Click here to read this article in pdf format: December 9 2012

Today, I want to summarize what we covered over the year. During 2012, I sought to address both theory and market developments. Under an Austrian approach, I discussed many macroeconomic topics: the effect of zero interest rates, the myth of decoupling (between the US and the Euro zone), collateralized monetary systems (as imposed by the European Central Bank), the technical (but not realistic) possibility of a smooth exit from the Euro zone, the destruction of the capital markets by financial repression, the link between the futures, repo and gold markets and consumer prices (I don’t like the word “consumer prices”, but it is better than speaking of a “price level”), insider trading, circular reasoning in mainstream economics, high-frequency trading, what can precipitate the end game to this crisis, the technicalities of a transition to a gold standard, the conditions for a successful implementation of the gold standard, and the flawed logic behind the Chicago plan, as proposed by Benes & Kumhof.

Let’s now briefly follow up on each of the market themes I covered in 2012:

1.-There has been no decoupling: The Euro zone is coupled to the US dollar zone

At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US.

As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency.

In January of 2012, I laid out an analytic framework to visualize the dynamics between these two currency zones. I reproduce the figure below without comment, as it is self explanatory:

 

In February, I anticipated that the European Central Bank was eventually going to need to floor the value of sovereign debt. It took about seven more painful months to see this take place, with the announcement of the Open Monetary Transactions. With this in mind, I suggested not to chase the stock rally and warned that shorting the euro would be a painful trade.

2.- Manipulation in the gold market

From my years at the Universidad de Buenos Aires, I always remember professors J. M. Fanelli and Daniel Heymann, because they used to and still think that policy makers (in Argentina) had no choice but to “manage” the price of the US dollar (vs. the peso) to fight inflation. The value of the US dollar, in pesos, was a signal that shaped inflation expectations, according to them. In the same fashion, I am convinced that those at the helm of the G7 central banks believe that to shape inflation expectations and avoid the burst of the bond bubble, they need to manage the price of gold. And that is exactly what they have been doing (via swaps, leases from their deposits at below market rates), since Standard & Poor’s downgraded the sovereign risk rating of the US. They are wrong of course and in time, it will prove to have been an expensive decision. The proof? Movements like the $100/oz drop upon the announcement of the second Long-term Refinancing Operation at the end of February. Nobody who lives marked to market would ever dump so much gold in seconds in a market, let alone do so sustainably and predictably, as it often happens, between 10am and 11am ET. I am convinced that had it not been for this manipulation, gold would have had a stellar performance this year. But how serious can I sound debating a counter-factual statement?

3.-Liquidity will not fund capital expenditures but share buybacks, dividends

In March, we were perhaps the first to suggest that the US dollar liquidity enabled by the Fed via swaps was going to be used to buy back shares and distribute dividends, rather than finance capital expenditures (I say “perhaps” because a few days later David Rosenberg expressed the same view). This is a typical outcome of financial repression. Nations under financial repression generate bankrupt companies owned by wealthy owners. Time will tell but so far, numerous articles have been suggesting that this trend is taking place (Eric Beinstein, from JP Morgan, shows evidence to the contrary, in his latest Credit Markets Outlook report). Because of this, I proposed that as a trading theme, one should buy the product, rather than the producers, which is a winning trade in inflationary environments. Therefore, the suggestion was to buy gold, rather than gold miners.

4.-To defend their currency, the Euro zone destroyed its capital markets

(At this stage, I think no comments are needed on this point, which I made in March.)

5.- Sovereign debt owned by other sovereigns is a concern

In March too, I noticed that the situation in 2012 resembles that of 1931, as Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and just like in 1931 (when France, for political reasons, allowed the KreditAnstalt to go bankrupt), when the next bailout is due, political conditions will be demanded that no private and rational investor would demand.

6.-Canada’s story will be different

In April, I proposed that the Canadian context was different and that rather than expect contagion from the banking system to the government, in Canada, we should expect contagion from the government to the banking system. I still expect this deterioration to be triggered by an exogenous development (i.e. outside Canada) and the reaction of the Canadian dollar to the revised unemployment rate on December 7^th may be telling us that this view has merit.

7.- September marked a tectonic shift

I will not elaborate on the points below. I wrote extensively about them in September (see here, here and here), but I need to mention them because they are very relevant for the next year. These points, I must clarify, are my best case scenario, because the necessary condition for their validity is that Spain and any other peripheral country in need of a bailout asks for one and receives the support of the European Central Bank (ECB) in exchange :

-The market will arbitrage the rates of core Europe and its periphery, converging into a single Euro zone target yield (with higher German rates).

-We will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield. Inflation expectations will pick up

-The Canadian dollar should not rise significantly above the US dollar (i.e. above $1.04 per 1 CAD).

-The ECB backstop (i.e. purchase of sovereign debt) generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)

This implies that in the future, sterilization at low rates or the suggested negative deposit rates at the European Central Bank, under Open Monetary Transactions, will not be feasible. Banks will demand high rates in exchange, if they are to sell the debt to the central bank.

Epilogue

In my next letter, and likely the last one of the year, I will address the topic of why we have not yet seen high or hyper inflation and what is necessary, in general, to see this phenomenon take place. The letter will go dedicated to Peter Schiff. In it, I will seek to show that unlike Keynesian economists believe, not only are high nominal interest rates compatible with high inflation, but in fact they are a necessary condition for high inflation to exist and morph into hyperinflation. This is a paradox to mainstream economics…and, coming from Argentina, I love paradoxes.

A final observation, on method

As my approach is within the Austrian school, you may have noticed that I use praxeology. ( “a theorem of a praxeological science provides information that has been derived by sheer reasoning; it is the product of pure logic without the assistance of any empirical observation”, I. Kirzner). Hence, you find almost no statistics in my articles. My aversion to them is due to my view that the national accounting system used to date is simply a barbaric relic of mercantilist doctrine. But that’s a story for another time… I walk through problems using simple axioms and test their logic with identities (i.e. balance sheets). Mainstream economists, on the other hand, use equations. Hence, they need to “torture” their stats to prove their propositions, because they are inductive. I use deduction.

 

 

Martin Sibileau

If we have to summarize what drove the action last week, we will say it was the speculation over an upcoming (perhaps in June) Growth Pact in the Euro-zone. That was all. That did the trick. There is really nothing, absolutely nothing concrete. And no, we don’t think the market is speculating on a soon-to-come Quantitative Easing Version 3. But from pure intuition, it would seem that the market sees these conditions as necessary to take the any Pact seriously: a) Mario Draghi, President of the European Central Bank, would have to back such pact in a way that would guarantee some sort of deficit monetization, and b) Hollande should win France’s presidential ballotage, next weekend.

Indeed, most news were bearish last week and yet, every single asset class seemed to end on a bullish note. From the Euro zone, we saw a deceiving bond auction by Italy. We also learned that the unemployment rate in Spain (the official rate) averages between 20% and 30%, depending on which region one measures it, and that the United Kingdom is already in a double dip. This only resulted in a stronger Euro and stronger Euro stocks for the week.

Last week too, Moody’s downgraded Ontario’s credit rating to Aa2 with a stable outlook from Aa1 with a negative outlook. How did the market react? The Canadian dollar finished the week stronger. Then came the activity data release for the United States: Jobless claims, housing data, inflation data…all of them were worse than expected and yet….stocks rallied, with the S&P500 reaching again the 1,400pts. And we could say the same about oil and gold…

The lesson here is that a market that will not fall on bearish news is a bullish market. Even if it is a manipulated market, which brings us back to gold. Below is the daily chart (source: Kitco.com) for April 25th, 2012. It shows how upon the start of Bernanke’s press conference an algorithm sold whatever it could precisely at one point in time. Everybody saw it coming. We saw it coming, after what had happened on February 29th, or with the Euro peg announcement by the Swiss National Bank, in 2011. And this time, whoever was behind the move, lost money. We can only hope these moves stop or expect that newer, smarter moves will follow. We think the latter are more likely than the former:

Somehow, the idea of a “Growth Pact” reminds us of the New Deal and Ludwig Von Mises’ comment on the same. Von Mises wisely said:“…The comparatively greater prosperity of the United States is an outcome of the fact that the New Deal did not come in 1900 or 1910, but only in 1933…”. His words, in light of this Growth Pact speculation, sound to us wiser than ever…

We want to leave with this thought: As we have repeated, since the start of the Long-Term Refinancing Operations by the European Central Bank, the savings rate of the world (yes, now is the global savings rate) keeps slowly drifting lower either because of the manipulation of interest rates by central banks, or the fact that income is falling, as in the case of the European Union and the UK, or because of simple financial repression, as in the case of the debt swap between Greece and the European Central Bank, which left holders of sovereign debt suddenly subordinated. This simple observation leads us to think that this crisis will continue to unfold like a painful agony, and that we have many, indeed many more years of it to come.

Martin Sibileau

Last week we had suggested that the strength of the Euro (by strength, we mean a Euro above $1,30) could be based on the fact that the liquidity lines extended by the European Central Bank were collateralized. As the sovereign risk of Spain,Italy and Portugal had deteriorated, so had the value of their sovereign debt diminished and, as this debt had been used as collateral by the banks of the Eurozone, these banks would be forced to sell assets and buy Euros to post on margin. It was simple and beautiful logic. However, we were wrong and the reason for that left us even more concerned. Someone better informed than us, who shall remain anonymous, wrote us the following (the highlighting is ours):

“…Hi Martin,

I just wanted to chime in on the issue of ECB (European Central Bank) margin calls. I completely agree that in theory the collateralized lending that now dominates can develop into a vicious cycle (as well as a virtuous one of course). However, in practice, a lot of the collateral that is pledged at the ECB is marked to model rather than marked to market. At least that’s what I am inferring from the ECB margin calls. The spikes that you saw relate to Greek collateral coming in and out of the ECB refi ops. Abstracting from those the margin calls themselves tend to be too small in my view to have an impact on the Euro…”

Having proved our axiom wrong (i.e. margin calls triggered by market volatility), our thesis is proved wrong. We had at the beginning of 2012 however warned that: “…in the short-term, the demand for Euros does not wane, because sovereign debt is denominated in that currency and the refinancing operations of the European Central Bank facilitate the purchase of that debt. This suggests to us that shorting the Euro will be a painful trade, with very high volatility…” (“Walking the fine line”, Feb 6^th, 2012).

It is time now for us to write a few lines today about Canada and India. Over the past months, we have seen crude oil appreciate. Simultaneously, the Canadian dollar did not (the Canadian dollar is positively correlated with crude oil) and the data coming from activity in Canadahas been disappointing. What makes matters worse is that in light of this, the price of housing has remained strong and even slowly increasing. In discussions with those following this market we noticed that in general, investors tend to see the Canadian context with the same lens used to see that of the USand the UK: They see a bubble in the housing market that would eventually be harmful to the financial system, and which would end in systemic weakness for Canada. This is, after all, what occurred in the USand the UK(We remind readers that at “A View from the Trenches”, we have never seen the EU crisis based on anything else but an institutional problem, rather than a liquidity or solvency problem. Refer: http://sibileau.com/martin/2010/02/10/)

We see the Canadian context differently. We think that it is likely that the barbarians will use the back, rather than the front door. Because Canadians have on average tended to put significant down payments on their houses, only a fraction of the outstanding mortgages have required insurance from the Canadian Housing Mortgage Corp. That fraction can be (but is not necessarily) securitized. The rest remains warehoused by Canadian banks, which unlike US banks, have recourse on their borrowers (if these default on their homes). Our fear then is of a potential contagion from the government. Indeed, rather than expect contagion from the banking system to the government, inCanada, we expect contagion from the government to the banking system. If the fiscal situation deteriorated (led by Ontario), the guarantee of the Canadian Housing Mortgage Corp. and the implicit comfort based on the country’s sovereign AAA rating would immediately affect the banks.

Do we expect this deterioration to be triggered by an endogenous dynamic? No. We fear that Canada may be affected by a foreign development and we can think of many, from the Euro-zone,China, or theUS…which takes us to India.

India has and is embarked in an inflationary process and, like in any other inflationary process, the outstanding amount of money is the taxing base. Following the example set by the Mahatma Gandhi, Indians peacefully protest this taxation by leaving the taxing base, the rupee, in exchange of gold. This has angered the government there which has taken a few repressive measures. It has taxed gold (a tax currently under review), set import duties and even barred gold loan companies (that lend on gold as collateral) from lending against gold bars, coins and bullion. These companies can now only lend against gold jewellery, with a cap on the loan-to value asset ratio and maintaining a minimum Tier 1 capital of 12 per cent. Does anyone think that these measures will favour the development of capital markets in India? Does anyone actually believe that because the competition from the gold loan market falls, savings in rupees will grow and investors will accept the government’s strong hand and lend in rupees? This is another example of the idiocy of bureaucrats that is destroying capital markets across the globe. Not only will savings in rupees not grow, but the overall savings rate will tend to fall, because on the margin, if savings have nowhere to go…why save?

This destruction of capital markets, as we noted, is not only taking place in India. The same is carried away slowly, by breaking the price system, whose signals no longer seem to work. Compared to July 2011, we have more than a trillion of new Euros, we have had Operation Twist, the banks of England and Japan weaken their currencies, sovereign downgrades worldwide, Ben Bernanke announcing low rates until 2014 and yet, gold is below $1,700/oz, courtesy of the interventions (see: http://www.zerohedge.com/news/paul-mylchreest-presents-various-visual-case-studies-gold-price-manipulation) . Even worse, although gold is below $1,700/oz, it is obviously higher than a year ago…but the capitalization of the gold mining sector is lower.

Repression, repression, repression…Interest rates don’t reflect anything these days. If you ask us, we don’t even know what to call capital. The price of crude oil touched $110/bl and yet the capitalization of energy sector in Canada slipped. Only a few dare to short the Euro, in the face of the massive destruction of the financial system in the Euro-zone. How can this be possible?

People wonder and at the same time praise the fact that companies nowadays hoard record amounts of cash, as a sign of strength. We think this is actually a disgrace and it shows how central banks managed to distort the relative prices of the different components of the economy’s capital structure. These companies are not investing that cash but as we mentioned a month ago, they have started to return it via dividends or share buybacks.

The final outcome of these repressive policies can only be a reduction in the savings rate and investments, a fall in productivity, an increase in consumption, if the supply of money continues and the inevitable stagflation.

 

Martin Sibileau

Please, click here to read this article in pdf format: march-31-2010

This Monday, we attended a conference of The Economic Club of Canada, which had Mr. Paul Jenkins, Senior Deputy Governor of the Bank of Canada, as speaker. From the brief presentation titled “Beyond Recovery: Sustaining Economic Growth”,  we conclude the following:

-The Bank of Canada is most likely not going to explicitly intervene, if the Canadian dollar reaches parity and beyond. The speech itself was a message to Canada’s export sector to increase productivity to confront this appreciation.  The operative word here is “explicitly” because as we have written many times here, the Bank of Canada does actually intervene in the market via its repurchase agreement transactions.

-During the question period, we asked Mr. Jenkins about the Bank’s view on sovereign credit default swaps. We posed this question in a very open way, to test the reaction. Our impression was that Mr. Jenkins was not familiar with this asset class, as he referred us to upcoming G-20 meetings that will address regulatory matters related to the issue. We cannot blame him, since Canada has so far never been quoted in the sovereign credit default swaps market, given its relatively solid financial position.

-We are concerned about the view the Bank of Canada has on productivity, relative to the environment the country is in these days. We do not want to get too theoretical here, but we think the Bank of Canada still holds the nineteenth century view that value is based on the productivity of production factors. The Bank is lately making comments on the productivity of Canada, on the belief that if productivity increases to match the appreciation of the Canadian dollar, the country will remain “competitive” and avoid inflation.

Why are we concerned? Well, what is productivity anyway, and why do you think the Canadian dollar has appreciated?

I am sure most will agree with the opinion that the latest appreciation of the Canadian dollar, in light of the increasing sovereign risk concerns coming both from Europe and the US, was driven not only by the “commodity bid” that accompanied the recovery of 2009, but also by the “safe-haven bid”, which has left this currency almost neutral vs. gold. We first proposed this thesis back in June 2009 and refreshed it on March 4th (refer: “Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 and “The stars favor Canada”, in: www.sibileau.com/martin/2010/03/04 ).

If we are correct, Canada is not only competitive supplying the world with commodities, but with financial, fiduciary services too. The main fiduciary service is ironically supplied by the Bank of Canada (which means its staff is grossly underpaid) that seems to be very competitive providing a reserve asset to the world. In fact, perhaps this country is way more productive exporting a reserve asset than oil or gas or mining products or engineering services. But would this productivity be included in the Bank of Canada’s calculations? Why not? Why should we worry if we are not more competitive than Brazil destroying our forests to win the forest products market? Why should we be concerned if we are not effective contaminating our boreal landscape with oil sands projects so that we may compete with the Saudis in the energy sector? What is wrong with being competitive with fiduciary services? The Bank of Canada of course doesn’t share our perspective and will never clarify that they implicitly make a subjective judgment on productivity.

Lastly, for those interested in the formal aspect of this discussion, we refer to the concept of a “Social welfare function”, under the Theory of Public Choice. In our opinion, for the Bank of Canada, this function is:

W = y1 + y2 + …+yn ,

where W is social welfare and Yi is the income of a sector i among n in the Canadian society. To maximize the social welfare function we may seek to maximize for instance the income of sector 1 at the expense of sector 2, if we deem sector 1 is “more productive” than sector 2. Does it make sense to you? In our view, the function (and by the way, we don’t think there is such a thing as a social welfare function) should be: W = y1 =y2 =…=yn. But this is a discussion for another time!

Martin Sibileau