatility that followed was marked by subsequent refinancing transactions (which resulted in liquidity reductions) done by the ECB, as well as the direct purchases of sovereign bonds, which so far have amounted to approximately EUR60BN, sterilized. The cost of liquidity in Euro has been driven by the ECB refinancing operations, as we anticipated on May 13th, when we described the sterilization process. We reproduce the chart below:

Back to the most important question (i.e. is the widening sustainable?), we think the market may be misled by looking at the 3-mo Libor-OIS spread, as the driver here:

Spread = (3-mo Euribor – OIS)  - (3-mo Libor – OIS)

Spread widens if  (3-mo Euribor – OIS) > (3-mo Libor – OIS),  over time

As you can see, the spread is not only driven by movements in the Libor – OIS spread. This is what we think is occurring lately We think that so far, the USD has been on the passenger seat. The widening of the spread has been mostly driven by the European Central Bank’s refinancing transactions, which brings us to an important conclusion: If the ECB does not have relevant refinancing transactions in the near future, the spread between the Euro and USD liquidity cost should stabilize. So far, we understand that the ECB will not have any relevant refi operations until September 30th, and we don’t see the Fed making any changes prior to that date. Change therefore should be born out of exogenous factors. There are no such factors on the sovereign risk horizon in the next month, coming from the Euro zone and we doubt we will see municipal/state debt stress arising in the US during the same period. Yesterday, China announced a stress test to its banking system against a 60% drop in the value of their real estate holdings (vs. prior 30%). It did not affect the picture.

In conclusion, in the absence of any catalyst for a further widening of the 3-mo Euribor-OIS spread vs. 3-mo Libor – OIS spread, the risk rally (i.e. gold, stocks, oil, credit, Euro) that we have witnessed in the last weeks should remain range bound.

Approaching October, should the recovery in the US become stronger, in the absence of further quantitative easing, (= 3-mo Libor – OIS rises ), ceteris paribus (=things in Europe remain flat), the rally will weaken. The debate on monetary policy is therefore delayed a few months. The problem here is that by October, things in Europe will not have remained flat (sovereign debt refinancings will take place) and the US will be facing an election.

Martin Sibileau

Please, click here to read this article in pdf format:july-29-2010

From our vantage point, the last 72 hours are confirming our long-term perspective that the recent strength in the stock markets is baseless.

There are currently two main arguments supporting the belief that the recent strength in asset prices may have longer legs. The first one refers to the positive surprises of earnings vs. expectations, which (for instance) the greater part of the S&P500 constituents are showing. In Europe, sovereign refinancings have been carried out without major problems and banks have “formally” passed the stress tests. The second argument refers to the asset shortage in the credit space. This means that there is more capital chasing yield than there is demanded. This applies not just to corporate credit, but to sovereign as well.

We think that these arguments are both misleading. Earnings are past information and should not be a decisive factor. Outlooks are more relevant to us and, in macroeconomic terms, the outlook is not too compelling.

Today, governments are raising and not lowering taxes. When governments cut spending, they don’t do so by privatizing assets, which triggers resource allocations. Governments simply cut temporarily. This is quite the invitation to evade rather than to pay taxes.

Monetary aggregates are barely expanding (i.e. Europe) or not expanding at all and, given the destruction of global savings, armies of young people will remain unemployed for longer than most imagine. The incentive lies in saving and paying or refinancing debts, rather than investing. Regulations punish entrepreneurship and encourage companies to use or reduce the existing labor force, rather than to hire.

Interest rates are currently useless as the transmission mechanism that they are and which is needed to guide savings to productive endeavors. In summary, we have a hard time justifying the recent “asset inflation” most want to see in the last days rallies. Gold proved the case, we think. Other assets should follow.

The second argument is essentially an insult to intelligence. Indeed, asset shortage does support the current technical compression in credit spreads we are witnessing, but it should hardly be supportive of economic growth on its own. That would equal to argue that investors will keep investing just because they have the funds available to do so, regardless of the return/risk profile of the investment opportunities considered.

A final testimony of our two points above is the situation the Euro zone financial system is in. As we had anticipated in May, the European Central Bank has had to increase the refinancing as well as the short-term facility rates, in order to carry their liquidity and sterilization operations respectively. These operations are obviously affecting the inter-bank Euro rate, Euribor, which is slowly approaching the 100bps level. When we add this to the institutional and sovereign risk crisis the Euro zone is in, the result is a fragmented, two-tiered, financial system. With excess liquidity in the Euro system close to EUR150BN driven by the stronger banks, the weaker banks still survive at the expense of the central bank. Yesterday, for instance, at the 3-month Long-Term Refinancing Operation the ECB held, 70 banks were bidders, for more than EUR23BN. In this refinancing, EUR4.8BN were maturing and taken by 24 banks. In conclusion, the weak (banks) get rewarded by the central bank, while the strong (banks) cannot find investment opportunities. This is hardly a promising environment.

Martin Sibileau

Please, click here to read this article in pdf format: july-26-2010

We start the week without the uncertainty of the Euro stress tests and with further data on the US macro picture, namely, the two factors driving discussions and action last week. On the stress tests, readers by now know our position from day one: They are flawed by method and any comparison against the US case is misleading.

Banks in the US were financing a stock of assets, mortgages, the counterpart of brick-and-mortar investments, whose generation collapsed much, much earlier than the tests carried out in March 2009. When the US were doing their stress tests, they were actually counting their dead. European banks were and continue to finance fiscal deficits, which lack an identified pool of assets backing them. The generation of deficits has not stopped at the time of the tests and will continue for the foreseeable future. The Euro zone banks are  not counting their dead, they are simply speculating whether they can survive if the illness becomes mildly worse. Therefore, they must present their illness as mild. There was an element of surprise on Friday, hours prior to the announcements: The stress tests were carried out on the banks’ trading books. With this, we think, Euro zone financial authorities surrendered every last drop of “moral authority” to defend their case. Time will tell, and in the meantime, the only thing that markets will now care about will be the evolution of fiscal deficits. Rightly so!

We had anticipated our opinion that the Euro would drop on the news. As the chart below shows (source: Bloomberg), it did drop intraday, right after the disclosure that the tests were on the trading books, but it managed to close higher, although within what seems to be an increasingly clear renewed downward trend, since it last peaked at 1.30+, on July 20th:

The US macro picture is challenging. On one hand, we are seeing earnings that surprise on the upside, but on the other, activity indicators are neutral at best. In credit, spreads are tightening, by the mere fact that there is more demand for spread than supply. The question here is whether the trend towards lower spreads, driven by the gigantic amounts of cash stored on the sidelines, will fuel the last push required to avoid a double dip. This concern has shifted also to the analysis of monetary policy.

While months ago we were debating what was the most appropriate way to a approach an orderly exit strategy by the G-3 central banks, today everyone is focused on how best can monetary policy accommodate a moderate growth. Back in the ‘30s, Keynes had clearly conceived a recovery where monetary policy would have to be accommodative.  We first raised this point more than a year ago, on April 28th, 2009 ( “A Keynesian Perspective”, www.sibileau.com/martin/2009/04/28 ), and have very often quoted one of his famous paragraphs, from Chapter 13th, of his “General Theory”:

“…whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(…)…Finally, if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…(…)…And when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest...”

Every research note on interest rates today, is pointing at the slowdown in the growth of monetary aggregates. This had been foreseen by Keynes, who openly, just like Krugman, was in favor of an increase in the quantity of money. The problem with this approach is that it is not dynamic, it is short-sighted. Monetarists (i.e. Milton Friedman) blamed “expectations” for the failure of Keynes’ approach. Given the market’s expectation that higher amounts of money would trigger inflation, prices were increased in a self-fulfilling path, if “capacity”, slack in the system, was gone. Today’s Keynesians don’t disagree, which is why Krugman is always reminding us how weak activity is.

The Austrian school, however, looks at the problem from a different perspective. Unlike monetarists or Keynesians, Austrians acknowledge that credit expansion is non-neutral, generating what people generally refer to as “asset bubbles” or asset inflation. As the problem of asset inflation compounds, its final version, general inflation, becomes more evident. The level of activity or its opposite, the level of slack in the system is irrelevant. That was the reason behind our bullish call on stocks all along 2009 and that may be what is fueling the recent strength in stocks. However and unlike in 2009, this latest strength would be based on the speculation that the quantity of money necessary to maintain a given rate of interest will increase. In 2009, the rally was based on facts. In 2010, it is trying to survive on speculation. The chart below (source: Bloomberg) shows that since July 20th, when the Euro last peaked, the S&P500 is making higher highs and higher lows, although still below its 200-day moving average, which stands at 1,113pts. We doubt the S&P500 will break this trend without the actual monetary increase supporting it. And if such monetary support shows up, we doubt the price of gold will remain indifferent vs. stocks, like it did in 2009.

Martin Sibileau