To read this article in pdf format, click here: May 5 2013

With equity valuations no longer levitating but in a different, 4^th dimension altogether, and credit spreads compressing… Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out.

It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool:  Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…

How it all began

Let me clarify: By currency swaps, I refer to a transaction carried out between two central banks. This means that currency swaps cannot be older than the central banks that extend them. On the other hand, foreign exchange swaps between corporations may date back to the late Middle Ages, when trade began to resurface in the Italian cities and the Hansastädte. Having said this, I believe that currency swaps were born in 1922, during the International Monetary Conference that took place in Geneva. This conference marked the beginning of the Gold Exchange Standard, with the goal of stabilizing exchange rates (in terms of gold) back to the pre-World War I.

According to Prof. Giovanni B. Pittaluga (Univ. di Genova), there were two key resolutions from the conference, which opened the door to currency swaps. Resolution No. 9 proposed that central banks “…centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves…”

Resolution No. 9 also spelled how the cooperation among central banks would work, which “…should embody some means of economizing the use of gold maintaining reserves in the form of foreign balance, such, for example, as the gold exchange standard or an international clearing system…”

In Resolution No. 11, we learn that: “…The convention will thus be based on a gold exchange standard.” (…) “…A participating country, in addition to any gold reserve held at home, may maintain in any other participating country reserves of approved assets in the form of bank balances, bills, short-term Securities, or other suitable liquid assets…. when progress permits, certain of the participating countries will establish a free market in gold and thus become gold centers”.

Lastly, gold or foreign exchange would back no less than 40% of the monetary base of central banks. With this agreement, the stage was set to manipulate liquidity in a coordinated way to a degree the world had never witnessed before. The reserve multiplier, composed by gold and foreign exchange could be “managed” and through an international clearing system, it could be managed globally.

How adjustments worked under the Gold Standard

Before 1922, adjustments within the Gold Standard involved the free movement of gold. In the figure below, I show what an adjustment would have looked like, as the United States underwent a balance of trade deficit, for instance:

Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs.

It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a “perpetual” level. This expectation provided “…the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations…”

There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention.  This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPM-led pool of liquidity injected to the call loan market.

How adjustments worked under the Gold Exchange Standard

During the 1920s and particularly with the stock imbalances resulting from World War I, the search for sustainable financing of reparation payments began. Complicating things, the beginning of this decade saw the hyper inflationary processes in Germany and Hungary. By 1924, England and the United States rolled out the Dawes Plan and between 1926 and 1928, the so called Poincaré Stabilization Plan in France. The former got Charles G. Dawes the Nobel Prize Peace, in 1925.

As the figure below shows, against a stable stock of gold, fiat currency would be loaned between central banks. In the case of a swap for the Banque de France, US dollars would be available/loaned, which were supposedly backed by gold. The reserve multiplier vs. gold expanded, of course:

 

With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefiting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.

How the perspective changed as the US became a debtor nation

Fast forward to 1965, two decades after World War II, and currency swaps are no longer seen as a tool to temporarily “stabilize” the financing of flows, like balance of trade deficits or war reparation payments, but stocks of debt. By 1965, central bankers are already worried with the creation of reserve assets, just like they are today; with the creation of collateral (see this great post by Zerohedge on the latter).

Indeed, 48 years ago, the Group of Ten presented what was called the Ossola Report, after Rinaldo Ossola, chairman of the study group involved in its preparation and also vice-chairman of the Bank of Italy. This report was specifically concerned with the creation of reserve assets. At least back then, gold was still considered to be one of them. In an amazing confession (although the document was initially restricted), the Ossola Group explicitly declared that the problem “…arises from the considered expectation that the future flow of gold into reserves cannot be prudently relied upon to meet all needs for an expansion of reserves associated with a growing volume of world trade and payments and that the contribution of dollar holdings to the growth of reserves seems unlikely to continue as in the past…”

Currency swaps were once again considered part of the solution. Under the so called “currency assets”, the swaps were included by the Ossola Group, as a useful tool for the creation of alternative reserves. Three months, during a Hearing before the Subcommittee on National Security and International Operations, William McChesney Martin, Jr., at that time Chairman of the Board of Governors of the Federal Reserve System, acknowledged a much greater role to currency swaps, in maintaining the role of the US dollar as the global reserve currency.

In McChesney Martin’s words: “…Under the swap agreements, both the System (i.e. Federal Reserve System) and its partners make drawings only for the purpose of counteracting the effects on exchange markets and reserve positions of temporary or transitional fluctuations in payments flows. About half of the drawings ever made by the System, and most of the drawings made by foreign central banks, have been repaid within three months; nearly 90 per cent of the recent drawings made by the System and 100 per cent of the drawings made by foreign central banks have been repaid within six months. In any event, no drawing is permitted to remain outstanding for more than twelve months. This policy ensures that drawings will be made, either by the System or by a foreign central, bank, only for temporary purposes and not for the purpose of financing a persistent payments deficit. In all swap arrangements both parties are fully protected from the danger of exchange-rate fluctuations. If a foreign central bank draws dollars, its obligation to repay dollars would not be altered if in the meantime its currency were devalued. Moreover, the drawings are exchanges of currencies rather than credits. For instance, if, say, the National Bank of Belgium draws dollars, the System receives the equivalent in Belgian francs; and since the National Bank of Belgium has to make repayment in dollars, the System is at all times protected from any possibility of loss. Obviously, the same protection is given to foreign central banks whenever the System draws a foreign currency.

The interest rates for drawings are identical for both parties. Hence, until one party disburses the currency drawn, there is no net interest burden for either party. Amounts drawn and actually disbursed incur an interest cost, needless to say; the interest charge is generally close to the U.S. Treasury bill rate…”

My graph below should help visualize the mechanism:

 

Essentially, with these currency swaps, foreign central banks that during the war had shifted their gold to the USA, became middlemen of a product that was a first-degree derivative of the US dollar, and a second-degree derivative of gold.

On September 24^th 1965, someone called this Ponzi scheme out. In an article published by Le Monde, Jacques Rueff publicly responded to this nonsense, under the hilarious title “Des plans d’irrigation pendant le déluge” (i.e. Irrigation plans during the flood). He minced no words and wrote:

“…C’est un euphénisme inacceptable et une scandaleuse hyprocrisie que de qualifier de création de “liquidités internationales” les multiples operations, tells que (currency) swaps…” “C’est commetre une fraude de meme nature que de présenter comme la consequence d’une insuffiscance générale de liquidités l’insufficance des moyens dont disposent les Etats-Unis et l’Anglaterre pour le réglement de leur déficit exterieur”

My translation: “…It is an unacceptable euphemism and an outrageous hypocrisy to qualify as creation of “international liquidity” multiple transactions, like (currency) swaps…”…“…In the same fashion, it is a fraud to present as the consequence of a general lack of liquidity, the lack of means available to the USA and England to settle their external deficits…”

Comparing the USA and England to underdeveloped countries, Rueff added that these also lack external resources, but those that are needed cannot be provided to them but by credit operations, rather than the superstition of a monetary invention disguised as necessary and in the general interest of the public (i.e. rest of the world).

With impressive prediction, Rueff warned that the problem would present itself in all its greatness, the day these two countries decide to recover their financial independence by reimbursing with their dangerous liabilities (i.e. currencies). That day, said Rueff, international coordination would be necessary and legitimate. But such coordination would not revolve around the creation of alternative instruments of reserve, demanded by a starving-for-liquidity world.  That day would be a day of liquidation, where debtors and creditors would be equally interested and would share the common responsibility of the lightness with which they jointly accepted the monetary difficulties that are present….Sadly, Rueff’s call could not sound more familiar to the observer in 2013…

How adjustments work today, without currency swaps

Until the end of the Gold Exchange Standard, even if the reserve multiplier suppressed the value of gold (like today), gold was still the ultimate reserve and had in itself no counterparty risk. After August 15^th, 1971, when Nixon issued the Executive Order 11615 (watch announcement here), the ultimate reserve was simply cash (i.e. US dollars) or its counterpart, US Treasuries. And unlike gold, these reserve assets could be created or destroyed ex-nihilo. When they are re-hypothecated, leverage grows unlimited and when their value falls, valuations dive unstoppable. Because (and unlike in 1907) the transmission channel for these reserves today is the banking system, when they become scarce, counterparty risk morphs into systemic risk.

When Rueff discussed currency swaps, he had imbalances in mind. In the 21^st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21^st century, we cannot afford to see the big picture. We can only see the “here and now”. Therefore, when we talk about currency swaps, the only thing we have in mind is counterparty risk within the financial system. The thermometer that measures such risk is the Eurodollar swap basis, shown below (source: Bloomberg). As the US dollar became the carry currency, the cost of accessing to it became the cornerstone of value for the rest of the asset spectrum, widely known as “risk”.

In the chat below, we can see two big gaps in the Eurodollar swap basis. The one in 2008 corresponds to the Lehman event. The one in 2011 corresponds to the banking crisis in the Eurozone that was contained with a reduction in the cost of USDEUR swaps and with the Long-Term Refinancing Operations done by the European Central Bank. In both events, the financial system was in danger and banks were forced to delever. How would the adjustment process have worked, had there not been currency swaps to extend?

 

 

In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. We live in a fiat currency world, and banks simply let their loans amortize; there’s no mark to market. With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. As long as this process is left to the market to work itself out smoothly, borrowers don’t suffer, because ownership of the loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.

How adjustments work today, with currency swaps

Let’s now proceed to examine the adjustment –or better said, lack thereof- in the presence of currency swaps. The adjustment is delayed. In the figure below, we can see that the Fed intervenes indirectly, lending to Eurozone banks through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, of 2011, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk. The Fed becomes a creditor of the Eurozone. If systemic risk deteriorates in the Eurozone, the Fed is forced to first keep reducing the cost of the swaps and later to roll them indefinitely, as long as there is a European Central Bank as a counterparty for the Fed, to avoid an increase in interest rates in the US dollar funding market. But if the Euro zone broke up, there would not be any “safe” counterparty –at least in the short term- for the Fed to lend US dollars to. In the presence of a European central bank, the swaps would be bullish for gold. In the absence of one, the difficulty in establishing swap lines would temporarily be very bearish for gold (and the rest of the asset spectrum).

Final words

Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation. 

 

Martin Sibileau

Click here to read this article in pdf format: January 15 2013

In the same fashion that I proposed an analytic framework for 2012, I want to lay out today what I think will be the big themes of 2013. Their drivers were established in September 2012, and I sought to give a thorough description of them here, here and here.

An analytic framework for 2013

In one sentence, during 2013, I expect imbalances to grow. These imbalances are theUS fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. A stronger Euro is the consequence of capital inflows driven by the elimination of jump-to-default risk in EMU sovereign debt. Below is a drawing I made to help visualize these concepts:

The drawing shows a circular dynamic playing out: The threat of the European Central Bank to purchase the debt of sovereigns (that submit to a fiscal adjustment program) eliminates the jump-to-default risk of this asset class. As explained and forecasted in September, this threat also forces a convergence in sovereign yields within the EMU, to lower levels. As long as the market perceives that the solvency of Germany is not affected, the Bund yields will not rise to that convergence level. So far, the market seems not to see that (Possunt quia posse uidentur). But the resulting appreciation of the Euro will eventually address that illusion.

This convergence, in my view, is behind the recent weakness in Treasuries. I proposed this thesis last September. However, the ongoing weakness in Treasuries does not mean I was right. In fact, I fear I may have been right for the wrong reasons. The negotiations on the US fiscal deficit and the latest announcement of the Fed with regards to debt monetization quantitative easing to infinity may also be behind this move. But until proven wrong, I will cautiously hold to my thesis.

The above factors drove capital inflows back to the European Monetary Union and strengthened the Euro. I believe this strength will last longer than many can endure. The circularity of this all resides in that the strength of the Euro will make unemployment and fiscal deficits a structural feature of the EMU, forcing the ECB to keep the threat of and eventually implementing the Open Monetary Transactions. The alternative is a social uprising and that will not be tolerated by the Euro kleptocracy.

All this -and particularly the strength of the Euro- is not sustainable. Ad infinitum, it would create a Euro so strong that the periphery would drag coreEuropein its bankruptcy. But while it lasts, the compression in sovereign yield will mask the increasing default risks in Euro corporate debt, specially the one denominated in US dollars. Both have been fuelling the rise in the value of equities globally.

The unsustainable framework rests upon the shoulders of the Federal Reserve, which thanks to the established USD swaps and unlimited Quantitative Easing, has completely coupled its balance sheet to that of the European Central Bank. In the end, as this new set of relative prices between asset classes sets in, it will be more difficult for the European Central Bank to sterilize the Open Monetary Transactions.

History provides an example of the current growth in imbalances

By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth “should be made of sterner stuff”.

Under the current framework, the European Central Bank can afford to engage in the purchase of sovereign debt because the Fed is indirectly financing the European private sector. The Fed does so with the backstop of USD swaps and tangible quantitative easing, which provides cheap USD funding to European banks and thus avoids a credit contraction of the sorts we began to see at the end of 2011.

This same structure was in place between the Federal Reserve and the central banks of France and England in 1927, 1928 and 1929 and, as a witness declared, “(it) transformed the depression of 1929 into the Great Depression of 1931”. Something tells me that this time however it will be different. It will be worse. That little something is the determination of the new Japanese government to devalue its currency via purchases of European sovereign debt (ESM debt).

How fragile is this Entente?

Most analysts I have read/heard, focus on the political fragility of the framework. And they are right. The uncertainty over theUSdebt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible.

However, unemployment is “the” fundamental underlying factor in this story and I do not think it will fall. In the long term, financial repression, including zero-interest rate policies, simply hurt investment demand and productivity. I do not see unemployment dictating the rhythm in 2013, indirectly through defaults. Furthermore, in the meantime, the picture may look different, because “…we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private…”. This is obviously supportive of risk.

No systemic meltdown in 2013?

From earlier letters, you know that I believe quasi-fiscal deficits (i.e. deficits from a central bank) are a necessary condition for a meltdown to occur, and that these usually appear when deposits begin to seriously evaporate. So far, capital is leaving main street (via leveraged share buybacks and dividends), but at the same time, it is being parked at banks in the form of deposits. 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).

 

Martin Sibileau

Please, click here to read this article in pdf format: October 14 2012

Today, we were supposed to follow up on our last topic (how to shift to a commodity-based standard, with a 100% reserve requirement). However, we will have to leave that for quieter times. Right now, we have to address a few points that we have been making since 2009:

There’s a truly “must-read” book, for anyone who is really interested in understanding how central banks have run the show since the 1920’s: “The monetary sin of the West”, by Jacques Rueff. In his memoirs, M. Rueff makes it clear that the rally that ended in October 1929 was fueled by what we call today currency swaps. Indeed, in 1931 (Robert Triffin was still a student) M. Rueff was writing:

“…There is one innovation which has materially contributed to the difficulties that are besetting the world…(…)… 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.” Letter to Pierre-Étienne Flandin, October 1^st, 1931.

The innovation M. Rueff referred to 81 years ago was what Keynesian economists of the 21st century very mistakenly call “decoupling”; a term that was used precisely to characterize the impact that the reduction in the price (to 50bps) of USD currency swaps had on the funding market, in December of last year. Today, this impact is best reflected in the cost of funding of the world’s carry currency, the US dollar, in terms of Euros. That price is called the Eurodollar swap basis. From the chart below (3-month basis, source: Bloomberg), we see how it has performed since 2008, as a result of interventions. Every time the cost spiraled up (basis down), the Fed intervened with the swaps (i.e. US dollar liquidity lines).

On December 12^th, 2011, we explained the mechanics of these swaps, and in January 2012, tired of reading the idiotic claim that policy makers had decoupled the US from the Euro zone, we wrote in a note titled “There is no decoupling” that : “…The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fed’s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse, together with the ECB, without any swaps …”

Why did we say (and still maintain) that “The problems of the Euro zone are now really coupled to the Fed’s balance sheet”? The same economists who view these swaps as decoupling the Euro zone from the USD zone also believe that the swaps effectively removed “tail risk”. As we warned on March 4^th, the FX swaps would allow credit Euro zone corporations to raise debt in US dollars, opening the door for the European Central Bank to monetize sovereign debt and crowd out, in Euros, the non-financial private sector. In US dollars, this crowding out was not going to happen (and it did not happen), courtesy of the Fed.

However, if the Euro zone was going to survive, we wrote that: “…eventually, we shall see a wave of EU corporations defaulting: Compared to US corporations, 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)…. but, if that wave of defaults occurred…who would be bailing out the US institutions that financed the EU corporations? 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.” We offered the chart below:

Which brings us back to the core of today’s article…What has happened since we wrote about these issues?

First, last week Dennis Gartman, in his homonymous letter said that he was concerned about the fact that the adjusted monetary base has been falling, rather than rising, taking away the bullish case for gold on the topic of “money printing”. One must therefore remind those with this concern that the credit expansion caused by the backstop of the Fed alone is enough to inflate asset prices. This is consistent with the case we made in our last letter, that a commodity based standard is not as relevant as having a 100% reserve requirement. By the same token, if the reserve requirement is below 100%, it is not that relevant to see the expansion of the monetary base! The “printing of money” will eventually come, when EU corporations begin to default and the Fed has to “ensure there is enough US dollar liquidity”. It happened in 1931-33, in spite of the fact that the adjusted monetary base had been contracting since 1929: The US dollar was devalued from approx. $20.65/oz to approx. $34.70oz and gold was confiscated. If you don’t believe this, here’s the video showing the bailout of Germany from USD debt, announced by President  Hoover in 1931:

 And here’s the announcement of the confiscation of gold:

It can happen in the future, because the same Ponzi scheme is being played out before our eyes. We are not alone with this concern. Congressman Ron Paul has publicly expressed this view, as this video shows:

 We will repeat ourselves: AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER.

 But, how do we know this is a problem? Is it true that EU corporations have already embarked in US dollar borrowing which can have consequences in the future? On October 5^th, BNP Paribas’ US Credit team published a review of the state of the Yankee market. Compared to a decade ago, the Yankee market represents now 20% of the US dollar corporate bond market (from 10%), but the strongest growth occurred since 2011/12. The same publication notes that industrials (i.e. non-financial issuers) have grown in importance and now constitute 58% of all Yankees (bonds) (Curiously, the authors of the publication see this positively, because –apparently-, thanks to this growth in US dollar borrowing by non-US issuers, the market (both demand and supply) gains in diversification. I hope someone reminds these people to check what level the cross-asset correlation reaches, when the next liquidity crunch comes. Our bet is that it probably reaches 1!)

 Can we see this “coupling” of the Fed’s balance sheet with the rest of the world causing other distortions? The Credit Derivatives team of Morgan Stanley, in its Credit Derivatives Insights publication of October 9^th, noticed that less than 5% of the bonds in USD non-financials (in the iBoxx) are trading below par. And in the high-yield space, 70% of the non-financials are above par. What’s even worse, 24% of high-yield non-financials is even above their call prices!

In this context, hedging with credit default swaps is not efficient, because under the respective contracts, protection on default is covered only up to 100% of the price of the bond, and these bonds are trading above 100%. This means that, in some cases, even if one bought a bond and hedged it with a credit default swap, at default, one would suffer a significant loss. In other words, this shows a probability of default that is under priced, underestimated. And guess what…it makes sense!! Yes, with Bernanke at the helm of the Fed, you have to underestimate the probability of default, because he is telling in our faces that he will print dollars as long as US dollar liquidity is needed! But, but….should we really fear defaults? Well, there is always the ongoing concern that the Euro zone may break, sending shock waves everywhere. But also, in corporations, leverage is once again building up, and this time, more because EBITDA is deteriorating than the debt increasing.

This brings us to our final point: Will interest rates increase? We have observed a discrepancy of views in US Treasury rates forecasts this week too. If you read our last letters, you will know by now that we expect, if the ECB engages in its Outright Monetary Transactions, a convergence of short-term sovereign yields within the Euro zone. And, in the end, we expect both the short-term Euro zone yield and the USD yield to converge too, courtesy of the Fed’s coupling via the backstop entailed in the FX swaps. But the path towards that convergence is what has been taking our attention lately. We think that in the beginning, US yields should increase until a maximum tolerable level is achieved, after which, the Fed intervenes via purchases to keep yields within an implicit target. Until we get there, we will have to first see the bailout of Spain and some concrete steps towards an EU banking union. That will surely be the topic of future articles. But right now, obviously, we’re not seeing the materialization of these steps.

Once that level in USD rates is reached, the Fed will have to regularly purchase US Treasuries, to keep yields within their acceptable range. The assumption is that both the US fiscal deficit and the Outright Monetary Transactions continue. This would devalue the USD, making Yankee issuance even more palatable! This will be the bailout of the Fed, to the EU corporate sector and it can only last as long as the appreciation of the Euro does not hurt the Euro zone periphery. But it will…

Martin Sibileau

 

Click here to read this article in pdf format: May 29 2012

In our last letter, we dealt with the issue of (EUR/USD) liquidity in the capital markets and although we described some facts, we did not mention a relevant one: That while the 3-month EURUSD swap basis has not risen, the 3-yr (and longer term) has. In other words, the spread between the two bases has widened, as the chart below shows (source: Bloomberg).

This steepening, in our view (and we welcome readers’ feedback), is caused by the existence of the 3-yr LTROs (Long-term refinancing operations), established by the European Central Bank (ECB) at the end of 2011, beginning of 2012, coupled with the 3-month Fed currency swaps. As is also visible from the chart, in the past, the widening (i.e. steepening) of this spread  of the EURUSD basis curve was corrected with (i.e. preceded) interventions. Is there one coming soon? A long-term currency swap? For three years? We doubt it, given we’re only a few months away from the US presidential election, and not only do we doubt it: We also think that should there be one, its effect would be very marginal.

During the past week, one rumored alternative intervention was a blanket guarantee on euro denominated deposits, across the European Union. We will explain why we think it would not work:

A guarantee is a contingency. According to generally accepted accounting principles, they way to record a loss contingency is to show a liability, against a loss. This means that in the balance sheet of the corporation issuing the guarantee, liabilities will rise and the value of equity, by the same amount, will fall.

In corporate finance, these contingencies must be shown every time that the following conditions are simultaneously met:

a)       Information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred,

b)       The amount of loss can be reasonably estimated

Indeed, national accounting is not corporate accounting. But principles are principles and at the end of the day, it is the private sector, people, that end up holding euros to be guaranteed by Bunds.

Should, as the rumor spread, Germany and others from core Europe, offer the guarantee to the ECB to back liquidity, the value of their own liabilities would fall, helped by the corresponding downgrade of the ratings agencies. In other words, the benchmark rate of the Euro zone, the bund yield (i.e. German sovereign bonds), would increase. The asset, the Bunds, would have been impaired, as condition (a) states. This would fuel the ongoing recession within the Union, possibly buffered a bit by the fall in the value of the Euro and capital gains (stock gains) in Euro financials.

An answer to this would come from the ECB, via purchases of Bunds. With them, the expansion of Euros would be driven by the purchase of Bunds and all and any support left for Bunds from the private sector would be lost, just like it was lost for the long-term US Treasury bonds: As you may know, under Operation Twist, the Fed purchased 91% of all 20-30 yr gross issuances!!

At the end of the day, Germany would have run a bigger deficit (i.e. coming from the losses reflecting the guarantees), higher interest rates, lower ratings, a weaker financial system with bigger deposit runs (now affecting core European banks), and a currency of lower value….The question is…..What makes you think  Germany will want to go for this?

 

Martin Sibileau

Please, click here to read this article in pdf format: March 25 2012

During the past week, we think, we witnessed some interesting developments. In our previous letter, we had discussed what was the KreditAnstalt event of 1931. We saw a striking similarity with the current status quo because just like then, we now have sovereigns at the brink of default, whose creditors are other public institutions or countries, rather than private investors.
But there is more to it…

During the past week, we had Fed’s Chairman Ben Bernanke answering questions at the US Congress. It was there that Rep. Dan Burton (Indiana, 5th District) took Mr. Bernanke to task on the issue of the currency swaps the Fed has extended to the European Central Bank. On Thursday, we learned that the amount outstanding, which had reduced to $67BN, has remained there and increased a little bit. All this, in the face of a 7 ½ -month record low in US dollar funding costs for EU banks, given the 3-month cross currency swap basis reached 53bps below Euribor, on that same Thursday. The fact that the Fed currency swap lines are still in demand while the cost of US dollar funding keeps falling tells us that the EU financial system is segmented, with those who can access the market and those who cannot. But it also tells us that there is, paradoxically, an oversupply of US dollars, as we explain below.

R. Dan Burton then asked Mr. Bernanke how would the Fed recover the US dollars it loaned, should the Eurozone break. We made this point at “A View from the Trenches”, many, indeed many times before. You may see our latest letter on this issue at: http://sibileau.com/martin/2012/01/23/. Of course, Mr. Bernanke categorically played down the likelihood of such a scenario. He first lied to everyone saying that the debtor, the European Central Bank, does not finance governments. It was an insulting lie because not only does the ECB finance them indirectly via LTROs, but also explicitly and directly, through its Securities Market Programme, where more than EUR200BN are booked. Mr. Bernanke could not have and does not ignore this fact. Here is the link to the discussion: http://youtu.be/HzejoDbVXXs

On the other hand, we know that exactly this scenario, where the US had to bailout Europe, has already taken place in similar conditions. Back in 1931, when Austria defaulted leaving the gold standard, there was a generalized bank run (which the LTRO of last December prevented) and the United States had to establish a moratorium on the loans it had outstanding to Germany and to others. It was precisely this decision, that later pushed the United States to abandon the gold standard too, in 1932. Obviously, Americans understood that the amount of gold at the Fed, backing those claims now in moratorium, was not enough and they run against their banks as well. We found the video that shows President Hoover announcing the moratorium. It would have been so nice to have it handy to show to Mr. Bernanke before Congress: http://youtu.be/MFdTISc1KG0

Last week too, it was painful for those of us who still hold on to gold. Gold made interim lower lows at $1,628/oz on Thursday and bounced back to $1,665/oz on Friday afternoon. Is it still trading within range or is it consolidating to retake its bullish trend. We have our doubts, but the long term fundamentals support it. Let’s see…

One of the things that really caught our curiosity was to see the Euro appreciate since March 14th, with the simultaneous deterioration in sovereign credit risk. Since then, the sovereign spreads of Portugal, Spain, Italy and even Germany have been increasing. Should we not be looking at a weaker Euro in light of this? Why would we see the Euro flirting with a $1.33 level?

That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.

There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. This is the scenario that R. Dan Burton was proposing to Mr. Bernanke. Again, if this logic is correct, that scenario is not a tail risk, but the base risk.

How do we escape this circularity? With the ECB embarking in plain, good old Quantitative Easing. The collateralization of liquidity lines forces the EU to work within a context similar to that of the gold standard, where liquidity has to be backed by a commodity! In fact, if on the margin the supply of liquidity will only grow from collateralization, the EU would be better off under the gold standard, because gold at least, does not entail any credit risk!!!!Lowering interest rates, weakening collateral rules or extending maturities will not solve this problem.

If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU. These reasons make us feel comfortable holding gold.

We run out of time here, and we wished we had had the opportunity to discuss the fragile situation in two relevant countries: India and Canada. We will in our next letter.

Martin Sibileau