Please, click here to read this article in pdf format: February 10 2013

During the past weeks I have been on the sidelines, waiting for a relevant event to take place but fully aware that I was wrong. I just wanted to hope. Sometimes, it feels good to hope. But since last September, nothing has really changed. At least not fundamentally and that which seems new, is simply the result of the tectonic shift we had back at the end of the summer (of 2012).

It is vox populi that the rise of Spanish and Italian sovereign yields was triggered by corruption scandals that may be of political consequence. They were not alone, as the Libor affair is still making news. I don’t think scandals by themselves bring consequences, but before I go further, let me discuss the topic of corruption itself, for as I will explain, the ongoing policies will bring nothing else but more corruption.

Corruption in government is simple arbitrage. Whenever governments intervene in a market either by restricting supply or demand, capping or flooring prices, the affected goods will have two prices: The government fixed price and the market price. And because prices are nothing else but critical signals for the process of social cooperation (also known as “market”) to work, markets get confused by two different signals from the same good.

If there is restricted supply of a good, or if the price of a good is capped, the market will be willing to bid more than the current price for that good. That bid will be noticeable and the only economic agent capable of acting on the signalled gap will be someone in power: a government official or a politician. This person’s responsibility will be to allocate scarce resources where they are most needed. The public will call him corrupt, but he will just be an arbitrageur. He will offer an additional quantity of that good which is restricted at a higher price, including his fees (also called “bribes”), of course. He will be simply taking over a function that a repressed market cannot perform at that time.

Government corruption is nothing else but the reflection of a repressed market. The immorality lies not in the act of corruption (i.e. arbitrage), but in the market repression that enables it. And as we all know by now, the repression in the financial markets has only grown exponentially in the past years. This may only mean that more corruption is underway. Above all, the two repressed markets we should all be very familiar with are the ones for US Treasuries and gold.

The US Treasuries market is not really a market. As I understand, about 75% of the issuance expected for February will be purchased by the Fed, whose SOMA account already represents about a third of the stock of Treasuries outstanding, across the curve. How an asset that requires that 3/4ths of its flow be purchased by a central bank to maintain its price can be deemed to have 0% risk and be used as collateral is beyond me! As well, I am completely amazed that we still have analysts from the main banks publishing research notes where they try to assess implied future rates…Implied??? By whom?

This brings me to the gold market. As I mentioned in past letters, Keynesians give a lot of weight to the role of expectations. If they manage expectations to make the public believe that the purchasing power of their salaries has not decreased in real terms, they believe they may get an economic system from recession back to growth. In the same fashion, if they already have a benchmark for real value, say gold, all they need is to suppress the price of this benchmark, to control their expectations. They need not lower the value of the benchmark. Making it volatile enough to discourage any inclination to have that asset used as a store of value is enough. Hence, the endless take down in the price of gold triggered by leveraged sales during thin trading. It has coincidentally taken place ever since the rating on the US Treasuries was challenged by those martyrs at S&P. Below, I show the interventions during the last month (source: Bloomberg).

The two pillars of the current global financial system are therefore (a) the illusion of the existence of a risk-free asset and (b) the repression of that market which demonstrates that the risk-free asset and its derivatives (stocks, bonds, the Euro, all bred in the repo market) are an illusion.

On the subject of a risk-free asset, back on September 16^th, I suggested that  “… for all practical purposes (…) the European Central Bank would set the value of the world’s risk-free rate…”. The assumption behind this conclusion was that, thanks to Draghi’s offer to establish Open Monetary Transactions, “…the market (would) arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone target yield…”. The two charts below (source: Bloomberg) help us visualize the status of the predicted convergence, as well as the relative stability in the long-term German sovereign debt vis-à-vis that of the United States.

With obvious “noise”, the underlying convergence (shown above left) is clear. On the right, we can appreciate how the yield in the 30-yr Treasuries is on the rise, thanks to in spite of billions being bought by the Federal Reserve, while the yield on the German bunds remains within range. We also still have the usual flags I have been calling collective attention to for the past year, and they are all related to repressed markets. The zero-interest rate policies were going to encourage share buybacks, dividend payments and any method to allow the extraction of whatever real value is still available to extract from corporations/businesses by their owners. This meant leverage was going to increase, unemployment would remain high, capital expenditures were going to decrease and the risk of defaults was to going to rise.

A year later, all these symptoms are starting to surface. One more reason to avoid stocks and be long gold. But in my view, it will take longer than many believe, for these imbalances to burst. This is the point I made at the start of 2013, when I wrote that “…during 2013, I expect imbalances to grow…”. Those who hold a view more bearish than mine point to inconsistencies, gaps between valuations expressed by different asset classes. But how can we point to such dislocations and at the same time sustain that markets are being repressed? We must be consistent: If the signals prices send to us are detached from fundamentals, we cannot at the same time call upon them to make our case! That would only be appropriate in a world where markets are not repressed.  So… If I am not that bearish but still believe that imbalances in the long term will burst, what will make them burst? On this point, I stick to what I said at the start of 2012:

“…As long as the people of the EU put up with this situation and the EU Council (…) effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain…(…)…Whenever the political sustainability of the EU is challenged, we will see a run for liquidity…(…)…The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo…” . Unemployment and the tolerance of those unemployed will tell us when the time has come. If it is not that, it will be the wave of defaults the same unemployment produces. There will still be corrections in between, but they will be just that: corrections. That tolerance, of course, is always tested by corruption cases made public. And as I explained above, the more repressed markets become, the higher the number of corruption cases we will learn from.

 

Martin Sibileau

Click here to read this article in pdf format: June 25 2012

We are as deceived as you are with the policy decisions undertaken by the European Union (EU) and the US. As we muddle through their consequences, today we take a moment to offer a few thoughts…

-On the EU: Banking Union, bailout funds and other tricks

After the second LTRO (i.e. long-term refinancing operation) and the Greek debt swap exchange (in March), the likelihood of the break-up of the European Monetary Union has risen exponentially, and continues to rise. Along with this trend, cross border lending by banks continues to fall and flight of capital from the periphery remains in place. The fear of a final collapse is there and rumours of a pending banking union were thrown at the markets.

A banking union, if true and under whatever form it takes, requires a final omni guarantor, backed by an omni pool of resources, funded by an omni tax. This means that the required step of a EU fiscal union is still the only solution to the (only) problem. As we repeated since 2010: This is an institutional crisis! The same analogy is applicable to any bailout fund that “they” may want to throw at us. EFSF? ESM? You name it, they are all useless. They all need an omni guarantee. To think otherwise is simply delusional and a waste of time. Fiscal union, on the other hand, is not possible overnight. It demands constitutional changes. Any strength in the Euro upon these rumors should be faded.

-The European Central Bank (ECB), its collateral and Argentina:

On Friday, the ECB announced that it will reduce the rating threshold and amend the eligibility requirements for certain collateral. In other words, the ECB is accepting lower rated assets to back its liabilities, i.e. the Euro. This brings the European Monetary Union closer to an “Argentina 2001” moment. Why? Argentina suffered from a fast deterioration because its banks, after years of hyperinflation and the confiscation of the 1989 Bonex Plan could only fund themselves via deposits. The European Union banks are getting dangerously close to that stage: Raising equity is no longer an option, unsecured funding has been subordinated by past bailouts, available assets to encumber are almost non-existent at this point (which is precisely why the ECB had to accept lower rated assets on Friday). Therefore, the only fools still funding the banks, at least  the banks in core Europe (because banks in the periphery live on liquidity lines from the ECB) are the depositors. We want to believe that majority of these deposits come from corporations, whose treasurers deposit other peoples’ (i.e. the corporations’ shareholders’) monies. Otherwise, we would be underestimating the intelligence of the people of the European Union, and we don’t.

Given the circularity in the solution proposed by the leaders of the EU (i.e. banks buy  debt from bankrupt nations; the banks go insolvent and are “saved” by the bankrupt nations, which in turn, are now even more insolvent), it is only a matter of time until the very deposits of EU banks are challenged, after every last asset owned by the banks is downgraded to junk and pledged to the central bank.  This brings us to the next point…

-Who leaves first?

With the outlook of former austerity programs (which never got to be implemented, by the way) being relaxed, to “promote growth”, we now believe that it is likely that Germany be the first to leave the European Monetary. The latest action in bunds (i.e. Germany’s sovereign debt) seems to indicate that we are not alone with this thought. Here is why: If a peripheral country is seen as likely to leave the monetary union, the flight of deposits from that country to Germany’s banks appreciates Germany’s sovereign debt and its yields drop, as it has, to negative territory. But if those countries are perceived to stay, as it was after the Greek’s election during the past weekend, then Germany will have to foot the bill. Therefore, the value of its sovereign debt will fall and its yield rise. This is precisely what occurred in the past days. The question is: When will Germany leave? To which we answer in these simple terms: Germany will leave only when the cost of staying surpasses that of leaving. Under both scenarios (staying or leaving) there is a cost. The cost of staying, is a higher yield on Germany’s debt. How high? Potentially, to the magical 7% that Spain has touched and Italy is on its way to touch. Germany would leave before then, as the unthinkable (i.e.Germanyout of the capital markets) takes place. The cost of leaving would be represented by the defaults of the countries that stay, on their obligations to the Bundesbank (for the liquidity lines they enjoyed under Target 2). We think (and explained in our last letter) that this cost can be mitigated, if no capital controls are imposed and bi-monetarism is embraced. This would allow banks –both in Germany and the periphery- to take deposits in Euros and in the new local currencies. Under this scenario, the European Central Bank would not be dissolved. However, if Germany left first, we doubt there would be any incentive from the rest of the countries to allow the existence of Euro-denominated deposits.

-Operation Twist, Part Two

We are not going to add noise to the decision by the Federal Open Market Committee (FOMC) to extend its purchases of long-term US Treasuries and selling, in equal amount, short-term US Treasuries. We are only surprised (very much) by the fact that every analyst, fund manager or media anchor judges the decisions of the FOMC –past, present and future ones- by their impact on the private sector: On activity, on the labour market, on asset prices, etc. Why is nobody openly saying that in a country where fiscal deficits are higher than $100BN per month, the central bank has no alternative but to buy and monetize fiscal debt? Why is nobody linking the deficit and the purchases? Who can really believe that the US are not kicking the can? Who can really think that there will not be, eventually, straight debt purchases?

-The unintended consequences of zero-rate policies, from a micro perspective.

From our lessons in corporate finance, as students, we remember that equity is the riskiest part of a company’s capital structure. Equity is a call option on the assets of the company, with the value of its debt being the strike price. If the value of the assets increases over that of the debt, the spread goes to the shareholders. Hence, for that to occur, the company must “grow”. Companies that have a high likelihood of growing can be financed via equity. Companies that are not likely to grow, that are established in a mature industry and generate steady cash flows, are better candidates to be financed with debt.

With this in mind, we now turn to the fact that zero rate policies sought after globally by central banks have destroyed any possibility of obtaining a decent yield in corporate debt. This forces those who cannot afford to eat off their savings, to “gamble” them in the stock markets, with the hope that the same central banks will boost equity valuations. However, the zero-rate policies kill growth and those poor peoples who were forced to leave the comfort of corporate debt and transfer their savings to stocks will find themselves invested, contrary to common sense, in the riskiest part of the capital structure, in a call option, exactly at the time when no growth will come. How unfair is this?

-Why this agony can last longer than you or we can think

Unlike financial crises in underdeveloped countries, the one affecting the developed world takes place in sophisticated capital markets. There are futures/derivatives markets, forced savings via pension plans, and legalized Ponzi schemes whereby collateral can be pledged multiple times to support liquidity. These factors can cause a significant delay in reaching the “final outcome” and are subject to manipulation:

To break the futures markets, one needs to see a failed delivery by one of the players. But politicians can always capitalize or inject liquidity to that counterpart and avoid the break-up of that market.

A significant portion of the workforce is coerced to save through collective pension plans. The coerced savings act as a cushion between reality and illusion. Those forced to save believe in the illusion that somehow, their pension plans will provide them with an income in the future. If reality set in and the magic was lost, politicians could (and have done so) simply postpone the retirement age or even hike the savings rates enforced upon them. Even in the case where people realized that the cost of staying in the pension plans was higher than leaving them under penalties, politicians can simply “temporarily” prohibit withdrawals and effectively confiscate the monies.

It will take dramatic events to be confronted with these situations, but we think that this crisis will last long enough to face them.

-Murray Rothbard and his book “America’s Great Depression”

The question is therefore: When is this crisis going to crystallize and what will it take for it to do so? Don’t ask us why but we re-read Murray Rothbard’s “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard tells 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…”

From this, we take two conclusions: (a) The crisis ends with a rigorous deflation or liquidation of liabilities,  (b) That deflation has to be expressed in terms of a new standard (gold?).

In the ‘30s, the US dollar was still backed by gold. Gold was the Fed’s asset, the US dollar its liability. Today, the US dollar is backed by US Treasuries. Therefore, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. We can now see the implications of such repudiation, but we have written enough for today. We will elaborate more on this topic, in our next letter.

Martin Sibileau

Please, click here to read this article in pdf format: november-29-2010

We start the week with three main themes, plus the absence of one. Indeed, yesterday the EU/IMF disclosed the “85 Milliarden Euro Rettungspaket für Irland”. So far, this is to the best of our understanding, what has been agreed to:

-In terms of sources, das Paket will consist of EUR17.5BN contributed by Ireland + EUR22.5BN contributed by the IMF + EUR22.5BN contributed by the European Financial Stabilisation Mechanism + EUR17.7BN by the European Financial Stability Facility  + EUR3.8BN in bilateral loans from the UK + EUR1BN in bilateral loans fra Sverige og Danmark.

We note that the sources of the EUR17.5BN Irish support will be Irish Treasury (yes, I know…) and the National Pension Reserve Fund (no different than what Kirchner did in Argentina a few years ago, when the private pension funds were nationalized and put to good use financing the federal fiscal deficit).

-In terms of uses, das Paket will assign EUR10BN to capitalize Irish banks, EU50BN to cover budget financing needs and EUR25BN as contingent banking support. And here is where things get rather interesting…After Kanzler Merkel would threaten with haircuts on senior bank debt holders, European finance leaders yesterday had to commit to a plan, post-2013 (i.e. when temporary crisis facilities expire) that would treat writeoffs only on a “case-by-case” basis (as reported by Bloomberg), addressing “collective action clauses”. In our view, although this offers a bit of calm to investors, the “technical” damage has been done and it will be difficult to repair, unless there is now an explicit rejection by the EU finance ministers on the issue. They don’t want that? Fine, Mr. Market will eventually force their hands. Just sit tight and watch… What’s next now? Portugal?

The second theme that will impact this week’s action, and perhaps more to come, is the situation in the Yellow Sea, between the Koreas. The recent mediation by China to hold discussions among the Koreas, Russia, the US and Japan smells to a set-up to us, to buy more time for North Korea. It raises the question too, of whether this would have all not been planned before hand. Now, if South Korea rejects the invitation, it will look bad on them. If they don’t, nothing will come out of it, except that the dictatorship to the north will have won time. This could have been a great opportunity for China to demonstrate they are politically up to their pretension to be a global superpower. Because nothing will be solved, in our view, Asian stocks will be capped on their potential to the upside and the price of gold will keep a premium.

The third theme in our view is the expectation, after Black Friday, that consumer spending is slowly recovering and that this will be a force behind a “trend to rally”. Certainly, the recently announced $600BN monetization of federal debt by the Fed (also known as Quantitative Easing II) will also keep a bid on asset prices.

Lastly, another theme is actually the lack thereof, that we may see more clear if and once the public becomes comfortable with the situation in the EU: Namely, the lack of an exit strategy in the US. See, since the beginning of this year, the EU has been working towards gaining trust. Let’s recap:

 First, nobody thought they would pull out a spending cuts program. But so they did! We now have spending cuts from Ireland, UK to Greece. Yes, citizens protested big time, but the cuts are here to stay. Yes, they are not enough, but there is always more to cut and privatizations have not even been discussed yet. What about spending cuts in the US? 

Later, nobody believed the EU would really pull out a package for Greece. Yet, they rescued Greece and now Ireland. They even worked out a mechanism to address future crisis and most importantly they put deadlines to them: 2013. What did the US do on its municipal and state debt problem? So far, the municipal bond market suffered a huge outflow of money two weeks ago and Wall Street is making every effort to downplay the issue, as we expect of course, from those who make money distributing this debt.

Finally, the European Central Bank stated that their government purchase bonds would be sterilized. Nobody believed them (we included) and nevertheless, they did so issuing their own debt (EUR65.8BN at Nov 24th) and without driving rates to expensive levels. What has the Fed done? This is all brewing USD weakness in our opinion and it won’t be long till we see it bursting.

 
Martin Sibileau