Please, click here to read this article in pdf format: March 18 2012

We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…

Title No.1: “The market proved us wrong”

Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!

We have no doubts that the plunge in gold on February 29^th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:

The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.

The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.

As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…

Title No. 2: “Financial repression, Stage 1”

Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously.  It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:

“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945

The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…

Title No. 3: “Remember the KreditAnstalt”

Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.

The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11^th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.

In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17^th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21^st. The countries that held sterling pounds as foreign reserves suffered heavy losses.

Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.

The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.

Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.

In 2012, 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 will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…

Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…

Martin Sibileau

Please, click here to read this article in pdf format: september-23-2010

Continuing with our last letter, which laid out the details of the Yen intervention (ref.: www.sibileau.com/martin/2010/09/23 ) we want to proceed to answer a few questions. But before that, let’s clarify the concept of sterilization…

Under sterilization, a central bank seeks to bring the supply of money back to the original size it had, prior to an intervention in the markets (in this case, in the foreign exchange market). The outcome, after the sterilization is carried out, is a change in the composition of the asset side or the liabilities’ side of the central bank’s balance sheet.

Let’s take, as examples, the last interventions of both the Fed and the European Central Bank (ECB).

When the US dollar spiked in the midst of the liquidity crisis of 2008 or when the Greek problem generated a rush to sell Euro and buy US dollars, the Fed extended cross-currency swaps to the ECB (and other central banks too).

These swaps are an asset to the Fed, which is matched by the creation of a reserve, as Mr. Daniel Tarullo, member of the Board of Governors of the Fed explained to Ron Paul, on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ). The mechanism is shown in the graph below

In step 1, the Fed creates money out of a reserve, which in step 2 debits for a cross currency swap (credited). That cross currency swap is an asset to the Fed, which it extends to the ECB. To the ECB, it is a liability and the ECB credits US dollars. Does anything here seem out of place? If this puzzles you, you are not alone. This was criticized way back in the ‘30s, as Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ), in his book “The Monetary Sins of the West” wrote:

“…On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government’s attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:

There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold exchange standard. Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange. The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin. The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect. For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market, without reducing in any way the money supply in their market of origin. The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit….” (Here is the link, refer page 12 at : www.mises.org/book/monetarysin.pdf )

Anyway, the interesting point here is that at the end of the exercise, on the balance sheet of the Fed, both assets and liabilities are matched in terms of currency. If the US dollars depreciate, this doesn’t impact the assets of the Fed.

The Fed does not need to sterilize this intervention, because the currency swap has a finite term and the rate charged by the other central banks, like the ECB, to their financial institutions (i.e. Euro-zone banks) using this facility is punitive enough to encourage repayment. In fact, the rate establishes an implicit cap in the market, since no bank will pay more for US dollar funding than what they can if they borrow from their respective central bank. The intervention, effectively, depreciates the US dollar.

In the case of the European Central Bank, sterilization did take place this year. We actually described the mechanism in our letter from May 13th (www.sibileau.com/martin/2010/05/13 ) and reproduce the graph below.

In step 2, we see that the ECB purchases government bonds from peripheral countries (i.e. PIGS debt), issuing Euros. To bring the supply of Euros back to the original size, the ECB (Step 3) issues debt, which is bought by the Banks (i.e. the banks place the Euros in deposit). In effect, this debt has been issued under weekly refinancings, using the Term deposit for SMP facility. Deposits (i.e a liability of the ECB) amounted to EUR61.5BN by September 21st.  Here, as can be seen, sterilization consisted in an exchange of liabilities: Euros in exchange of Term Deposits.

How did the ECB manage to depreciate the Euro, even under sterilization? Because it decreased the quality of the assets backing its liabilities: The proportion of riskier sovereign debt backing the Euro increased. Most importantly still, the message to the public was that, if required, that proportion could grow even bigger (as reflected in the current fears about the Irish banking system).

Once again, the important concept here is that both the asset side and liabilities side of the balance sheet of the ECB are denominated in the same currency: The Euro. As in the case of the Fed, there is no mismatch here. If the Euro drops in value, it does affect assets by the same proportion it affects liabilities.

At this point, we are prepared to address the intervention of the Yen. We reproduce here the graph shown in the previous letter.

As we wrote, in order to sell Yen to the FX market to devalue it, the Ministry of Finance issues Finance Bills (i.e. Finance Bills 1), which are “bought” by the Bank of Japan, in exchange for Yen (i.e. Yen1). Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases.  At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1.

Let’s stop for a moment here. As you can see, without sterilization, the Ministry of Finance ends up holding US dollars as assets, and Finance bills, in Yen, as liabilities. They have a mismatch here.

What happens if they sterilize? We show the process below:

To bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills (i.e. Finance Bills 2) in the market. The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2.

Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. (In fact, it sounds inappropriate to call this “Sterilization”, because the Bank of Japan does not participate in it and as a result, there are no changes in either the asset side or the liabilities side of its balance sheet).

But the important thing here is that even after this “sterilization”, the Ministry of Finance still has US dollars on the asset side of its balance sheet. The mismatch, now against Finance bills 2, remains.

This is why we think sterilization is irrelevant here. Why? Because as long as these US dollars continue in the balance sheet of the Ministry of Finance, they will be a source of further imbalances. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:

P&L = D US dollars (in its Assets) / D t – D Finance Bills 2 / D t

(* D = Delta)

As the Fed engages in further quantitative easing, as it clearly stated yesterday in its the FOMC statement, the P&L of the Ministry of Finance will deteriorate. A negative P&L can be bridged with higher taxes (not acceptable), sale of assets (not in question), less spending (not possible) or higher debt.

Thus, the Ministry of Finance, as the US dollar falls further, will have to issue more Finance Bills, to cover the deficit, which may be substantial, given the massive size of its interventions. But as it issues more debt, the interest rate will increase, appreciating the Yen even more against the US dollar. This is a self-feeding, spiraling problem.

How can the Ministry of Finance get rid of the currency mismatch? By selling the US dollars to another central bank!!! This is why we have been saying that coordination with other central banks is more relevant than sterilization.

Which central bank wants to buy US dollars? None at the moment.
The Fed? They can’t! They are actually doing the opposite: They are buying Treasuries to sell US dollars!

What is then the Ministry of Finance to do with the US dollars? Buy treasuries? Most likely and in doing so, the Japanese tax payer will be further financing the American consumption party. With this intervention, finally, the last asset left to serve as reserve for our savings is gold. The verdict is unanimous. The Yen gets the contagion from the quantitative easing policies of the US, the US debases its currency, and those holding Euros are at the mercy of the politicians in the peripheral countries.

What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!

Martin Sibileau

Please, click here to read this article in pdf format: september-20-2010

In our last letter, we made the point that the intervention to devalue the Yen was supportive of gold. We explicitly decided to exclude from our comments the details of the intervention, but now in hindsight, believe it was not appropriate. Therefore, we want to start the week going through these details. We think it is important to understand the same because they give us a lot of information and we can deduct important conclusions.

Without further ado, let’s examine how this intervention should work. The operative word here is “should”, because the intervention is still in its early stages and there is speculation about its effectiveness. We refer the reader to the latest research by Bank of America’s G10 FX Strategy team published on September 16th, 2010 (our source), for a slightly different perspective on the mechanism we will describe below. We understand this mechanism is best explained in a work titled “Modern Monetary Theory”, written by Mr. Shirakawa, who is currently the Governor of the Bank of Japan (we have not been able to access it yet). Finally, we wish to devote two letters to the analysis of this event, given its relevance. In today’s letter, we will go through the details and some important conclusions. In the next letter, we will explain the differences between this type of intervention and the one we are used to see, via central banks. We will also examine why coordination with other central banks, which is missing so far, is important and how that in turn gives support to gold. Let’s start…

In Japan, the FX intervention is carried out by the Ministry of Finance, rather than the Bank of Japan. In order to sell Yen to the FX market to devalue, the Ministry of Finance issues Finance Bills, which are “bought” by the Bank of Japan, in Yen. Let’s call these first issuances Finance Bills “1” and Yen “1”, which are issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (graph 1):

Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases.  At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1. However, to bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills in the market. We will call this issuance Finance Bills 2, which are shown below (graph 2). The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:

Of course, as the Ministry of Finance goes to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increases. Given the current market conditions, the impact on price must be minimal. However, as in any other bond market, as supply grows, yield tends to grow (i.e. price tends to fall), to encourage market participants to buy the increased supply.

Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. The Ministry of Finance has USDs on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (graph 3):

The three graphs above show the balance sheets of all the participants in this intervention: The Ministry of Finance, the Bank of Japan, the FX market and the Yen Government debt market. However, we think it may also be interesting to show the intervention in terms of cash flows. Therefore, we show graph 4 below, where we can see that de facto, the Ministry of Finance ends up acting as intermediary between the Government debt market and the FX market. In essence, the intervention “moves” Yen from the Government debt market to the FX market, and this is a “fragile” movement, because it lends itself to arbitrage. Hence, the importance of central bank coordination, to gain “independence” from this source of Yen supply.

Why does this movement of Yen lend itself to arbitrage? Because an asset can never have two different prices in different markets. Whenever that occurs, arbitrageurs fix the problem.

You may question why we think the Yen has two different prices. Well, let us answer that question with another one: Why would the Yen Government Debt market need a “middle-man” (see graph above, graph 4) to provide Yen to the FX market?

It doesn’t!!! The Yen Government Debt market is “not willing” to buy US dollars (i.e. provide Yen) from the FX market at a loss (i.e. buying US dollars at above market prices).

So, who ends up taking the loss? Who ends up buying US dollars at above 82 Yen per dollar? The Ministry of Finance does, which means the average Japanese tax payer! This person is subsidizing the big exporting conglomerates of Japan, so that they can provide “financing” to the American consumer who is broke. The subsidy can be significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen will tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) will lose purchasing power.

In the long term, the Ministry of Finance incurs into a deficit (if the USD depreciates further) which can only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:

P&L =

D US dollars (in its Assets) / D t – D Finance Bills 2 / D t

(* D= Delta)

If the Fed undertakes quantitative easing again, the value of the US dollars will fall, generating a loss to the Ministry of Finance. Will they keep buying US dollars then?

Today, we have laid out the general details of the Yen intervention. In the next letter, we will examine other issues/conclusions associated with it: Why is it important to coordinate with other central banks? How would that coordination work? What makes this intervention different to others? Why did Mr. Shirakawa note that under this mechanism the issue of sterilization is meaningless? Is the coordination supportive of gold? Can the intervention affect US interest rates (i.e. Where will the Ministry of Finance invest the US dollars it buys?). These are all important questions and they need answers.

Martin Sibileau

Please, click here to read this article in pdf format: february-12-2010

(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)

The statement released by European authorities yesterday was a mere expression of support for Greece, explicitly denying a request by Greece, for financial aid. The markets accordingly sold all things European, including and in particular Spanish financials. The picture does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.

What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for $16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended 4bps steeper at 285bps. The Czech Republic was also deceived when it raised 15-yr debt on Wednesday and Greek banks seem to be facing funding problems. We also face significant uncertainty with the latest developments in Iran.  But on the other hand, the markets received some “optimistic” releases too. Continuing job claims in the US kept their downward trend, Australia also saw an improvement in its labour market and the CPI reading in China was stronger than expected.

Briefly, of one thing we may be certain: Capital is flowing out of the Eurozone and into the rest of the world. But at the same time, capital seemed yesterday to also be preferring commodities and basic materials, which puzzles us, because the macroeconomic backdrop is bearish for us.

In our view, we should not see yesterday’s rally in North American stocks and credit, as well as in crude and oil, as a bullish signal, after the EU meeting’s statement. Why? Because for this rally to be interpreted as bullish, the Euro should have rallied as well! It didn’t and in fact plunged from a tall cliff, specially against the Canadian dollar. A reduction in the purchasing power of the Eurozone should not be seen as something positive for global growth (= for oil demand and hence for the Canadian market!)

Interestingly enough, Freddie Mac yesterday announced that it will buy practically all 120+days delinquent mortgage loans from its fixed rate and adjustable rate mortgage Participation Certificate securities. We had foreseen a move of this type and discussed it in December and on our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:

“…As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity. In December, I associated this process with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)…”

Back to the impressive strength shown yesterday by the Canadian Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At close, 1.05 were enough. The CAD was even stronger of course vs. the Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted such a move?  In our view, the strength in the CAD was not fully reflected in the stocks market (TSX 60), which closed +1.32% higher, at 11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.

Martin Sibileau