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