Click the link to read this article in pdf format: January 21 2013

In our last letter, I wrote that: “…The case of Wells Fargo and the temporary pause in the flight of deposits from the periphery of the European Union suggest that the process towards a meltdown, if any (and I believe there will be one) will be a long agony. Furthermore, in the short term, at the end of January, European banks have the option to repay the money lent by the European Central Bank in the Long-Term Refinancing Operations from a year ago, on a weekly basis. I expect them to repay enough to cause more pain to those still long of gold (including me, of course)…”

Today, I want discuss the implication of the repayment of loans made under the Long-Term Refinancing Operations. These loans were extended at the end of 2011 and at the beginning of 2012. The first thing that comes to mind, of course, is the irony that last Friday (i.e. January 18^th), a $200 million 7-day repo operation by the Federal Reserve pushed the price of gold up $10/oz, while a EUR529.5 billion 3-yr collateralized loan from the European Central Bank (also known as the 2^nd LTRO) made on February 29^th, 2012 triggered a $100/oz sell-off. Should we expect the price of gold to rise upon the first repayment on January 30^th? J

A Long-Term Refinancing Operation consists in the European Central Bank loaning funds (with a 3-yr maturity) to a bank, against collateral. Banks have the option to begin repaying loans taken under the first LTRO (made for EUR489 billion, at 1%) on January 30^th, and on every week thereafter. The figure below (on the first LTRO only) should help visualize the above:

It is clear that an LTRO is a collateralized lending transaction. Why then is a repayment all of a sudden relevant? Because thanks to the backstop of Open Monetary Transactions, jump-to-default risk on the collateral used in the LTRO is perceived as non-existent. This suggests that the repayments will therefore not affect the assets purchased with the loans from the ECB. In other words, if the assets (i.e. Euro sovereign debt) that the banks had pledged as collateral are now backstopped, upon repayment of the loans, the banks will not feel the urge to get rid of them. Banks will simply have the option to fund their investments elsewhere, if appropriate. And lately, deposits in the periphery of the Euro zone seem to have ceased to flee.

All this means that, as of January 30^th, there will be a demand in the Euro funding market that was absent during 2012. A bank that wants to ensure access to funds at reasonable prices may fall prey to the concept of certainty equivalence. To such bank, guaranteed funding today may seem more valuable than probably cheaper funding tomorrow, as sourcing funds in the fragile Euro market is nothing short of a non-cooperative game. But this means that in the absence of further interventions by the Central Bank, time has value (again)!!! In a world of zero-interest rate policy, such an achievement may have a relevance that goes beyond a steepener curve in the EUR funds market or the new dynamic between the EONIA and Refi rate. At the moment, one can only intuit that it will be supportive of risk and hence the Euro.

Initially, it may very well confuse the market, representing an opportunity to buy risk, including (physical) precious metals for the long term. But as I proposed earlier, in 2013 I expect imbalances to grow, and the most important gauge of these imbalances will be the value of the Euro. The higher it gets, the more difficult it will become for the Euro zone periphery to repay its debt. And I will have more to say about this in coming letters.

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