Click here to read this article in pdf format: December 9 2012

Today, I want to summarize what we covered over the year. During 2012, I sought to address both theory and market developments. Under an Austrian approach, I discussed many macroeconomic topics: the effect of zero interest rates, the myth of decoupling (between the US and the Euro zone), collateralized monetary systems (as imposed by the European Central Bank), the technical (but not realistic) possibility of a smooth exit from the Euro zone, the destruction of the capital markets by financial repression, the link between the futures, repo and gold markets and consumer prices (I don’t like the word “consumer prices”, but it is better than speaking of a “price level”), insider trading, circular reasoning in mainstream economics, high-frequency trading, what can precipitate the end game to this crisis, the technicalities of a transition to a gold standard, the conditions for a successful implementation of the gold standard, and the flawed logic behind the Chicago plan, as proposed by Benes & Kumhof.

Let’s now briefly follow up on each of the market themes I covered in 2012:

1.-There has been no decoupling: The Euro zone is coupled to the US dollar zone

At the end of 2011, when the collapse of the banking system in the Euro zone (courtesy of M. Trichet) was dragging the rest of the world, the Swiss National Bank established a peg on the Franc to the Euro and the Federal Reserve extended and cheapened its currency swaps with the European Central Bank. These two measures –indirectly- coupled the fate of the assets in the balance sheets of the Euro zone banks to the balance sheets of the central banks of Switzerland and the US.

As in any other Ponzi scheme, when the weakest link breaks, the chain breaks. The risk of such a break-up, applied to economics, is known as systemic risk or “correlation going to 1”. As the weakest link (i.e. the Euro zone) was coupled to the chain of the Fed, global systemic risk (or correlation) dropped. Apparently, those managing a correlation trade in IG9 (i.e. investment grade credit index series 9) for a well-known global bank did not understand this. But it would be misguided to conclude that the concept has now been understood, because there are too many analysts and fund managers who still interpret this coupling as a success at eliminating or decreasing tail risk. No such thing could be farther from the truth. What they call tail risk, namely the break-up of the Euro zone is not a “tail” risk. It is the logical consequence of the institutional structure of the European Monetary Union, which lacks fiscal union and a common balance sheet. I am not in favour of such, but in its absence, to think that the break-up is a tail risk is to hide one’s head in the sand. And to think that because corporations and banks in the Euro zone now have access to cheap US dollar funding, the recession will not bring defaults, will be a very costly mistake. Those potential defaults are not a tail risk either: If you tax a nation to death, destroy its capital markets, nourish its unemployment, condemn it to an expensive currency and give its corporations liquidity at stupidly low costs you can only expect one outcome: Defaults. The fact that they shall be addressed with even more US dollars coming from the Fed in no way justifies complacency.

In January of 2012, I laid out an analytic framework to visualize the dynamics between these two currency zones. I reproduce the figure below without comment, as it is self explanatory:

 

In February, I anticipated that the European Central Bank was eventually going to need to floor the value of sovereign debt. It took about seven more painful months to see this take place, with the announcement of the Open Monetary Transactions. With this in mind, I suggested not to chase the stock rally and warned that shorting the euro would be a painful trade.

2.- Manipulation in the gold market

From my years at the Universidad de Buenos Aires, I always remember professors J. M. Fanelli and Daniel Heymann, because they used to and still think that policy makers (in Argentina) had no choice but to “manage” the price of the US dollar (vs. the peso) to fight inflation. The value of the US dollar, in pesos, was a signal that shaped inflation expectations, according to them. In the same fashion, I am convinced that those at the helm of the G7 central banks believe that to shape inflation expectations and avoid the burst of the bond bubble, they need to manage the price of gold. And that is exactly what they have been doing (via swaps, leases from their deposits at below market rates), since Standard & Poor’s downgraded the sovereign risk rating of the US. They are wrong of course and in time, it will prove to have been an expensive decision. The proof? Movements like the $100/oz drop upon the announcement of the second Long-term Refinancing Operation at the end of February. Nobody who lives marked to market would ever dump so much gold in seconds in a market, let alone do so sustainably and predictably, as it often happens, between 10am and 11am ET. I am convinced that had it not been for this manipulation, gold would have had a stellar performance this year. But how serious can I sound debating a counter-factual statement?

3.-Liquidity will not fund capital expenditures but share buybacks, dividends

In March, we were perhaps the first to suggest that the US dollar liquidity enabled by the Fed via swaps was going to be used to buy back shares and distribute dividends, rather than finance capital expenditures (I say “perhaps” because a few days later David Rosenberg expressed the same view). This is a typical outcome of financial repression. Nations under financial repression generate bankrupt companies owned by wealthy owners. Time will tell but so far, numerous articles have been suggesting that this trend is taking place (Eric Beinstein, from JP Morgan, shows evidence to the contrary, in his latest Credit Markets Outlook report). Because of this, I proposed that as a trading theme, one should buy the product, rather than the producers, which is a winning trade in inflationary environments. Therefore, the suggestion was to buy gold, rather than gold miners.

4.-To defend their currency, the Euro zone destroyed its capital markets

(At this stage, I think no comments are needed on this point, which I made in March.)

5.- Sovereign debt owned by other sovereigns is a concern

In March too, I noticed that the situation in 2012 resembles that of 1931, as 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 just like in 1931 (when France, for political reasons, allowed the KreditAnstalt to go bankrupt), when the next bailout is due, political conditions will be demanded that no private and rational investor would demand.

6.-Canada’s story will be different

In April, I proposed that the Canadian context was different and that rather than expect contagion from the banking system to the government, in Canada, we should expect contagion from the government to the banking system. I still expect this deterioration to be triggered by an exogenous development (i.e. outside Canada) and the reaction of the Canadian dollar to the revised unemployment rate on December 7^th may be telling us that this view has merit.

7.- September marked a tectonic shift

I will not elaborate on the points below. I wrote extensively about them in September (see here, here and here), but I need to mention them because they are very relevant for the next year. These points, I must clarify, are my best case scenario, because the necessary condition for their validity is that Spain and any other peripheral country in need of a bailout asks for one and receives the support of the European Central Bank (ECB) in exchange :

-The market will arbitrage the rates of core Europe and its periphery, converging into a single Euro zone target yield (with higher German rates).

-We will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield. Inflation expectations will pick up

-The Canadian dollar should not rise significantly above the US dollar (i.e. above $1.04 per 1 CAD).

-The ECB backstop (i.e. purchase of sovereign debt) generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)

This implies that in the future, sterilization at low rates or the suggested negative deposit rates at the European Central Bank, under Open Monetary Transactions, will not be feasible. Banks will demand high rates in exchange, if they are to sell the debt to the central bank.

Epilogue

In my next letter, and likely the last one of the year, I will address the topic of why we have not yet seen high or hyper inflation and what is necessary, in general, to see this phenomenon take place. The letter will go dedicated to Peter Schiff. In it, I will seek to show that unlike Keynesian economists believe, not only are high nominal interest rates compatible with high inflation, but in fact they are a necessary condition for high inflation to exist and morph into hyperinflation. This is a paradox to mainstream economics…and, coming from Argentina, I love paradoxes.

A final observation, on method

As my approach is within the Austrian school, you may have noticed that I use praxeology. ( “a theorem of a praxeological science provides information that has been derived by sheer reasoning; it is the product of pure logic without the assistance of any empirical observation”, I. Kirzner). Hence, you find almost no statistics in my articles. My aversion to them is due to my view that the national accounting system used to date is simply a barbaric relic of mercantilist doctrine. But that’s a story for another time… I walk through problems using simple axioms and test their logic with identities (i.e. balance sheets). Mainstream economists, on the other hand, use equations. Hence, they need to “torture” their stats to prove their propositions, because they are inductive. I use deduction.

 

 

Martin Sibileau

This is our first letter of 2012. The year started with a mini rally that every analyst out there attributes to something called “decoupling”. Why? Because the strength in asset inflation, although global in nature, is particularly more solid in the US.

The oddity appears to be higher asset prices, in spite of a weaker Euro, in a Eurozone whose main problems remain unsolved. Correlations are breaking! say analysts, at every opportunity they have to speak to the media.

We want to start the year tackling this issue, which we feel is very important to understand. Without mincing words, we will say that the concept of “decoupling” is completely wrong and if followed, it will lead to wrong conclusions and horrible investment decisions.

The fall in asset prices during the last quarter of 2011 was triggered by a run for liquidity, typical of fiat currency systems or systems with leverage. Euro zone banks had to sell USD denominated assets to raise liquidity, lifting the price of the USD and putting pressure on the rest of the risk asset spectrum. This was addressed in November, when the Fed confirmed its commitment to continue extending USD swaps to other central banks, at a reduced price of 50bps. At “A View from the Trenches”, not only have we dealt extensively with the mechanics and implications of currency swaps but also, we believe we would not be mistaken if we said that we were the first and only ones to point to its relevance, way before anyone else in the market. For instance, in February 2010 (almost two years ago!), we warned:

“…that France did the same (in the 1920s) that we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920’s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment…” (refer: www.sibileau.com/martin/2010/02/26 )

How relevant was this action taken in November? The chart below (source: Bloomberg) shows us how the price of the 3-month EURUSD swap reverted after November 30^th:

How consequential was the amount of swaps extended by the Fed? The next chart (source: Bloomberg)gives some perspective, showing what the Fed extended in 2008, vs. what occurred last November:

The spike is certainly visible. Back in 2008, the deleveraging was just starting, so it would seem unlikely to us to see those levels again. However, we must not underestimate the magnitudes seen in November and the sovereign problem ahead, particularly if it threatens to break the Euro zone. In light of all this, it is clear to us (and not to the rest, apparently) that rather than a decoupling, we are seeing a huge coupling. In fact, we are witnessing the mother of all couplings! As we explained on December 12^th, the Fed is bailing out the European Central Bank, because without US dollars, the run for liquidity in Europe would result in a general run against the ECB. But since December, the ECB is now also financing on a 3-yr basis, the liquidity, in Euros, of the Eurozone banks. There is plenty of speculation as to what the Euro zone banks do with that money but we think it is safe to say that at least, they are not forced to liquidate assets. On the accounting analysis of the 3-yr financing, we found a very interesting article, by Izabella Kaminska, at FT Alphaville, named “The curious case of ECB deposits”.

In summary, the mother of all couplings consists in linking the balance sheet of Euro zone banks indirectly with the Fed: The Euro zone banks get cheap liquidity from the ECB in Euros, supported by the US dollars provided by the Fed to the ECB. Asset are not sold now and in fact, they could actually be purchased later, if the sovereign crisis in Europe was to be addressed.

What does this all mean? Well, as we explained on December 12^th, this printing of billions of US dollars by the Fed to back the ECB means that Americans need not to save any extra, to bail out Europe. This is what puzzles mainstream economists, who refer to this “oddity” as a “break in correlations”. 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. Such a sell off would bring down the price of every single asset vs. the US dollar.

Now that we have clarified this point, we must ask ourselves how this should impact gold. On this point, we must say we are now in uncharted waters. Yes, the swaps are nothing new, but the context in which they unfold is. With this in mind, we think that the rhythm in 2012 will be marked the evolution of the fiscal situation in the Euro zone. On Friday, we saw a massive downgrade in sovereign risk by S&P that was fairly priced in by the market. Going forward, further deterioration or default surprises will accelerate the pressure on Euro banks, which in turn will force the Fed to become more coupled and to print more US dollars. We think that in this context the volatility and the bull trend in gold should both increase.

Why would we not also want to buy stocks? Because we follow the view of Friedrich Von Hayek: We believe that this process is also affecting relative prices everywhere and when relative prices are distorted, in the long term, production falls and we end with a higher amount of money in circulation, available to purchase a smaller amount of goods. Inflation, in the long term, always bankrupts producers and benefits the holder of products. If you don’t believe us, ask gold miners how they feel about the performance of their stocks vs. that of gold bullion.

Martin Sibileau