Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, 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. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, 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.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

Martin Sibileau

Please, click here to read this article in pdf format: september-5-2011

In our last letter, we showed that our view from May 2010 is fully developing (We had stated that eventually money supply in the Eurozone would be determined by the growth in the zone’s fiscal deficits). Also, the contagion from the Eurozone to the USD zone is also growing, thanks to the EUR/USD currency swaps extended by the Fed to the European Central Bank. This contagion, we wrote, is nothing new, but had been highly criticized already in the early 1930’s by Jacques Rueff. We insist therefore that readers get a copy of Mr. Rueff ‘s “The Monetary Sin of the West”, published in 1972. An online version can be found at: www.mises.org/books/monetarysin.pdf . Too old? Perhaps, but remember: There is nothing more practical than a good theory!

If you have been following us vs. other analysis, you will notice that only recently, other analysts are beginning to pay attention to these FX swaps. Mainstream analysts refer to it as the “Fed’s USD backstop”, which is also appropriate. Why is this for us so relevant? Because thanks to this backstop, the world ends up being impacted similarly (“similarly” being the operative word here) to what we would see, if the Fed bailed out Eurozone banks. Is the Fed bailing out foreign banks providing this backstop? We see it that way, although the Fed will always deny it. But think of this simple question: What would happen to the weakest Eurozone banks that need to roll over USD funding, if that backstop wasn’t there? They would certainly be insolvent by now. However, the Fed doesn’t see it that way. What the Fed sees is the underlying counterparty risk. The Fed turns around the question to tell us that if the backstop was not there, the US banks would have funding problems, competing with Eurozone banks for funding.

To his credit, Dr. Ron Paul, was the only politician to see this far in advance, last year, when he questioned Mr. Daniel Tarullo, member of the Board of Governors of the Fed, on this point on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ).

Had we been in that session with Mr. Tarullo, we would have asked him what would the Fed do, if the dollars lent to the European Central Bank, forwarded to Eurozone banks, cannot be paid back because the assets these dollars funded are in default or generating substantial losses to the originating banks?

This is important because that is exactly what occurs during stagflation: Businesses go bankrupt. We know the answer: The Fed would do nothing, allowing these dollars, printed money, to remain overseas. This is why we say that the FX swap is effectively quantitative easing from the Fed on the Eurozone. We will go on record stating this: 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.

Turning now to the Eurozone, it is completely clear now what we have been predicating time and time again, since February 8th, 2010: The zone faces an institutional crisis. Back then, it was only an institutional problem. The disastrous handling of the crisis by Euro politicians have made it now a real economic one and we think there is no way out here but dissolution in chaos. This again, shall be very bullish of gold and bearish of risk (unlike mainstream view, we distinguish gold from “risk” because to us, gold is money). Enough said. We could go on but we think that over the past letters we have been very clear and unfortunately, times will now accelerate and we will witness this problem evolve exponentially.

In China, it seems the People’s Bank has not been sterilizing its FX reserves purchases. However, to mitigate the corresponding inflationary impact, it has been relentlessly increasing the reserves requirement ratio of financial institutions, using the “credit multiplier” channel. According to Bank of America’s Rates and FX Research team (“Global Rates and FX Weekly”, August 26th, 2011), by September 2010 the level of USD reserves had reached $3.4 trillion (CNY21.8 trillion) , while the People’s Bank’s debt had decreased from CNY4.4 trillion to CNY2.7 trillion. The gap between the FX reserves (i.e. assets) and the debt (liabilities) was covered by the increase in reserve requirements (i.e. liabilities too: Remember that the banks’ reserves in a central bank are an asset to the banks and a liability to the central bank).

Why did China’s central bank choose to hike reserves rather than issue debt to mitigate the impact of its USD purchases? It was simply cheaper, apparently, which means that if the trend continues two things will become evident: 1) the profitability of China’s banking system will be hurt, and 2) the US Treasury will find it harder to place its debt.

On the first point, the central bank may be forced to increase the interest rate on the reserves, dragging banks to depend on it, increasing the cost of eventually appreciating the Yuan (i.e. exit strategy). On the second point, the Fed will be forced to step in, should China merely stop accumulating reserves. We may add that as the first point becomes more relevant, the cost of eventual defaults will be way higher. Both issues are very bullish of gold and bearish of risk, too.

After all these considerations, we are really surprised to hear mainstream analysts say that another recession (as if the last one had ended) would be a so-called Black Swan event (i.e. a rare event). How so? We would argue that the opposite is true: In this context, avoiding a double dip is actually the Black Swan event!

Martin Sibileau

Please, click here to read this article in pdf format: december-2-2010

Again, most of the action this week has been driven by speculation on the future of the European Union. Let’s begin today by repeating what we left with a week ago, when we changed our view, radically, on the survival of the Euro:

“…We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place…” (www.sibileau.com/martin/2010/11/24 )

In the past days, we have been contacted by readers asking for our view on the situation in Europe. We answered, consistent with the writing above, that the key here is the European Central Bank. We said we agreed with Mr. Trichet’s comment yesterday, in that we also thought the markets were underestimating the determination and capability of the Central Bank. A bit of this has been corrected yesterday, and some analysts have gone on record calling yesterday’s action a typical dead bounce cat. We wouldn’t be so sure about it…

If you think about it, the European Central Bank has not yet engaged into what we know as quantitative easing. Yes, it has bought sovereign debt directly or indirectly by purchasing bank debt guaranteed by the sovereign (i.e. Greece) but these purchases, unlike the case of Helicopter Ben, have been all sterilized through its Securities Market Program facility, which up to last week had the equivalent of EUR66BN in term deposits from the banks, as the chart below shows:

As you can see from the chart above, if the European Central Bank (ECB) simply let the term deposits expire, liquidity would be injected into the system, without the need to buy more government debt. If the problem is the government debt itself, because a sovereign refinancing is in the way, the ECB can always buy the issue, depreciating the Euro.

Before we move on, please note that the mechanism shown above may or not, in the short term, trigger a depreciation in the Euro, ceteris paribus. It will depend on the resulting rates spread with the USD. However, the depreciation is inevitable in the long term.

Now, we must not lose perspective of the fact that the European crisis, although fiscal and institutional in nature, carries the leverage created by its weak financial system, which is weak because the EU lacks a unified bond market. This brews an arbitrage between peripheral banks and core banks whereby depositors in a peripheral bank shift their deposits to a core bank (i.e. Deutsche Bank), precipitating what we saw in Ireland.

This therefore begs the question of whether the European Central Bank did not stand up to its responsibility, as lender of last resort, in Ireland. Personally, had we been in government there, we would have asked ourselves what benefit would be derived from remaining within the EU monetary union, if the issuer of the currency (i.e. the ECB) does not act as lender of last resort and allows deposits to leave our jurisdiction. After all, if the country needs to put their pension funds and tax revenue on the line to support its financial system…why the hell would it need Mr. Trichet’s authority over their monetary matters?  But then again, what do we know? It’s a done deal and the we all want to focus on the next in line…right?

So, what’s next? As we hinted in our last letter, we are more concerned about the US fiscal situation than that of Europe. We think the ECB will this time use its ammunition to prevent a run against Portugal and Spain and that it will be difficult to fight it. Of course, one can never underestimate the idiocy of policymakers, as when they introduced the idea of making senior bondholders of bank debt…well, not so senior…You certainly want to avoid this sort of language in the midst of a currency/financial crisis.

But in the US, we understand a bipartisan revision of spending is underway. We ignore how far it can go but the fact that it is taking place is a sign to us of what may be coming next. Below, we mention other “interesting signs”:
-Credit spreads of gold mining companies (i.e. Barrick Gold, Newmont Mining) are trading at lower levels than financials (excluding Canadian banks) and within the range of Germany’s

-The Euribor-OIS spread, after all the stress of recent weeks, remains reasonably low

-The price of oil remains impressively above $80/bbl

-Activity and prices (not just asset prices) in the US are picking up, in line with the price of gold

-The curves of Euro sovereign spreads are pricing the issuance of AAA debt under the European Financial Stabilization Facility

And there is more…but for now, these are enough to tell us that a major proto-federal institutionalization is underway in Europe, while in the US it will be difficult if not impossible to revert an upcoming explicit inflation.

Martin Sibileau.

Click here to read this article in pdf format: november-24-2010

We usually publish on Mondays, but this time, we wanted to see things play out before coming back. We stand therefore by our forecast published back in September, when most saw the European Financial Stability Facility as a source of strength for the Euro, while we publicly disagreed: We saw this facility as a the key that would trigger chaos within the Union. The chart below (source: Bloomberg) redeems us: the Euro fell by four cents vs. the USD, since the Irish requested access to the facility.

In our last letter, we suggested that the best way to understand the ongoing action within the EU is to use a “game theory” approach, of a non-cooperative nature, we should add. We put forth three main players: Ireland, Rest of peripherals and Core Europe. Now that the bailout for Ireland is news, a new dynamics unfolded. Early yesterday, Bloomberg reported German Chancellor Angela Merkel declaring that the prospect of serial European bailouts was “exceptionally serious”. However, we listened to the speech ourselves (Click here to watch it ) and believe the press may have taken Ms. Merkel out of context, which implies that the markets may have overreacted but also, that there is more in hand here .

Now that Ireland seems to have gotten away with its corporate tax structure, other “participants” in line (i.e. Portugal) have learned something: Time is on their side. Why? Because marginally, once a country’s sovereign yield shoots up and becomes the next in line, the marginal pain is bigger for Core Europe. When Greece’s bubble went bust, Ireland felt the pain, Core Europe barely felt it. When Ireland’s bubble goes bust, Portugal feels the pain and Core Europe begins to take notice. By the time Portugal’s bubble goes bust, the pain for Spain will be felt and Core Europe will be very uncomfortable, since France or Italy will be the next in line and Germany simply can’t afford this.

Therefore, the sooner Core Europe deals with Portugal, the cheaper it will be to cut the pain. How does Core Europe force Portugal to come to terms? By pushing their sovereign yields higher than the policy makers of the first-in-line countries expected. How? By going on record, like Ms. Merkel did yesterday, saying that the situation is exceptionally serious. That way, Portugal’s credit risk jumps 35bps to 490bps threatening with a margin increase at LCH Clearnet. This move leaves the first-in-line country unable to raise capital and asking for help to the EU and European Central Bank (sooner, rather than later! This is the point!). To us, this makes sense…Otherwise, why would someone as serious as Ms. Merkel say what she said with such a brutal sincerity? When are politicians sincere?

Where does this all leave us? It leaves us with a change in our view: We think the EU is far more serious about the survival of the Euro than we had previously thought. The problem is nevertheless still institutional, the Euro will have to continue depreciating and fiscal austerity will remain in place. However, if they succeed, it may well have again a chance to become the world’s reserve currency, if the US doesn’t correct their monetary mistakes. Why? Because the only way to succeed is through a dramatic institutional change, a true federal pan-European structure. In the meantime, the opportunity to become a reserve asset grows for gold by the day, because the risks of failure are just too big to be ignored.

Martin Sibileau

Please, click here to read this article in pdf format: june-4-20101
This short week is ending on a strange note. We’ve witnessed an escalation in geopolitical conflicts, from the Mediterranean to the Korean Sea. We’ve learned that the oil spill in the Gulf of Mexico will continue to exist for longer than expected. We’ve heard Mr. Buffet express concerns over the state of municipal finances in the US and the systemic significance of credit default swaps. We’ve seen the first G-7 central bank (i.e. Bank of Canada) start raising policy rates.

Finally, yesterday we realized again that the European Union can surprise us in new ways, with the news of Hungary’s fiscal budget gap. We’ve decided to show below a chart (source: Bloomberg) that we think shows what triggered the action yesterday, and which perhaps will contribute to a sell-off today (Friday). In this chart, we see the EUR (in white) vs. the S&P500 (in orange) intraday. We can see how right before 10am ET, as UBS Strategist Manik Narain was making comments on an earlier press conference by Prime Minister Orban in Brussels, the Euro clearly resumed its downward trend.

The chart also shows the S&P500 Index, as a reminder of how global sovereign risk has become. During the rest of the session, the index tried to get back to its intraday high of 1,105.67pts on the back of a rising price of oil, after the announcement by US Minerals Management Service of the prohibition of drilling in the Gulf, regardless of water depth.

What concerned us a bit was what we see as a “relative” (the operative word here is relative) underperformance in gold, in the face of these news. We prefer to think profit-taking may have been involved, given how crowded the short EUR/long gold trade is. But the trend in gold, which is nothing else but the reflection of the steady erosion of fiat currencies, remains upward.

We also think that there continues to be confusion in the analysis of the EUR problem. The latest one consists in criticizing the ECB for lack of clarity in its bond purchases (refer: BankofAmerica’s “Global Rates Weekly: Europe’s turn to act quickly and with clarity” May 28th, 2010). We don’t think this is a problem of “form” but of “content”.

While the Fed gave details about its unsterilized asset purchases, the ECB will not. But we explained why this is so:

The Fed was financing what we call in Economics a “stock”, i.e. “…a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past...” (http://en.wikipedia.org/wiki/Stock_and_flow ). The ECB is financing “flows”, deficits, or “…a variable that is measured over an interval of time…” Therefore, by definition, we cannot know that variable until the interval of time ends…When will deficits end? Exactly!! Nobody knows! Thus, it is naïve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seen.

At “A View from the Trenches” we were ahead of the curve, anticipating this “content problem” (refer: www.sibileau.com/martin/2010/05/10, “What to expect when you are expecting”), associated with secondary market purchases even before the announcement of the ECB’s plan. Back then we wrote:

“…the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, under scenario B, the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy under scenario B? In the long run, the only way out for the ECB under scenario B is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy…”

There is also another criticism that we think is unwarranted, namely, the short term nature of the existing currency swap contracts between the ECB and the Fed. It is maintained that because these contracts are renewed on a weekly basis, instead of a longer-term (i.e. 84 days), USD funding conditions remain “uncertain”, which does not contribute to calm the markets. We believe the opposite is true. If the Fed validated the capital investments in the Euro-zone via currency swaps, which are nothing else but a hidden bailout of financial institutions, the Fed would be feeding the bullish trend in gold, at the expense of future higher USD inflation and of US taxpayers, and delaying an adjustment that would affect the ECB’s balance sheet more violently.

The term mismatch in the currency swaps (1-week) and the 3-mo Libor-OIS benchmark, as well as the uncertainty over its renewal sends a clear signal to those yet surviving that they need to unwind and take losses. In 1965, M. Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ) described a very similar situation occurring in the ‘20s with “currency swaps” between Britain and France, in this way:

“There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.” (J. Rueff, “The Monetary Sin of the West”, 1972)

In those days, as the Sterling and French Franc were backed by gold, the currency swap consisted in having Paris “lend” gold reserves to London, to address funding problems. The 2010 version of the same problem could read like this:

“There is a very interesting document from this period, a letter from M. Trichet, who was then the European Central Bank’s President, to Mr. Bernanke, who was the Chairman of the U.S. Federal Reserve; it must be of 2011. M. Trichet said, “We know that you are entitled to ask dollars for your dollars, but in the frame of the close friendship between the European Union and the United States we ask you, so as to avoid trouble for the European Union, not to do that, and receive Euros instead.” And we were, I must say, weak enough to comply with this request and not ask for dollars. The fact that I had such important U.S. dollar deposits in Frankfurt shows that we did not use this right to ask for U.S. dollars. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 2009 and 2010. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.”

Martin Sibileau