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

Click here to read this article in pdf format:  August 6 2012

Today is a holiday in Canada and our letter is published later than usual. We will make a few comments on what we believe were the most relevant events impacting capital markets (do these still exist, by the way?) last week:

No news on monetary policy

During the past week, both the Fed and the European Central Bank had the opportunity to execute on new policies, be it price or volume driven. As we anticipated in our last letter, these banks decided to past on such an opportunity. There is really nothing else they can effectively do, except explicitly monetize sovereign debt. If they opt for unconventional policies, the medicine will have a worse effect than the sickness, although we want to make this clear: Monetizing sovereign debt is also not the solution. However, it buys time and is the less distorting of all available measures. Having said this, if we are right, the rally we saw in the Euro was only short-covering and soon, we will have to enter a new downward leg.

Relevering of corporate balance sheets: Rich shareholders, poor corporations

A few months ago, we warned that: “…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…”

This trend is increasingly becoming more evident, as new multi-billion shares-buyback programs and dividend raises are announced every week. Who’s financing this? Banks mostly and they will be sorry for it by the time interest rates (i.e. real interest rates go up). In the meantime, let’s enjoy the party!

Reconsidering our last comments on the repo market: Why we may be proven wrong

At the end of our letter on June 25^th, we brought up what we thought was a sharp comment from Murray Rothbard, in his book “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard told us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”

We concluded therefore that this crisis has to end with a rigorous deflation or liquidation of liabilities, which must be expressed in terms of a new standard. In the ‘30s, the US dollar was still backed by gold and gold was the Fed’s asset. Today, the US dollar is backed by US Treasuries. Therefore, we concluded, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. On July 2^nd, we made the case that such a repudiation was going to take the form of lower volumes in the repo market. By that, we meant illiquidity in the repo market. The same was going to make harder to short commodities naked, brining eventually one net short position in the futures markets to bankruptcy. In the process, counterparty risk would rise exponentially endangering the respective clearinghouse and forcing the Fed to intervene. The key conclusion here was that from that point on, spot prices of commodities were no longer going to be manipulated, given the broken futures markets, opening the door to high inflation.

As the title of this paragraph suggests, we may be wrong in this analysis. What makes us think so? New information: Namely, the potential massive use of floating rate notes (FRNs) by the US Treasury, starting 2013. We want clarify this: The introduction of FRNs will not suppress the process described above. It will only delay it and make the fall even more catastrophic.

The new information came to us upon reflection, based on a series of anonymous articles published on Zerohedge.com, regarding the upcoming change in the funding policy of the US Treasury. Please, find the links to these articles below. Give yourselves some time to read them carefully. They are worth it. We present them in chronological order:

1. www.zerohedge.com/print/446207
2. www.zerohedge.com/print/446655
3. www.zerohedge.com/print/447068
4. www.zerohedge.com/print/447126
5. www.zerohedge.com/print/452769

Floating Rate Notes are variable rate notes. If you hold them and rates increase, for instance, you don’t suffer a capital loss. Since the beginning of the crisis, the US Treasury has basically issued fixed rate debt. The long term portion of it, courtesy of Operation Twist, is being massively bought by the Fed. The short end, is accumulating in the balance sheets of the primary dealers. If interest rates were to rise, these dealers would suffer untold capital losses, and it would be politically difficult to bail them out. Therefore, the same dealers are pushing the US Treasury to slowly start refinancing this short-term fixed rate notes in their inventory with floating rate notes. That way, by the time interest rates rise, the problem will have already been transferred to the US taxpayer, who will be in a deeper hole.

What does all this have to do with our previous analysis of the repo market? Well, if floating rate notes are issued, they will have a strong bid from money market funds and liquidity will be enhanced in the repo market, which would continue funding the commodity futures markets.

However, with the US Treasury facing a higher fiscal cliff, the Fed would be forced to intervene buying not only the long-term, but the also short-term debt, to ensure that inflation transforms these higher nominal short-term rates into lower “real” rates. The Fed would not do this only to save the US Treasury, but also the private sector. Why? As short-term liquidity shifts from commercial paper to government-issued floating rate notes, levered companies (and we just said companies are pushing leverage) would have a hard time finding short-term working capital funding. Potentially, and only years ahead, this could well end in situations seen in Latin America, where banks offered weekly or weekend guaranteed investment certificates at high rates. Gold, again, would end up being “the” store of value. But this, this is years ahead and in the making.

The consequences of high frequency trading and the myth that it is needed to bring liquidity to markets

High frequency trading was brought back to light in the past week, after the tremendous losses suffered by the Knight Capital Group. We don’t have much time but want to simply say this: The whole idea that high frequency trading brings liquidity to markets is born out of a misconception of liquidity. And here, we go with the Austrian school: Liquidity is not and should never be intrinsic to an asset, but is the result of preference by acting men.

Secondly, High frequency trading does not even provide liquidity. It just plays the operational weaknesses of markets. In a casino, when the croupier says “rien ne va plus”, all the real bids are locked. In a stock exchange, it appears that this doesn’t happen, allowing high frequency traders to introduce false signals to trigger stop losses or profit taking. If that is liquidity, our markets are broken. It is another Ponzi scheme, with no real cash at the end, played within mili-seconds.

But the underlying point here is that we should not force liquidity into all stocks. If some are not liquid, it is for a reason and providing fake demand via high-frequency trading is an expensive mistake. If the world allows high frequency trading to continue, it will end, paradoxically, in illiquid markets. The real money will leave markets and flow to real assets, because if liquidity means being exposed to the manipulation of high frequency trading….why pay a premium to be liquid?

Martin Sibileau

Yesterday was another forgettable session. News of the pig flu, of the Federal Deposit Insurance Corp. Chairman Sheila Bair seeking authority to close “systemically important” financial firms, and of GM’s bondholders’ rejection of the $27BN debt-for-equity swap shaped a tense range trading day. The S&P500 closed -1% at 857.51pts. Treasuries had significantly dropped by noon, but managed to close up in a flight-to-safety move, driven by fears of a pig flu spreading. This same flu pushed Mexico’s credit default from 300bps to approx. 330bps. The Fed bought $7 billion in Sep/13 to Feb/16 Treasuries. Agency debt continued to tighten vs. Treasuries (1 to 2bps) and CDX IG12 finished flat, at 176bps. And we should leave things here.
While we wait for more policy decisions (FOMC meeting today and tomorrow, Fed purchase of Treasury coupons on Thursday), I thought it would be interesting to reflect not on the origins of this crisis, but on the origins of the ideas that shaped the response to this crisis. Most of you would agree that Mr. Keynes’ ideas are behind the policies being implemented these days. Therefore, let’s analyze Keynes’ thoughts on what to expect from a financial crisis.
John M. Keynes’s main work was the “General Theory of Employment, Interest and Money”, published in 1936. Today, we only need to deal with chapter 13. This chapter is titled “The General Theory of the Rate of Interest”.
Keynes was a very practical man. For him: “…the rate of interest is…the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash…” If we follow him, at close of yesterday, the benchmark (Feb/39 Treasury) price for holding USD cash long term was 3.84% p.a.
Keynes warned that: “…circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest…” Yes, this applies to the $300BN Treasury purchase program by the Fed. I let the reader judge the degree of influence this program has had so far (1 month later) on the rate of interest.
Keynes offered an explanation for these circumstances. He wrote that: “whilst an increase in the quantity of money may be expected… to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money” This should be self-explanatory and consistent with the necessary conclusion from our Thesis no.1 “Sell that which the US Govt. is buying and buy that which the US Govt. will buy (Tincho’s letter, April 6th 2009)”. Keynes further added that: “…whilst a decline in the rate of interest may be expected … to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest…” What is the “marginal efficiency of capital”? Basically, it is the (IRR) internal rate of return (refer Chapter 11 of the General Theory). Given a rate of discount, the IRR of a stock is driven by its dividends and final value. Since the beginning of the current crisis, dividends have been continuously cut or eliminated altogether, while stock prices have been falling. It is obvious then that the marginal efficiency of capital was falling until the current rally took place, in late February 2009. Is the marginal efficiency of capital STILL falling more rapidly than the rate of interest? I am not sure, because: a) we still ignore what level of losses the financial system may face in the future b) this ignorance means that we also have uncertainty on how expensive it will be to finance future investments c) given (a) and (b), we don’t know what the final inflation level will be, as the Fed continues to pump liquidity into a broken system. (On September 18, 2008, Goldman Sachs’ US Portfolio Strategy team published an analysis in line with Keynes’ approach. The publication suggested that the implied S&P500 trough for this crisis was at 1,000 points, consistent with a dividend yield of 2.9% for the S&P500 index).
Keynes continued his exposition saying that: “…whilst an increase in the volume of investment may be expected … to increase employment, this may not happen if the propensity to consume is falling off…” If I am right and the Obama administration is guided by these Keynesian ideas, we should therefore expect further policy from the Fed and the Treasury to address the retail credit market and the personal income tax structure, respectively, to boost consumption.
Finally, Keynes says something rather ominous: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…Will we keep wasting money on the auto sector?) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…”. THIS STRONGLY SUGGESTS THAT AN EXIT STRATEGY BY THE FED MAY BE COUNTERPRODUCTIVE. INFLATION MAY HIGH ENOUGH FOR US TO NEED TODAY’S INCREASE IN THE QUANTITY OF MONEY TO MAINTAIN THE RATE OF INTEREST AT THE END OF THIS EXPERIMENT.