Please, click here to read this article in pdf format: november-18-2010

A quick note to finish the week…We think we are entering a new stage in the dynamics of the Eurozone, and that the ongoing negotiation between Ireland and the European Union as well as the weakness in the Euro prove that the comment we made on September 9th was appropriate. We wrote:

“…Another interesting perspective is that which finds strength in the Euro, from the fact that peripheral countries can now access the European Financial Stability Facility, which is now effectively operational. We actually see it the other way: Precisely because the weak countries will access this facility, the break of the European Monetary Union will be accelerated, as the rich countries are faced with true costs; costs which until now were being piled under the big rug (the balance sheet) of the ECB…” (www.sibileau.com/martin/2010/09/09 )

Since November 4th, the Euro has embarked on a very defined downward trend. Counter intuitively, this should not occur.  Ireland does not need to access the market before June 2011 and if it required funding, the European Union is ready to sign the cheque. Therefore, what is behind the weakness?

To understand this issue and our previous comment, we need to see first that Europe has first and above all an institutional problem. Secondly, one can use the Game Theory approach. We are not well versed in this approach. We studied the theory while as undergraduate students and thanks to the extraordinary advancement of mathematics, we know it has evolved tremendously since John von Neumann and Oskar Morgenstern first published in 1944 the famous “Theory of Games and Economic Behavior”. We are very reluctant to use formal approaches to human action but we think the particular negotiations that are currently taking place can be easily analyzed under this method. Here are what we think can be premises:

1.-Ireland’s financial position, just like any other peripherals, deteriorates with the passage of time. However, as it does not require funding until June 2011, its position vs. time is stronger than that of Portugal or Spain (i.e. the first “derivative” of loss vs. time is lower for Ireland. But not the second. By 2011, everyone is on the same leveled field ).

2.-Ireland knows (1) above (i.e. has perfect information) and uses this upper hand to better negotiate the terms of the inevitable bailout. However, if it waits too long, the advantage is lost.

3.-Portugal, Spain and Italy know (i.e. have imperfect information) that once Ireland gets help via the EFSF, spaces will fill quickly. There isn’t simply enough room for everyone. The EFSF cannot be but for exceptions. Otherwise, there is no catch! An EFSF for everyone can simply not be AAA rated: A bank that lends with leverage cannot honor all deposits at once. Furthermore, keep in mind that there are no defined pan-European taxes supporting draws under the EFSF, but a promise from each respective EU member to get those funds somehow (Another important aspect here is that the IMF is contributing an additional 50% , which a friend and reader pointed to us is simply another important source of debt monetization).
Therefore, once Ireland draws under the EFSF, a race will start by Portugal, Spain and Italy to win the next seat, to be the next in line to draw, before the window closes. Be ready. All kinds of tricks and influences will be played at this point.

4.-Core EU members (i.e. Germany, France, Netherlands) know that the puck must stop somewhere, before their own solvency is compromised. If it is compromised, the only way out is a blanket, wide monetization of government debt by the European Central Bank, a massive currency crisis, assuming the EU monetary union doesn’t break. What are they doing about it? Ms. Merkel has been pushing to for the creation of a debt crisis mechanism, in which an “orderly” bankruptcy is carried out and whereby sovereign bondholders take a haircut. This is simply a wrong and absurd idea, which if implemented, it will only accelerate the demise of the monetary union. On this note, we think it is worth reading UBS Tommy Leung’s recent comments (UBS EU Credit Stategy – Daily Morning Walk, November 16th, 2010: “A glaring contradiction”) where he reflects upon this issue. Mr. Leung observes that this mechanism would discriminate between sovereign debt issued prior and after 2013, effectively creating a two-tiered EU sovereign debt market. This actually goes against the natural solution for Europe, which is a unified bond market! In this scenario, bonds issued prior to 2013 would be structurally senior to those issued from 2013 on. Mr. Leung further asks how would this be consistent under Basel III, where banks holding these bonds assign a zero risk-weight to them. Clearly, if a restructuring mechanism is considered, the possibility of default cannot be ignored.  Mr. Leung leaves the topic here, but we don’t. If default cannot be ignored, the arbitrage within the EU financial system will be immediate, with depositors shifting their savings from the banks holding the subordinated bonds to those holding the senior bonds. This can only deteriorate the balance sheet of the European Central Bank.

Where does all this leaves us? What can core EU members do? Nothing! Absolutely nothing. What will they do? Force more fiscal discipline on the other peripheral countries. But as we saw in point 3, once Ireland access the EFSF, these countries will have a strong incentive to fill in the last seat available. In other words, they will seek to show they can’t survive without it.

The US cannot react to this, as it is too concerned with its own problems. The latest performance of municipal debt is very telling in this respect. How can China react? By holding lower amounts of Euros as reserves and shifting that allocation to gold, slowly but steadily.

Lastly, we want to bring collective attention to the recent pressure the Fed is facing. Not only is there internal dissent regarding QE2, but also on Tuesday, as everyone must know by now, an open letter to the Fed was published by the Wall Street Journal, criticizing this latest move. Now, at our desk, we always have Bloomberg TV turned on and yesterday we noted how guest after guest was asked by different news anchors whether the Fed should not reconsider its dual mandate. Once an answer was given, the Bloomberg anchors replied asking whether Mr. Bernanke would likely resign on such change, noting that this is a possibility, given the new Republican majority in Congress. Are we thinking too much here? Were we watching a press op unfold or was this pure coincidence?

Martin Sibileau

Please, click here to read this article in pdf format:october-19-20101

Since our last letter, perhaps the most relevant event has been Mr. Bernanke’s speech, last Friday. Titled “Monetary policy objectives and tools in a low-inflation environment” (www.federalreserve.gov/newsevents/speech/bernanke20101015a.pdf ), this was a speech that made waves. Essentially, it made the case that given an environment with low inflation, there is room to look for alternative policy.  Will it be implemented as so many expect? The market’s belief that it will grows by the day. After yesterday’s release of capacity utilization (74.7% vs. consensus of 74.8%), the strength in the USD began to give way again…

As Mr. Bernanke put it, the topic of his speech was “…the formulation and conduct of monetary policy in a low-inflation environment…”. Interestingly, he introduced the subject reflecting on the fact that: “…From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world…”. We wonder if Mr. Bernanke ever asked himself why it would be the case that since the Great Depression and until the late ‘60s the greatest challenge was to bring inflation under control. In fact, in the case of emerging markets, this challenge lasted well into the ‘90s and is the topic of the day again, as these markets seek to avoid the appreciation of their currencies by “printing” money to buy the US dollars Bernanke prints, thereby importing Ben’s inflation.

If Mr. Bernanke would have asked himself why central banks in the past decades had such challenges, he would have surely found out that it was because his predecessors, just like he today, thought that a little bit of inflation would do no harm, and that the pain of having a high unemployment rate was bigger than that of high inflation.

If Mr. Bernanke did not underestimate our intelligence, he would surely realize that we know that in the end, even that little or high inflation generated no employment. In fact, inflation generates unemployment. Here’s why:

Inflation destroys savings and produces a lower savings rate. This destruction also generates a shortage in the stock of capital, which deteriorates productivity. To be certain, productivity also declines driven by the uncertainty in relative prices generated by inflation. As productivity falls, it is less feasible to maintain a labour force at the existing level of wages. Therefore, entrepreneurs/firms can only survive if they can get access to lower “real” wages or to “cheap” credit, to finance their working capital (i.e. collections deteriorate as clients seek to delay payments to profit from inflation, and inventories rise because firms anticipate future higher input prices). Naturally, with inflation, credit disappears and governments find that the only way to keep the music going is by further debasing the wages of those employed.

This cycle spirals even faster in a global economy, because as a consequence of the fall in productivity and unemployment of resources, citizens of the affected nation must now import those goods that were previously profitably produced in their land. However, as their currency depreciates (“wins” the currency war) against the rest of the world, the cost of those imports rises, further cutting their ability to save. If the nation initially required an increase in the supply of money of $1trillion of US dollars per year (as it is speculated Quantitative Easing 2 will entail) to keep the original demand level for goods, as this cycle runs its course, the need for additional liquidity will increase to replace the reduction in savings, wealth, chasing an even smaller amount of goods produced. The need for additional liquidity grows linearly at the beginning and exponentially at the end. This why it is never “politically” feasible to return to a “normal” state.

Yes, Mr. Bernanke is right. Any central bank has the tools to fight inflation later on. But none, absolutely none, has the political power to assume the cost when inflation is evident and high. It takes radical political change to break the cycle, the likes of which Reagan and Thatcher brought in the ‘80s. We see nothing close to this on the horizon for the next couple of years coming from any country.

Martin Sibileau

With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold.
 
We’ve seen this pattern before too, but it did not go too far, when it happened in 2008. Indeed, one could explain the behaviour by pointing at Mr. Bernanke’s comments yesterday, who made every effort before the Senate’s Banking Committee to be clear on the Fed’s intention to maintain a level of liquidity consistent with that of economic activity (weakness = low rate environment). Or maybe his comments on the possibility of reviewing MBS purchases, if required? But if that was the case, why would stocks not also rise, along with gold and oil? Why would the USD not weaken as well?
 
Clearly, the above factors cannot explain what happened yesterday. But if gold was bought as a way out of future currency debasements, then we have some comments to add here this morning.
 
If you have been reading “A View from the Trenches” long enough, you will remember that we turned neutral to bearish on gold (in USD) after the Dubai event, at the end of November 2009. Essentially, we believe the power of monetary policy coordination is a formidable challenge on gold’s prospects as a reserve currency. Therefore, if yesterday’s rally on gold and gold mining stocks was due to the increasingly likely fall of the Euro, as a consequence of the peripherals’ problems, we think gold bugs could later be disappointed.
 
Why?
 
In the 21st century, there are two global social classes: Politicians and taxpayers (This social stratification truly has global characteristics). If you think politicians will let you taxpayers get away from the inflation tax easily, think it twice. Let’s specifically consider the scenario where the Euro plunges. We think that if this happened, there would be an immediate increase in liquidity preference, expressed as a flight to the USD and the Treasuries markets. In that case, gold and stocks would be sold in favour of liquidity.
To those who disagree with this view, believing this chaotic situation would get off hands, we suggest that the Fed would be able to establish again, as it did in 2008, currency swap lines with other central banks, cushioning the impact of this move. This would be a deflationary event and no central bank would hesitate to provide extra liquidity. In summary, we fail to see a compelling story to be long of gold. And yet we are indeed worried, because the market proved us wrong yesterday and will prove us wrong today too, for gold is already at $1,112/oz.
 
For an historical perspective on this dynamic, let me quote below part of an interview M. Jacques Rueff gave to The Economist (Jacques Rueff: (http://en.wikipedia.org/wiki/Jacques_Rueff ). The interview was published on June 1965, and titled “The Role and the Rule of Gold.” The entire interview was reprinted in Jacques Rueff’s book “The Monetary Sin of the West”, MacMillan Co., New York, 1971, Part III. Its online version can be found at (www.mises.org/books/monetarysin.pdf ):
 
 
The Economist: …one of the countries that saw the biggest constriction imposed by the gold standard was, of course, Britain, which held no foreign exchange in its reserves. And, as we have always recognized, Britain at this time suffered precisely because of the harsh and inflexible disciplines of the gold standard, which you now want to restore.
 
J.R.: Let me tell you that you touch a point on which I have quite a few personal recollections. In 1930 I was financial attaché in the French Embassy in London, and in that capacity I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.
 
The Economist: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances, that was in part responsible for the general collapse later on?
 
 J.R. Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. 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. We were too gentle in complying with official appeals not to convert our sterling balances into gold…
 
 
The analogy here consists in that France did the same we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment. But politicians only care about the present.
 
Martin Sibileau

Please, click here to read this article in pdf format: february-11-2010

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau