On Friday, out of the office and away from the screens (we are currently visiting the US capital), we were spared the enormous volatility in gold. Gold tried to break through the lows made since a public institution liquidated bullion on Februrary 29^th but closed making a higher high (since the sell-off, of course).  This, in light of a jobs report taken mildly positively by the market and the drop in the Euro post Greek debt swap, is encouraging to gold bulls (not bugs, but bulls) like us.

The Greek resolution of their debt exchange, with its credit default swap triggered, was a real slap in the face to anyone who was educated under the mainstream portfolio theory, where the existence of a risk-free asset is cornerstone. (We don’t belong to that group of thinking, because we have always recognized that implicitly, modern portfolio theory rests on the Walrasian (refer: http://en.wikipedia.org/wiki/L%C3%A9on_Walras) view of general equilibrium and in the world of central banking, where banks lend multiple times other people’s real savings, general equilibrium theory looks like Ptolemy’s geocentric model of astronomy. But then again, Ptolemy’s model survived centuries and while it lasted, those who dared to challenge it were threatened with death and hell. We want to survive, which is why we are gold bulls, but not gold bugs J).

Indeed, the Greek debt developments, together with monetary policy in the European Union, are writing a new chapter in the history of financial crises. But first things first, we must say that those who seek to compare the situation in Greece with that in Argentina in 2001 are misled, very. When Argentina defaulted, the price of 1 USD rose from 1 peso to above 4 pesos. It was the devaluation that brought subsequent growth, not the default itself. Devaluation has so far been absent in Greece and as we wrote before, it can last as long as the Greek people are willing to put up with the austerity measures being imposed upon them by the EU Council.

Our next step is to recognize that from now on, if you are a holder of sovereign debt, you risk being deeply subordinated by a supranational institution (like the European Central Bank) and, on top of counterparty risk, you will suffer from a high degree of uncertainty related to the usefulness of credit default swaps you may own. Along the same path, you will have learned that whatever holdings you had in unsecured bank debt will also be deeply subordinated to the collateral taken by the European Central Bank to keep your borrower (i.e. the banks) solvent via long-term refinancing operations. You will also have found out that this collateral too, can be created out of thin air, as banks (as in the case of Italy) may obtain government guarantees on their debt issuance, post it at the central bank’s window and receive new, freshly printed Euros!

Capital is therefore flowing out of the European Union and the flow is set to increase, perhaps exponentially. Nobody should be surprised by the fall of the Euro last Friday. Where does that leave the European private sector? Those big conglomerates able to issue bonds in other currencies (mostly in USD) will be able to borrow. The small businesses who depended on the EU capital markets will struggle. The lesson here is that to defend their currency, the European Monetary Union has destroyed their capital markets. And we do not know which one will be easier to rebuild. If run uncontested, the European Union will end like an emerging market of the ‘80s, where foreign funding is needed to support private investments. In light of this, what are the chances that the Fed will raise real interest rates? Very slim we think, for if they are actually raised, currency swaps to the Eurozone will be needed, and that may not be politically sustainable at that time.

After this debt exchange, the public sector (ECB, IMF, etc) will be the majority owner of the debt of the public sector in Greece, and in the future, in the rest of the European Union. The way out of this mess can only be debt monetization.

We want to end with another comment on something that we think the markets may have not paid enough attention to. China is reported to start extending loans to other nations (Brazil, India, Russia) in their own currency. We are witnessing the start of a “reserves war”, where the supremacy of the US dollar will be challenged on the margin. We know so far that above 90% of the US Treasury’s issuance in long-term debt has been purchased by the Fed, while Russia and China have been selling it. What if the loans in Renmimbis from China are funded with the sale of stock in US Treasuries owned by the People’s Bank of China? What if the sale by a public institution of gold at the fixing on February 29^th was a warning to the other public institutions that are accumulating gold as reserves? What if that warning had been guessed by the Bank of Israel, influencing their decision to allocate up to 10% of their reserves in US equities, rather than in gold?

What if we are wrong? What if we are right? Should gold at $1,714/oz not look cheap? Should 30-yr US Treasuries not be a good short?

 Martin Sibileau

Please, click here to read this article in pdf format:january-21-20111

We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key assumptions for 2011 that we presented in our last letter are weak at best…Well….think again.

Has anything happened this week that may challenge the assumption of further consolidation in Europe? No. In fact, we have heard and read many times about Spain’s resolution to inject more capital to its savings banks (i.e. “cajas”) and Ireland may end up paying a lower interest rate on the bailout fund. In the US, the weekly jobless claims data showed that at least, they did not increase. Anecdotally also, the S&P National AMT-Free Municipal Bond Index has withstood the sell-off in risk. Existing home sales data also surprised with a stronger than expected rise. The Philly Fed manufacturing survey remained strong, and leading economic also provided positive news. However too, a weak TIPS auction shadowed the UST market.

Ah, but of course, it seems that the main concern comes from China. Apparently, given the last release of activity data, China is growing even in the face of incipient inflation (officially gauged at around 5%) and investors fear that an interest rate increase is on the works…Who spread this rumor? Why was it spread coincidentally with China’s Jintao visit to the US? We have no idea. Has China not been increasing interest rates unsuccessfully? Yes, they have. Has China not just manipulated the cost of capital (i.e. rates) but also its quantity via increases in the reserve ratio requirements (RRR)? Yes, they have.

Any basic textbook of macroeconomics will teach us that when a country decides to fix the value of its currency, it loses control over interest rates. At least the “real” interest rates…The same applies to credit controls. History shows they have always, always failed. Why would China ignore these facts? Because they have nothing to lose with trying. Because they seek to delay the inevitable. However, today we want to show that these manipulations can actually have the opposite effect, if they are abused. For instance, let’s take their policy of increasing RRR to the extreme. Below, we show the balance sheets of the People’s Bank of China (PBOC) and the Yuan banking system, in a very stylized way. On the asset side of the PBOC’s balance sheet, we find mostly US Treasuries backing the Yuan. On the liabilities’ side, banks’ reserves. On the asset side of the banks’ balance sheet, we find reserves and interest-bearing assets (loans). On the liabilities’ side, deposits and their net worth.

We have divided the process of taking the reserves requirement ratio to 100%, in three stages. In the second one we can see that as loans mature, their net issuance decreases, to boost reserves. We assume here that the process is neutral: Higher funding costs have no effect on defaults and the banks’ aggregate net worth does not need to change. The overall impact is simply a change in the composition of the banks’ asset side of their balance sheet.

As aggregate leverage decreases to the extreme, as we can see in stage 3, the PBOC is simply left with US sovereign debt fully backing reserves. Effectively, all deposits have been invested in these securities. The financial savings of the Chinese people have been coercively “loaned” to the US sovereign. With this extreme example, you start to realize the folly of this monetary policy.

Implicitly, once leverage is taken out of the picture, the PBOC is irrelevant. Legally, it continues to serve as a lender of last resort, but China is left entirely at the mercy of the US Treasury. As the US approaches default, the value of its debt will collapse…and so will the value of the deposits of Chinese citizens! The irony here is that a run against China’s financial system would not be triggered by an internal development. Nevertheless, if the PBOC had to bail out a financial institution in this context (by extending loans and/or decreasing reserve requirements), the increase in money supply would be felt much more than if there was leverage. For on the margin, the new quantity of Yuan being printed by the PBOC would truly stand out.

Therefore, the Yuan would depreciate and it would do so at the worst time, exactly when the world would need a strong reserve currency. The contagion from the US to the rest of the world would be widespread and more violently than necessary.

How would the rest of the world sort this out? Gold would have to fill the void, which is why the recent weakness represents an opportunity to us.

Martin Sibileau