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

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

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