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: December 18 2012

As anticipated in my previous letter, today I want to discuss the topic of high or hyperinflation: What triggers it? Is there a common feature in hyperinflations that would allow us to see one when it’s coming? If so, can we make an educated guess as to when to expect it? The analysis will be inductive (breaking with the Austrian method) and in the process, I will seek to help Peter Schiff find an easy answer to give the media whenever he’s questioned about hyperinflation. If my thesis is correct, three additional conclusions should hold: a) High inflation and high nominal interest rates are not incompatible but go together: There cannot be hyperinflation without high nominal interest rates, b) The folks at the Gold Anti-Trust Action Committee will eventually be out of a job, and c) Jim Rogers will have been proved wrong on his recommendation to buy farmland.

(Before we deal with these questions, a quick note related to my last letter: A friend pointed me to this article in Zerohedge.com, where the problem on liquidity being diverted back to shareholders in the form of share buybacks and dividends was exposed, before I would bring it up, on my letter of March 4th. )

A forensic analysis on dead currencies

When I think of hyperinflation, I think of dead currencies. They are the best evidence. There is a common pattern to be found in every one of them and no, I am not talking of six-to-eight-figure denomination bills or shortages of goods. These are just symptoms. Behind the death of every currency in modern times, there has been a quasi-fiscal deficit causing it. Thus, briefly, when someone asks: What causes hyperinflations? The answer is: Quasi-fiscal deficits! Why have we not seen hyperinflation yet? Because we have not had quasi-fiscal deficits!

What is a quasi-fiscal deficit?

A quasi-fiscal deficit is the deficit of a central bank. From Germany to Argentina to Zimbabwe, the hyper or high inflationary processes have always been fueled by such deficits. Monetized fiscal deficits produce inflation. Quasi-fiscal deficits (by definition, they are monetized) produce hyperinflation. Remember that capital losses due to the mark down of assets do not affect central banks: They simply don’t need to mark to market. They mark to model.

The only losses that can meaningfully affect central banks stem from flows (i.e. deficits), like net interest losses. These losses result from paying a higher interest on their (i.e. central banks’) liabilities than what they receive from their assets. These losses leave central banks no alternative but to monetize them, in a deadly feedback loop. They are like black holes: Once trapped into them, there is no way out, because (fiscal) spending cuts are no longer relevant, unless they produce a surplus material enough to offset the quasi-fiscal deficits. And that, by definition, is impossible.

This raises questions like: Why would a central bank need to pay interest on its liabilities? Why would the monetization of the losses necessarily lead to a spiralling process?

Why would a central bank need to pay interest on its liabilities?

This is a key point to understand inflation. According to mainstream economists, inflation is a process that pops once the potential output gap of a currency zone is eliminated. Inflation is the consequence of reaching full employment of resources, they say, and place the situation within the context of “hydraulics”.  In the figure below, I illustrate this context, showing two glasses: One is not full, and therefore, there should not be inflationary pressures.

Please, do not laugh at the figure. It also contains a citation from a speech given by Fed’s Governor Jeremy C. Stein a few months ago, that uses this same metaphor to illustrate how the Fed thinks about their policies. If it wasn’t so sad, it would be comic. And it is sad because there is absolutely no historical evidence of a nation sustainably living under inflation that would have reached full employment. In fact, it is quite the opposite: Inflation breeds unemployment, which breeds shortages and further inflation. This is why this whole situation is so sad. Millions of lives have been and will continue to be ruined because of this error.

The truth is however that inflation and financial repression are inseparable. They are different faces of the same coin, and as inflation develops, financial repression morphs into plain confiscation. As at December 2012, we have only had increasing financial repression, mostly in the form of price manipulation. Some of this manipulation is open, as with interest rates, and some of it is covered, as with gold, the consumer price index or the unemployment rate. But as the US fiscal deficits grows, the manipulation will be increasingly open and the fear of confiscation will be very tangible. Yes, the manipulation will be so open that even the GATA (Gold Anti-Trust Action Committee) will completely lose its raison d’être. It will be worthless to expose what will be public.

With regards to the fear of confiscation, there is a good example in the drop in deposits from the banks in the periphery of the Euro zone. Any rational investor could see that his bank was being coerced into purchasing the worthless debt of its sovereign and that the likelihood of being caught in a bank run was exponentially rising. Policy makers in the Euro zone chose not to confiscate. It was too early to do so, in the presence of other alternatives. But deposits dropped nevertheless, and to restore them, the European Central Bank will have to pay higher interest rates on its sterilized purchases, when it finally engages in Open Monetary Transactions (i.e. purchase of sovereign debt with maturity under three years). I explained this in September: Since the backstop of the ECB removes jump-to-default risk from the front end (i.e. 1 to 3 years, in sovereign debt), selling the sovereign debt to the central bank for cash will be a losing proposition for banks. The Euro zone banks will demand that the purchases be sterilized, to receive central bank debt in exchange and at an acceptable interest rate. This rate will have to be higher than it currently is. This is why, in my opinion, we are seeing a stronger Euro and weaker Treasuries.

Why would a government want to maintain a certain level of deposits?

Governments need bank deposits to fund the bonds they force their banks to buy. The regulations, the pressure on the bankers, the open threats are all part of the same means to coerce bankers to fund their debts with your savings. Is this what was behind the failed moves in 2012 to destroy the US money market funds?

Essentially, hyperinflation is the ultimate and most expensive bailout of a broken banking system, which every holder of the currency is forced to pay for in a losing proposition, for it inevitably ends in its final destruction. Hyperinflation is the vomit of economic systems: Just like any other vomit, it’s a very good thing, because we can all finally feel better. We have puked the rotten stuff out of the system.

Why would depositors not want to renew deposits?

Whenever the weight of deficits passes a certain milestone, people begin to flee en masse from the system. They not only take their savings from the system, but they generate income outside it too. This has happened since times immemorial. Below is a picture of buried coins, found in Hertfordshire. They are presumed to have been hoarded in 4th century during the final years of Roman rule.

 

Then and now, the tax pressure ended breaking capital markets and trade. In the early stages, everyone seeks to stop investing and collect by any means whatever capital that can be recovered. Nobody should be surprised if, with these low interest rates, the wave of share buybacks and dividend payments increases. The shrinkage of the system exacerbates the fall in tax revenue and the intervention of central banks, leading to the self fulfilling outcome of quasi-fiscal deficits. Production falls and the shortage of goods, together with the increase in the circulation of money, triggers high inflation. Price controls follow. If this is correct, Jim Rogers is wrong and you should not buy farmland. Farming will not be profitable. The increase in food prices would not be a signal to encourage farming, but the reflection of the fact that farming is not profitable because it is easy to tax. Hence, the food shortages. The same applies to real estate in general, as the rule of the mob spreads and the rights of debtors and tenants are favoured over those of creditors and landlords. Hyperinflation therefore is not just a run from a currency, but from the economic system entirely. Thousands of years of Diaspora are screaming to us in the face that the advantage of gold as an easy-to-transport and store asset is not to be underestimated.

Why have we not seen a quasi-fiscal deficit yet and how close are we to see one?

I think that at this point one can easily see how high nominal interest rates (to attract deposits) and hyperinflation go together. The loss of confidence in the system pushes nominal rates higher, which causes even more pain to produce, unleashing shortages of goods and higher prices. Von Mises, for instance, remembered that in the case of the German hyperinflation, “…With a (my note: nominal) 900 per cent interest rate in September 1923 the Reichsbank was practically giving money away…” (Chapter 7, in “Money, Method, and the Market Process”).

Frankly, I do not have a definitive answer to the question of why we have not seen a quasi-fiscal deficit yet. But I can intuit that we are still far from seeing one. There are many factors at play. The existence of coercive pension plans (i.e. monies coercively taken from salaries to fund collective distributions) could be playing an important role. These funds are “other peoples’ monies” to their managers and they will not risk their careers to protect them from governments that force them to assign a zero risk weight to US Treasury holdings. It is conceivable that as funds are burdened with losses, the contributors wake up to them and decide that at a certain point, one is better off working outside the system than in it, to avoid this hidden tax. Just like Romans left the city, millions of workers in the developed world may decide to become self-employed and leave the system. This is a typical characteristic of under-developed economies.

So far, the Federal Reserve does not even need to sterilize what it prints. The European Central Bank did have to sterilize but the market does not demand an interest rate on its liabilities, higher than that of the sovereign debt it purchases. Not yet…Perhaps because the market somehow still believes that institutional structure of the European Monetary Union is fixable. Further downgrades in the risk rating of core Europe, the concurrent rise in the yields ofGermany’s sovereign debt and corporate defaults in USD denominated bonds will eventually wipe this belief. For now, the European Central Bank has been successful in not even having to pay interest on deposits.

If I have to think of a main and most likely trigger of quasi-fiscal deficits, I have to name the future bailout of the next wave in corporate defaults, particularly from the Euro zone.

 

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: September 30 2012

This week, we want to follow up on some thoughts from our last two letters, where we deduce the impact of the policies undertaken by both the Fed and the European Central Bank (ECB). As well, we provide a few comments on an ongoing debate: Will we ever experience hyperinflation?

Last week, we came up with three important conclusions:

-Conclusion No.1: The ECB backstop 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 is what we wrote on Sept. 10th: “… Until now, selling distressed sovereign bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate…”

Where do we stand?

Everyone expects Spainto request a bailout and accept the conditions that would allow the ECB to buy their bonds. In the meantime, someone took the time to measure the impact of the ECB backstops over the past year and came up with a number: EUR9BN in capital gains. On Sep. 20^th, the European Banks research team from Barclays published a note titled “Liability management-understanding the rationale”. Barclays estimates that in their liability management transactions on EUR200BN of unsecured debt, European Banks have gained EUR9BN, from lower interest expenses. This of course, came courtesy of the Fed first (remember the EURUSD swaps put in place at the end of 2011?) and the ECB later, with 3-year long-term refinancing operations. The chart below (source: Bloomberg) shows the iShares MSCI Europe Financial Sector Index Fund (ticker: EUFN). The rally that began at the end of July with the speculation on the future actions of the ECB has peaked, awaiting further news.

 If we are correct with this conclusion, removing (i.e. buying) the assets backstopped by the ECB (i.e. sovereign debt) from the banks in the secondary market via the OMT (Outright Monetary Transactions), will be expensive to the banks. Why? Because these banks, which after so much misery, end up finding out that the assets they were holding are no longer in risk of default and provide a nice interest, will now have to hand these assets over to the ECB. It would be ok to do this every once in a while. However, the fiscal deficits of the EU countries do not happen every once in a while, but every minute and they keep on growing! Should the ECB seek to make the OMT sustainable as the fiscal deficits of the Euro zone periphery continue, the banks will have to be appropriately compensated. The risk remains then, that at a future, much later date, the ECB faces a net interest loss (between the interest it receives for their sovereign debt holdings and the one it pays to the banks). Under this scenario, the only alternative left will be to monetize that deficit all the way to hyperinflation. But in the meantime, let’s  move to…

 

-Conclusion No.2: The ECB backstop will set a floor to yields

This is what we wrote: “…As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone…”

Where do we stand?

It is too early to say anything, as the ECB has not purchased anything yet and the potential secession ofCataloniaand recent protests have delayed (if we are correct) the establishment of a floor.

 

-Conclusion No.3: The ECB backstop will first push rates within the Euro zone to a convergence (periphery will have lower rates, core will see higher rates). And secondly, will force US rates to converge to the Euro zone rate, if the Euro zone survives the first convergence.

This is what we wrote: “…within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target….” and “…If the () trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield. For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the world’s risk-free rate! The big assumption here is of course, that the first trend, above, holds true. Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered…”

Where do we stand?

Again, with the political struggle between the periphery and coreEuropeand (within the periphery) between the people and their appointed leaders, this convergence has been temporarily interrupted

The charts below (source: Bloomberg) show the convergence that started at the end of July, in 2-yr rates (but can also be observed in 10-yrs, not shown here). In the second chart, we show theUS30-yr yield, which suggests that a bearish trend is building (i.e. higher yields), consistent with our conclusion. Time will decide….

 

All this would indicate that the key to what’s coming next is simply political, which brings us back to one of the first letters of the year, titled “An analytic framework for 2012”, where we precisely showed the tragic (and spiraling) circularity of enhanced deficits, adjustments programs and coercion by the EU council, backstopped by the actions of the ECB. We reproduce a chart from that letter, below.

As the problem spirals, the actions of the ECB must strengthen: If at the beginning of the year, 3-yr lines of secured lending bought time, by September, “conditional” but unlimited bond purchases were now required. A few months from now, that conditionality will surely be merely a simple protocol. In every turn of this circularity, as unemployment, prices and fiscal deficits grow, so does social unrest. Social unrest therefore is the determinant in this overdetermined system.

To those familiar with Algebra, we suggest that the Ponzi scheme we live in is actually an overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America. That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system!

 

Some final comments on hyperinflation

We have noticed of late that there’s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. We will not discuss the latter today. With the regards to the former, we think it is still early to talk about hyperinflation. We don’t know when it will take place. All we can guarantee is that there are certain conditions necessary to see inflation spike up and morph into hyperinflation, and such conditions have not crystallized yet. However, there is a high risk at this stage in the game that they do, and we briefly examined that risk for the Euro zone, on September 10^th.

Money has two purposes: to store value and to transact. There is however another use of money, which is a derivative of the storage-of-value use. The use of money to repay debt.

Those who demand money to repay debts do not do so to store value or to transact. But as long as there are debts outstanding, there will be a demand for currency to repay that credit. This means that, in order to see such demand diminish, we need to see defaults first, which will along eliminate credit extended in fiat, debased currency. As this process unfolds, the banking system goes bankrupt, is nationalized, and credit is directed towards and centrally managed by the government. This may easily takes years, but it is taking place in the Euro zone right now. The repo market and futures markets die along and central banks end up becoming counterparties in cross currency and interest rate swaps. Once this stage is reached, the private sector is out of the system and fiat money is only demanded to transact. Here’s when the velocity of circulation of money starts to rise exponentially.

As these successive steps are passed, slowly, central banks suffer structural changes in their balance sheets. For instance, let’s take the example of Argentina. At one point, after many devaluations of the peso, the central bank by 1982 had become the main USD swap counterparty for corporate credit. However, to avoid a wave of bankruptcies after the June 1982 devaluation (after the Falklands War), it refinanced USD denominated debt at a 23% lower exchange rate, and in the process sold FX insurance at a cost (for the corporations entering the transaction) of 5%/month, when the inflation rate was 7.9%/month. This was going to be a huge burden that accelerated the deficit of the central bank, which of course was monetized (refer here), unleashing the first high inflation of 1985.

The parallel with the situation in the Euro zone is self-evident: If the ECB starts buying sovereign bonds as fiscal deficits continue, the recent transitory appreciation of the Euro (to $1.3150 was mainly driven by short covering and the capital gains in financials, mentioned above) is not sustainable. In the long run, the intervention of the ECB would only devalue the Euro, creating a currency mismatch for those companies  in the Euro zone that issued USD denominated debt. Thanks to the FX swaps by the Fed and the crowding out of the ECB in favour printing Euros for government debt, these companies are more numerous than they would have been. Therefore, the ingredient for an hyperinflationary process is already present, but we’re not quite there yet…

In the end, by the time the use of fiat money is reduced to its transactional role, central banks run huge deficits, called quasi-fiscal. They have backstopped government debt, money markets, repo markets, future markets and derivatives markets. The interest they pay on their liabilities to sterilize their actions always ends being higher than the one they receive for their assets. And it makes perfect sense: Otherwise, nobody would have asked these central banks to be their backstop! An additional source of fuel for this fire is the so called Olivera effect (after Julio H. Olivera). This is another ingredient to turn a mild inflationary process into hyperinflation. This effect refers to the fact that when inflation reaches a relevant number, it becomes profitable for taxpayers to delay their tax filings, which reduces the tax burden. Governments are thus forced print more money to cover the loss in real revenue they suffer.

The fact that we are still in the early chapters of the story just narrated does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 won’t lead to spiraling quasi-fiscal deficits.

 

Martin Sibileau