To read this article in pdf format, click here: May 5 2013

With equity valuations no longer levitating but in a different, 4^th dimension altogether, and credit spreads compressing… Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out.

It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool:  Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…

How it all began

Let me clarify: By currency swaps, I refer to a transaction carried out between two central banks. This means that currency swaps cannot be older than the central banks that extend them. On the other hand, foreign exchange swaps between corporations may date back to the late Middle Ages, when trade began to resurface in the Italian cities and the Hansastädte. Having said this, I believe that currency swaps were born in 1922, during the International Monetary Conference that took place in Geneva. This conference marked the beginning of the Gold Exchange Standard, with the goal of stabilizing exchange rates (in terms of gold) back to the pre-World War I.

According to Prof. Giovanni B. Pittaluga (Univ. di Genova), there were two key resolutions from the conference, which opened the door to currency swaps. Resolution No. 9 proposed that central banks “…centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves…”

Resolution No. 9 also spelled how the cooperation among central banks would work, which “…should embody some means of economizing the use of gold maintaining reserves in the form of foreign balance, such, for example, as the gold exchange standard or an international clearing system…”

In Resolution No. 11, we learn that: “…The convention will thus be based on a gold exchange standard.” (…) “…A participating country, in addition to any gold reserve held at home, may maintain in any other participating country reserves of approved assets in the form of bank balances, bills, short-term Securities, or other suitable liquid assets…. when progress permits, certain of the participating countries will establish a free market in gold and thus become gold centers”.

Lastly, gold or foreign exchange would back no less than 40% of the monetary base of central banks. With this agreement, the stage was set to manipulate liquidity in a coordinated way to a degree the world had never witnessed before. The reserve multiplier, composed by gold and foreign exchange could be “managed” and through an international clearing system, it could be managed globally.

How adjustments worked under the Gold Standard

Before 1922, adjustments within the Gold Standard involved the free movement of gold. In the figure below, I show what an adjustment would have looked like, as the United States underwent a balance of trade deficit, for instance:

Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs.

It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a “perpetual” level. This expectation provided “…the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations…”

There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention.  This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPM-led pool of liquidity injected to the call loan market.

How adjustments worked under the Gold Exchange Standard

During the 1920s and particularly with the stock imbalances resulting from World War I, the search for sustainable financing of reparation payments began. Complicating things, the beginning of this decade saw the hyper inflationary processes in Germany and Hungary. By 1924, England and the United States rolled out the Dawes Plan and between 1926 and 1928, the so called Poincaré Stabilization Plan in France. The former got Charles G. Dawes the Nobel Prize Peace, in 1925.

As the figure below shows, against a stable stock of gold, fiat currency would be loaned between central banks. In the case of a swap for the Banque de France, US dollars would be available/loaned, which were supposedly backed by gold. The reserve multiplier vs. gold expanded, of course:

 

With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefiting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.

How the perspective changed as the US became a debtor nation

Fast forward to 1965, two decades after World War II, and currency swaps are no longer seen as a tool to temporarily “stabilize” the financing of flows, like balance of trade deficits or war reparation payments, but stocks of debt. By 1965, central bankers are already worried with the creation of reserve assets, just like they are today; with the creation of collateral (see this great post by Zerohedge on the latter).

Indeed, 48 years ago, the Group of Ten presented what was called the Ossola Report, after Rinaldo Ossola, chairman of the study group involved in its preparation and also vice-chairman of the Bank of Italy. This report was specifically concerned with the creation of reserve assets. At least back then, gold was still considered to be one of them. In an amazing confession (although the document was initially restricted), the Ossola Group explicitly declared that the problem “…arises from the considered expectation that the future flow of gold into reserves cannot be prudently relied upon to meet all needs for an expansion of reserves associated with a growing volume of world trade and payments and that the contribution of dollar holdings to the growth of reserves seems unlikely to continue as in the past…”

Currency swaps were once again considered part of the solution. Under the so called “currency assets”, the swaps were included by the Ossola Group, as a useful tool for the creation of alternative reserves. Three months, during a Hearing before the Subcommittee on National Security and International Operations, William McChesney Martin, Jr., at that time Chairman of the Board of Governors of the Federal Reserve System, acknowledged a much greater role to currency swaps, in maintaining the role of the US dollar as the global reserve currency.

In McChesney Martin’s words: “…Under the swap agreements, both the System (i.e. Federal Reserve System) and its partners make drawings only for the purpose of counteracting the effects on exchange markets and reserve positions of temporary or transitional fluctuations in payments flows. About half of the drawings ever made by the System, and most of the drawings made by foreign central banks, have been repaid within three months; nearly 90 per cent of the recent drawings made by the System and 100 per cent of the drawings made by foreign central banks have been repaid within six months. In any event, no drawing is permitted to remain outstanding for more than twelve months. This policy ensures that drawings will be made, either by the System or by a foreign central, bank, only for temporary purposes and not for the purpose of financing a persistent payments deficit. In all swap arrangements both parties are fully protected from the danger of exchange-rate fluctuations. If a foreign central bank draws dollars, its obligation to repay dollars would not be altered if in the meantime its currency were devalued. Moreover, the drawings are exchanges of currencies rather than credits. For instance, if, say, the National Bank of Belgium draws dollars, the System receives the equivalent in Belgian francs; and since the National Bank of Belgium has to make repayment in dollars, the System is at all times protected from any possibility of loss. Obviously, the same protection is given to foreign central banks whenever the System draws a foreign currency.

The interest rates for drawings are identical for both parties. Hence, until one party disburses the currency drawn, there is no net interest burden for either party. Amounts drawn and actually disbursed incur an interest cost, needless to say; the interest charge is generally close to the U.S. Treasury bill rate…”

My graph below should help visualize the mechanism:

 

Essentially, with these currency swaps, foreign central banks that during the war had shifted their gold to the USA, became middlemen of a product that was a first-degree derivative of the US dollar, and a second-degree derivative of gold.

On September 24^th 1965, someone called this Ponzi scheme out. In an article published by Le Monde, Jacques Rueff publicly responded to this nonsense, under the hilarious title “Des plans d’irrigation pendant le déluge” (i.e. Irrigation plans during the flood). He minced no words and wrote:

“…C’est un euphénisme inacceptable et une scandaleuse hyprocrisie que de qualifier de création de “liquidités internationales” les multiples operations, tells que (currency) swaps…” “C’est commetre une fraude de meme nature que de présenter comme la consequence d’une insuffiscance générale de liquidités l’insufficance des moyens dont disposent les Etats-Unis et l’Anglaterre pour le réglement de leur déficit exterieur”

My translation: “…It is an unacceptable euphemism and an outrageous hypocrisy to qualify as creation of “international liquidity” multiple transactions, like (currency) swaps…”…“…In the same fashion, it is a fraud to present as the consequence of a general lack of liquidity, the lack of means available to the USA and England to settle their external deficits…”

Comparing the USA and England to underdeveloped countries, Rueff added that these also lack external resources, but those that are needed cannot be provided to them but by credit operations, rather than the superstition of a monetary invention disguised as necessary and in the general interest of the public (i.e. rest of the world).

With impressive prediction, Rueff warned that the problem would present itself in all its greatness, the day these two countries decide to recover their financial independence by reimbursing with their dangerous liabilities (i.e. currencies). That day, said Rueff, international coordination would be necessary and legitimate. But such coordination would not revolve around the creation of alternative instruments of reserve, demanded by a starving-for-liquidity world.  That day would be a day of liquidation, where debtors and creditors would be equally interested and would share the common responsibility of the lightness with which they jointly accepted the monetary difficulties that are present….Sadly, Rueff’s call could not sound more familiar to the observer in 2013…

How adjustments work today, without currency swaps

Until the end of the Gold Exchange Standard, even if the reserve multiplier suppressed the value of gold (like today), gold was still the ultimate reserve and had in itself no counterparty risk. After August 15^th, 1971, when Nixon issued the Executive Order 11615 (watch announcement here), the ultimate reserve was simply cash (i.e. US dollars) or its counterpart, US Treasuries. And unlike gold, these reserve assets could be created or destroyed ex-nihilo. When they are re-hypothecated, leverage grows unlimited and when their value falls, valuations dive unstoppable. Because (and unlike in 1907) the transmission channel for these reserves today is the banking system, when they become scarce, counterparty risk morphs into systemic risk.

When Rueff discussed currency swaps, he had imbalances in mind. In the 21^st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21^st century, we cannot afford to see the big picture. We can only see the “here and now”. Therefore, when we talk about currency swaps, the only thing we have in mind is counterparty risk within the financial system. The thermometer that measures such risk is the Eurodollar swap basis, shown below (source: Bloomberg). As the US dollar became the carry currency, the cost of accessing to it became the cornerstone of value for the rest of the asset spectrum, widely known as “risk”.

In the chat below, we can see two big gaps in the Eurodollar swap basis. The one in 2008 corresponds to the Lehman event. The one in 2011 corresponds to the banking crisis in the Eurozone that was contained with a reduction in the cost of USDEUR swaps and with the Long-Term Refinancing Operations done by the European Central Bank. In both events, the financial system was in danger and banks were forced to delever. How would the adjustment process have worked, had there not been currency swaps to extend?

 

 

In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. 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. As long as this process is left to the market to work itself out smoothly, borrowers don’t suffer, because ownership of the loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.

How adjustments work today, with currency swaps

Let’s now proceed to examine the adjustment –or better said, lack thereof- in the presence of currency swaps. The adjustment is delayed. In the figure below, we can see that the Fed intervenes indirectly, lending to Eurozone banks through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, of 2011, 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. The Fed becomes a creditor of the Eurozone. If systemic risk deteriorates in the Eurozone, the Fed is forced to first keep reducing the cost of the swaps and later to roll them indefinitely, as long as there is a European Central Bank as a counterparty for the Fed, to avoid an increase in interest rates in the US dollar funding market. But if the Euro zone broke up, there would not be any “safe” counterparty –at least in the short term- for the Fed to lend US dollars to. In the presence of a European central bank, the swaps would be bullish for gold. In the absence of one, the difficulty in establishing swap lines would temporarily be very bearish for gold (and the rest of the asset spectrum).

Final words

Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation. 

 

Martin Sibileau

Please, click here to read this article in pdf format: March 25 2012

During the past week, we think, we witnessed some interesting developments. In our previous letter, we had discussed what was the KreditAnstalt event of 1931. We saw a striking similarity with the current status quo because just like then, we now have sovereigns at the brink of default, whose creditors are other public institutions or countries, rather than private investors.
But there is more to it…

During the past week, we had Fed’s Chairman Ben Bernanke answering questions at the US Congress. It was there that Rep. Dan Burton (Indiana, 5th District) took Mr. Bernanke to task on the issue of the currency swaps the Fed has extended to the European Central Bank. On Thursday, we learned that the amount outstanding, which had reduced to $67BN, has remained there and increased a little bit. All this, in the face of a 7 ½ -month record low in US dollar funding costs for EU banks, given the 3-month cross currency swap basis reached 53bps below Euribor, on that same Thursday. The fact that the Fed currency swap lines are still in demand while the cost of US dollar funding keeps falling tells us that the EU financial system is segmented, with those who can access the market and those who cannot. But it also tells us that there is, paradoxically, an oversupply of US dollars, as we explain below.

R. Dan Burton then asked Mr. Bernanke how would the Fed recover the US dollars it loaned, should the Eurozone break. We made this point at “A View from the Trenches”, many, indeed many times before. You may see our latest letter on this issue at: http://sibileau.com/martin/2012/01/23/. Of course, Mr. Bernanke categorically played down the likelihood of such a scenario. He first lied to everyone saying that the debtor, the European Central Bank, does not finance governments. It was an insulting lie because not only does the ECB finance them indirectly via LTROs, but also explicitly and directly, through its Securities Market Programme, where more than EUR200BN are booked. Mr. Bernanke could not have and does not ignore this fact. Here is the link to the discussion: http://youtu.be/HzejoDbVXXs

On the other hand, we know that exactly this scenario, where the US had to bailout Europe, has already taken place in similar conditions. Back in 1931, when Austria defaulted leaving the gold standard, there was a generalized bank run (which the LTRO of last December prevented) and the United States had to establish a moratorium on the loans it had outstanding to Germany and to others. It was precisely this decision, that later pushed the United States to abandon the gold standard too, in 1932. Obviously, Americans understood that the amount of gold at the Fed, backing those claims now in moratorium, was not enough and they run against their banks as well. We found the video that shows President Hoover announcing the moratorium. It would have been so nice to have it handy to show to Mr. Bernanke before Congress: http://youtu.be/MFdTISc1KG0

Last week too, it was painful for those of us who still hold on to gold. Gold made interim lower lows at $1,628/oz on Thursday and bounced back to $1,665/oz on Friday afternoon. Is it still trading within range or is it consolidating to retake its bullish trend. We have our doubts, but the long term fundamentals support it. Let’s see…

One of the things that really caught our curiosity was to see the Euro appreciate since March 14th, with the simultaneous deterioration in sovereign credit risk. Since then, the sovereign spreads of Portugal, Spain, Italy and even Germany have been increasing. Should we not be looking at a weaker Euro in light of this? Why would we see the Euro flirting with a $1.33 level?

That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.

There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. This is the scenario that R. Dan Burton was proposing to Mr. Bernanke. Again, if this logic is correct, that scenario is not a tail risk, but the base risk.

How do we escape this circularity? With the ECB embarking in plain, good old Quantitative Easing. The collateralization of liquidity lines forces the EU to work within a context similar to that of the gold standard, where liquidity has to be backed by a commodity! In fact, if on the margin the supply of liquidity will only grow from collateralization, the EU would be better off under the gold standard, because gold at least, does not entail any credit risk!!!!Lowering interest rates, weakening collateral rules or extending maturities will not solve this problem.

If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU. These reasons make us feel comfortable holding gold.

We run out of time here, and we wished we had had the opportunity to discuss the fragile situation in two relevant countries: India and Canada. We will in our next letter.

Martin Sibileau

Please, click here to read this article in pdf format: March 5 2012

Let’s start by confirming that we remain long-term bullish of gold, near-term neutral of stocks (and long-term bearish of stocks), bullish of corporate credit risk, neutral of sovereign risk (European and US). We are neutral on the EURUSD (but if we had to make only one trade and hold on to it, we would be bearish) and surprised by the latest performance of the Canadian dollar (happily surprised, of course, as we are long of this currency).

It is a widespread rumor by now that the huge sell off at theLondonfixing on Wednesday February 29th was not driven by Bernanke’s comments before the US Congress, but by plain manipulation, likely from a non-private seller. We, having seen no reaction in 30-yr Treasuries, decided to buy the dip, for we think that in this context one can only buy and hold gold, sitting tight in the face of all this volatility, or risking to lose one’s position in the bull trend.

Someone asked us why, if we were such believers in gold, did not buy stocks of mining companies. To answer this, we will have to first understand why we buy gold. It is not because of anything intrinsic to gold. We don’t care that we cannot eat gold or that it doesn’t give you a dividend. You cannot eat US Federal Reserve notes either and these, rather than give you a dividend…depreciate.

We have to understand that one of the services rendered by money, namely the storage of value, is no longer attached to fiat currencies. And the world needs that service. There is demand for a reserve asset and gold can address it. Is it the only asset fit for that? No! The only thing we care is that in the long run, the demand for that service will keep increasing and at the margin, even competing with other assets, gold will get a bid. It is that simple.

Now, we can dig a bit deeper and ask ourselves what are the causes and implications of witnessing fiat currencies lose their demand as a reserve asset. The causes are clear to all of us, but not the implications. The one least understood is the distortion in relative prices caused by the intervention of central banks. We write more about it below but for now, think of this: In the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?

I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place. We can intuit when it is going to happen, but will only be lucky in actually calling it. However, with gold, it is different. Hence, our buy and hold approach. We’ve seen it before: When decadence arrives with inflation, people want to own the product, not the producer. We want to own gold, not miners.

And some have brought to our attention that by doing so, we lose the leverage provided by stocks. We disagree and think that the price action in mining stocks speaks for itself. Besides, should one want to lever the bet in gold, the only thing required is to borrow and buy more gold. It is more efficient: One knows ex-ante the leverage one wants and will end up with!

Now, let’s address the distortions generated lately by central banks (We will focus on the Fed and the European Central Bank, but we could also write about the intervention of the Japanese Yen and the scary fall in Yuan deposits in China, that is forcing a steady cut in reserve requirements over there. But these are underlying, long term problems. We will have to deal with them later). When the Fed provided the currency swap at 50bps to the European Central Bank in December, US dollars that were needed to fund EU banks, all of a sudden, were no longer needed. We are speaking here of more than $90billion. This is no small change! Also in the December and a few days ago, we had two 3-yr refinancing operations by the European Central Bank. In all, more than a trillion Euros were printed to, among other things, repay previous funding, some of which was in US dollars too. As you see, suddenly, the providers of US dollar funding saw themselves with a lot of cash in their hands.

They could not offer cheaper funding to EU banks or sovereigns because a) the Euro funds from the central bank are against collateral, which deeply subordinated USD unsecured debt, and b) the latest decision by the ISDA, which considers the swap of Greek bonds with the ECB not to trigger a credit event, further guarantees the subordination of private sovereign debt holders going forward.

What did they do? They poured the money into equities, corporate bonds, commodities. But in the Eurozone, the banks that now count with cheap Euro financing, will not take risks. If they take risks, it will be in the form of sovereign risk, buying sovereign bonds. They have been doing this since January and will continue to do so. All this means that the private sector in the Eurozone will remain affected by a credit crunch, unless…..well, unless those who were previously providing US dollar funding to EU banks now use their excess balances to fund EU corporates. This, we think, is going to be the case as USD denominated debt (Yankee issuance) will be increasingly issued by EU corporates. This is why we said at the beginning that we are bullish of corporate credit risk. We make this more visual in the chart below:

The problem with this new situation is that eventually, we shall see a wave of EU corporates defaulting: Compared to US corporates, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries). However, the hunger for yield these last two central bank interventions has generated is pushing US financials to chase riskier assets and high yield EU corporates look today like sweet, low hanging fruit ready to be picked. Who’s going to be in the way??? Nobody, as this is an election year and nobody ruins parties in election years!

But, if that wave of defaults occurred…who would be bailing out theUSinstitutions that financed the EU corporates? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we don’t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.

 

Martin Sibileau

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