Click here to read this article in pdf format: october-17-2011

We apologize for not having written sooner. We usually do if we find new, market moving information. Unfortunately we have not in the past three weeks, which is also evident in the range trading all asset classes have witnessed.

As we write, the G-20 is meeting and the EU will have its own discussions, later in the week. One of the main topics markets have been paying attention to is that of EU banks recapitalization. This is not news. We have been discussing the futility of this issue since 2010. It is nothing short of circular reasoning. On June 4th, 2010, we warned that:

“…there continues to be confusion in the analysis of the EUR problem. The latest one consists in criticizing the ECB for lack of clarity in its bond purchases (…) While the Fed gave details about its unsterilized asset purchases, the ECB will not. But we explained why this is so:

“…The Fed was financing what we call in Economics a “stock”, i.e.( mortgages) “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…” (http://en.wikipedia.org/wiki/Stock_and_flow ). The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen…”

Again on June 29th, 2010, we added that: “…Finally, we want to discuss an idea suggested yesterday by Morgan Stanley’s Global Economics Team (ref.: “The Lure of Liquidity”, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that “…the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each other…”. Essentially, monetary policy, which this report calls “Passive quantitative easing” is to blame for this spiraling circle. It is also proposed that had the ECB activated “Active quantitative easing”, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been different…the crisis would have been contained.

We could not disagree more with this flawed and misleading notion. It is flawed because it doesn’t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing “stocks” (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing “flows”, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.

This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this story….”

The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital:

However, as we write, policymakers are considering the recapitalization of EU banks again. Not only does it not make sense, but also, should this exercise be coercive in nature to the private sector, forcing bondholders to become equity investors in a mandated conversion, unspeakable damage will have been done globally to any prospects of growth. This is the path that may be taken after all and we are accordingly ready to see higher correlations, volatility and the run for USD liquidity make a comeback. Gold could be seriously affected in the process.

What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility. On January 28th, 2011, we described in detail what we think is still a viable alternative: The swap of EFSF bonds for sovereign bonds, in the secondary market.

We want to end our comments today with two observations, back on this side of the pond:

1.- Since the announcement of Operation Twist, unlike what was expected, the US yield curve has steepened, rather than flattened. Is this the result of a reallocation from US bonds to stocks, or a vote of non confidence on the Fed? For now, we are inclined to believe in the former, but only because we find stocks had been oversold too fast. Longer term, we have our doubts and we find that this steepening of the yield curve and gold stronger in USD terms rather than in Euros, is not a coincidence.

2.- Last week, the Fed created ex-nihilo approx. $1.3 billion to lend for 3 months US dollars to EU banking institutions. These are US dollars nobody in the US has saved for, and these are US dollars indirectly financing, many times via the credit multiplier, the fiscal deficits of the EU. A forced recapitalization of EU banks would eventually increase the size of these operations, because private investors would dump their holdings running for liquidity. We hope this will not occur because the only possible unwind in that case would be through global USD inflation. Again, gold stronger in USD rather than in Euros, we think, is not a coincidence.

Martin Sibileau

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

Since our last letter, we have witnessed (and perhaps are still witnessing) once more, the typical run for liquidity, when all asset classes tell us that diversification is a myth and that there is no place to hide but in the US dollar. Those who were long of gold (including ourselves) got a good lesson (in our case, a reminder) in asset management under central banking and hopefully too, got to appreciate the value of stop losses, like we did, which saved our day.

Let’s first begin by saying that from the perspective of the “real” economy, absolutely nothing has changed since September 12th. This sell off was indeed a déjà vu and we had, in previous letters, described a scenario like it. For instance, on February 2nd 2010, we proposed three phases in this downward cycle, shown in the chart below. Everything would seem to indicate that we are in what we called phase 2:

When are we going to enter phase 3? Before we address the question, let’s briefly comment on the announcement that triggered the recent sell off: the Fed’s so-called Operation Twist. By now, everybody knows that the Fed announced it will shift the composition of its assets, basically selling short-term Treasuries and using the proceeds to buy longer term Treasuries (this is a very, very basic description). In doing so, three things will occur.

Firstly, the yield curve should flatten, affecting negatively the profitability of credit investors (banks, insurance companies) that fund cheap in the short term market to lend long term, at higher spreads. If providing credit will be less profitable, credit supply will contract, affecting borrowers.
Secondly, by shifting the tenor of its assets to a longer term, the Fed will suffer huge losses, when interest rates finally rise forced upon this central bank by a massive repudiation of the US dollar (its liabilities). By then, how will the Fed be recapitalized? This point however will take a lot to materialize. But we nevertheless mention it here for the record. Peter Schiff in his blog described these first two (watch: http://youtu.be/BCYGVKBOcCo ) issues.

Thirdly, and to us this is perhaps the most important, Operation Twist contributes to confirm the stagflationary trend. For mainstream economists, this is difficult to see, because they ignore the role of the price system in the market process. Every mainstream analyst has told us in the past days that because the Fed is not expanding its liabilities, this move should not be inflationary. Let us tell you why, although this fact (i.e. no expansion of Fed’s liabilities) is correct, the conclusion is not.

Since the beginning of QE1, central banks and regulators have incrementally exercised financial repression on global markets. In doing so, they have deprived markets of the benefit of the price discovery mechanism through which they can efficiently allocate resources.

With the purchase of government bonds, whose yield are a benchmark rate, the benchmark rate has been manipulated to the point where, with rates practically at zero levels, markets no longer have a benchmark.
With the intervention in the banking system, markets no longer can easily price the solvency of banks and their capital needs.
With the intervention, during the waves of defaults, in the legal proceedings between creditors and borrowers, markets can no longer have a clear view on recovery values at default, or even seniority of credits. Will pension plans have priority over lenders? Will private investors in sovereign debt end up deeply subordinated?

Until last week, therefore, we had slowly lost our benchmark rates, the capacity to calculate losses/defaults, and understand the legal consequences of extending credit. Since last week, thanks to Operation Twist and a flatter yield curve, we will also lose a benchmark for the inter-temporal rate of exchange: The relative value of time will almost disappear. How can anyone make an educated investment decision in this context? He/she can’t, which brings us sad memories of our life during the hyperinflation years in Argentina. During those extreme years, we remember having seen stores closed because “they lacked prices”. Many stores would simply shut and leave a sign by the door that read: “Cerrado por falta de precios”. Indeed, given the acute movement in prices, store owners could not decide whether their sales would leave them with a profit or a loss, and would not open to the public!

There and then, this happened with consumption goods. Here and now, it is starting to occur first with investment goods. All parameters relevant to an investment decision are absent: the value of a risk-free asset, probabilities of default and cost of capital, institutional certainty and soon, the value of time. In this context, investments, and subsequently productivity and employment can only collapse.

Going back to our point on the inflationary impact of Operation Twist, if we understand now that this measure contributes to destroying investment, if the produce of the USA drops, even if the size of the Fed’s liabilities doesn’t increase, the amount of money stock vs. output will have still grown and the value of the US dollar will have to drop! This is why people call it stagflation! (Money stock = monetary base + fiduciary media, refer Figure 2 in “The causes of price inflation and Deflation: Fundamental Economic principles the deflationists have ignored”, by Laura F. Davidson at: http://libertarianpapers.org/articles/2011/lp-3-13.pdf )

Returning now to our previous question of “when are we going to enter phase 3?”, the answer is: We are not sure. In summary, if the Euro crisis finds a fiscal way out in which the European Central Bank (ECB) does not have to capitulate (and this includes the ECB lending to a bigger European Financial Stability Facility (EFSF)) we will not have phase 3, and gold will continue to sell off, in our opinion, at the expense of equities.  If the ECB is made to capitulate because no fiscal solution is reached and the only way out is a weaker Euro, we will enter phase 3, with gold and equities rallying.

Lost in the mess of these negotiations, there remains the issue of what will happen in China with its current imbalances. We are starting to lose sleep on this one…

Martin Sibileau

Please, click here to read this article in pdf format: september-12-2011

Today’s comments will be brief. In fact, we will not seek to provide answers but to leave the reader with questions.

By now, everyone is surely aware of the decision by the Swiss National Bank to peg the Swiss Franc to the Euro, at 1.20. Effectively, the SNB would buy as many Euros as sold to them, at 1.20EUR/CHF.

On this news, Dennis Gartman, last week wrote that from now on, the policy of the SNB will be driven by that of the European Central Bank. We think that is not correct. Because the European Central Bank has no policy of its own. The ECB has its hands tied. As we wrote back in May 10th, 2010 , when we foresaw this:

“…We think that (…), the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, (…), the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy (…)? In the long run, the only way out for the ECB (…) is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy …”

Indeed, we think that with the peg, the supply of Swiss Francs will also be determined by “…the growth rate of the EU’s consolidated fiscal deficit…”.

Back then, on our next letter dated May 13th, 2010, we further discussed this point and added this graph, that now looks ominous:

The letter, titled “ECB Plan = The End of Paper Money?” already mentioned the importance of currency swaps extended by the Fed (seen in the chart above). We finished that letter noting that gold looked like a bargain at $1,240/oz. And just like we wrote about these swaps 16 months ago, last Monday we went on record stating that: “… 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…”

With this in mind, we invite readers to think about this: If, in the face of upcoming US dollar funding problems for Eurozone banks, the Fed will commit to lend unlimited US dollars to the European Central Bank, to further sell them to Eurozone banks….WILL THE FED NOT BE EFFECTIVELY PEGGING THE US DOLLAR TO THE EURO? WILL THERE NOT BE AN UNOFFICIAL EQUILIBRIUM EXCHANGE RATE AT WHICH THE FUNDING MARKET IS CLEARED?

And if that is the case…What will differentiate the Fed from the Swiss National Bank? We think nothing!

After the German’s High Court ruling, where any institutional fix to the Eurozone problem, including Eurobonds will be legal but operationally unfeasible, the European Central Bank is the only savior and will have to monetize the consolidated fiscal deficit of the Eurozone. If the Fed, just like the Swiss National Bank, pegs its currency to the Euro, then the supply of US dollars will also be driven by “…the growth rate of the EU’s consolidated fiscal deficit…”.

We saw it coming . This scenario will eventually make the case for gold clearer and clearer. In the process, the banking system of the world will go bankrupt, nationalized and more concentrated, and financial repression will grow exponentially.

Martin Sibileau

Please, click here to read this article in pdf format: september-5-2011

In our last letter, we showed that our view from May 2010 is fully developing (We had stated that eventually money supply in the Eurozone would be determined by the growth in the zone’s fiscal deficits). Also, the contagion from the Eurozone to the USD zone is also growing, thanks to the EUR/USD currency swaps extended by the Fed to the European Central Bank. This contagion, we wrote, is nothing new, but had been highly criticized already in the early 1930’s by Jacques Rueff. We insist therefore that readers get a copy of Mr. Rueff ‘s “The Monetary Sin of the West”, published in 1972. An online version can be found at: www.mises.org/books/monetarysin.pdf . Too old? Perhaps, but remember: There is nothing more practical than a good theory!

If you have been following us vs. other analysis, you will notice that only recently, other analysts are beginning to pay attention to these FX swaps. Mainstream analysts refer to it as the “Fed’s USD backstop”, which is also appropriate. Why is this for us so relevant? Because thanks to this backstop, the world ends up being impacted similarly (“similarly” being the operative word here) to what we would see, if the Fed bailed out Eurozone banks. Is the Fed bailing out foreign banks providing this backstop? We see it that way, although the Fed will always deny it. But think of this simple question: What would happen to the weakest Eurozone banks that need to roll over USD funding, if that backstop wasn’t there? They would certainly be insolvent by now. However, the Fed doesn’t see it that way. What the Fed sees is the underlying counterparty risk. The Fed turns around the question to tell us that if the backstop was not there, the US banks would have funding problems, competing with Eurozone banks for funding.

To his credit, Dr. Ron Paul, was the only politician to see this far in advance, last year, when he questioned Mr. Daniel Tarullo, member of the Board of Governors of the Fed, on this point on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ).

Had we been in that session with Mr. Tarullo, we would have asked him what would the Fed do, if the dollars lent to the European Central Bank, forwarded to Eurozone banks, cannot be paid back because the assets these dollars funded are in default or generating substantial losses to the originating banks?

This is important because that is exactly what occurs during stagflation: Businesses go bankrupt. We know the answer: The Fed would do nothing, allowing these dollars, printed money, to remain overseas. This is why we say that the FX swap is effectively quantitative easing from the Fed on the Eurozone. We will go on record stating this: 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.

Turning now to the Eurozone, it is completely clear now what we have been predicating time and time again, since February 8th, 2010: The zone faces an institutional crisis. Back then, it was only an institutional problem. The disastrous handling of the crisis by Euro politicians have made it now a real economic one and we think there is no way out here but dissolution in chaos. This again, shall be very bullish of gold and bearish of risk (unlike mainstream view, we distinguish gold from “risk” because to us, gold is money). Enough said. We could go on but we think that over the past letters we have been very clear and unfortunately, times will now accelerate and we will witness this problem evolve exponentially.

In China, it seems the People’s Bank has not been sterilizing its FX reserves purchases. However, to mitigate the corresponding inflationary impact, it has been relentlessly increasing the reserves requirement ratio of financial institutions, using the “credit multiplier” channel. According to Bank of America’s Rates and FX Research team (“Global Rates and FX Weekly”, August 26th, 2011), by September 2010 the level of USD reserves had reached $3.4 trillion (CNY21.8 trillion) , while the People’s Bank’s debt had decreased from CNY4.4 trillion to CNY2.7 trillion. The gap between the FX reserves (i.e. assets) and the debt (liabilities) was covered by the increase in reserve requirements (i.e. liabilities too: Remember that the banks’ reserves in a central bank are an asset to the banks and a liability to the central bank).

Why did China’s central bank choose to hike reserves rather than issue debt to mitigate the impact of its USD purchases? It was simply cheaper, apparently, which means that if the trend continues two things will become evident: 1) the profitability of China’s banking system will be hurt, and 2) the US Treasury will find it harder to place its debt.

On the first point, the central bank may be forced to increase the interest rate on the reserves, dragging banks to depend on it, increasing the cost of eventually appreciating the Yuan (i.e. exit strategy). On the second point, the Fed will be forced to step in, should China merely stop accumulating reserves. We may add that as the first point becomes more relevant, the cost of eventual defaults will be way higher. Both issues are very bullish of gold and bearish of risk, too.

After all these considerations, we are really surprised to hear mainstream analysts say that another recession (as if the last one had ended) would be a so-called Black Swan event (i.e. a rare event). How so? We would argue that the opposite is true: In this context, avoiding a double dip is actually the Black Swan event!

Martin Sibileau

Please, click here to read this article in pdf format: august-19-2011

 

In light of the events yesterday, which in our view were mainly driven by fears of US dollar funding problems in the Eurozone banks, we thought it would be appropriate to reproduce our comments from June 4th, 2010, which anticipated a scenario like yesterday’s. From the comments, it should be clear that the ongoing environment is and probably will continue to be highly supportive of gold and bearish of stocks. The only thing that could change things here is a strong, determined will to fiscally integrate ALL members of the Eurozone and the simultaneous announcement of Euro bonds (to understand how they would work, please refer our letter from January 28th, 2011). Below, our comments from June 4th, 2010:

 

“…At “A View from the Trenches” we were ahead of the curve, anticipating this “content problem” (refer: www.sibileau.com/martin/2010/05/10, “What to expect when you are expecting”), associated with secondary market purchases even before the announcement of the ECB’s plan. Back then we wrote:

 

“…the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, under scenario B, the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy under scenario B? In the long run, the only way out for the ECB under scenario B is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy…”

 

There is also another criticism that we think is unwarranted, namely, the short term nature of the existing currency swap contracts between the ECB and the Fed. It is maintained that because these contracts are renewed on a weekly basis, instead of a longer-term (i.e. 84 days), USD funding conditions remain “uncertain”, which does not contribute to calm the markets. We believe the opposite is true. If the Fed validated the capital investments in the Euro-zone via currency swaps, which are nothing else but a hidden bailout of financial institutions, the Fed would be feeding the bullish trend in gold, at the expense of future higher USD inflation and of US taxpayers, and delaying an adjustment that would affect the ECB’s balance sheet more violently.

The term mismatch in the currency swaps (1-week) and the 3-mo Libor-OIS benchmark, as well as the uncertainty over its renewal sends a clear signal to those yet surviving that they need to unwind and take losses. In 1965, M. Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ) described a very similar situation occurring in the ‘20s with “currency swaps” between Britain and France, in this way:

 

“There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.” (J. Rueff, “The Monetary Sin of the West”, 1972)

 

Back in those days, as the Sterling and French Franc were backed by gold, the currency swap consisted in having Paris “lend” gold reserves to London, to address funding problems. The 2010 version of the same problem could read like this:

 

“There is a very interesting document from this period, a letter from M. Trichet, who was then the European Central Bank’s President, to Mr. Bernanke, who was the Chairman of the U.S. Federal Reserve; it must be of 2011. M. Trichet said, “We know that you are entitled to ask dollars for your dollars, but in the frame of the close friendship between the European Union and the United States we ask you, so as to avoid trouble for the European Union, not to do that, and receive Euros instead.” And we were, I must say, weak enough to comply with this request and not ask for dollars. The fact that I had such important U.S. dollar deposits in Frankfurt shows that we did not use this right to ask for U.S. dollars. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 2009 and 2010. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.”…”

 

Martin Sibileau