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

We will be brief today, for nothing of macroeconomic consequence has taken place in the past 24hrs. The action that caught our attention yesterday was in the foreign exchange market (the market that never lies). In particular, we refer to the action in the Canadian dollar. The cross with the Euro gained (i.e. the CAD rose against the Euro) 2.3 cents intraday, and although (or because) the TSX composite closed +0.85% higher, we can only deduct that the demand for Canadian dollars did not reflect a pari-passu demand for Canadian assets. Therefore, our intuition is that with yesterday’s calm, the demand for Canadian dollars that did not end in assets was a demand for reserve purposes, at a central bank. We are open to alternative suggestions to explain this phenomenon but any of these explanations would also have to address how the Canadian dollar did so perform on a day where neither oil nor gold rallied.

Was the CAD rally based on the news that the Canadian economy expanded at a 5%  annualized rate in the fourth quarter (faster than forecasted by the Bank of Canada)? We doubt it because a) the CAD’s sensitivity to interest rate gap (i.e. with the higher than expected growth rate the market revises its forecast on policy rates) has been low, and b) the strength was not uniform but clearly against the Euro.

On another note, in an interesting report, Bank of America estimated yesterday that approximately $160BN will flow to private investors by the end of 2010, as a result of the buyout of delinquent mortgage loans by Fannie Mae and Freddie Mac (refer: “The long and short of delinquency buyouts”, in Situation Room, Bank of America Merrill Lynch Credit Strategy, March 1, 2010). At “A View from the Trenches” we had anticipated the consequences of this operation back on January 4th, when we wrote:

“ …Since (our) last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells (us) that the USD strength will be only a relative notion in 2010. (We) say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)… “

We stand by these comments and the market is proving us right. What we did not grasp back then was the magnitude of this operation ($160BN of private liquidity) under certain loan delinquency level assumptions that can further deteriorate, if the recovery process disappoints. We invite readers to closely monitor activity in the GSE market for this is serious enough to keep the dream of asset inflation alive.

(Note: Mainstream economists use the term “asset inflation” to refer to bubbles, because their theory of inflation is wrongfully based on the non-neutrality of money, as implied by the exchange equation: M*V = P*Q. Therefore, they treat bubbles as an aberration that can only be addressed with regulation)

Martin Sibileau

Please, click here to read this article in pdf format: february-12-2010

(This is the last day of the week and “A View from the Trenches” will not be published again until February 25th, as we will be traveling.)

The statement released by European authorities yesterday was a mere expression of support for Greece, explicitly denying a request by Greece, for financial aid. The markets accordingly sold all things European, including and in particular Spanish financials. The picture does not look so good and yet, stocks outside the Euro zone (except for Athens, of course) rallied yesterday.

What do we make of this?
On one hand, we had another Treasuries auction yesterday. This time for $16BN 30-yrs, with the yield rising to 4.72%. The UST 2y10y curve ended 4bps steeper at 285bps. The Czech Republic was also deceived when it raised 15-yr debt on Wednesday and Greek banks seem to be facing funding problems. We also face significant uncertainty with the latest developments in Iran.  But on the other hand, the markets received some “optimistic” releases too. Continuing job claims in the US kept their downward trend, Australia also saw an improvement in its labour market and the CPI reading in China was stronger than expected.

Briefly, of one thing we may be certain: Capital is flowing out of the Eurozone and into the rest of the world. But at the same time, capital seemed yesterday to also be preferring commodities and basic materials, which puzzles us, because the macroeconomic backdrop is bearish for us.

In our view, we should not see yesterday’s rally in North American stocks and credit, as well as in crude and oil, as a bullish signal, after the EU meeting’s statement. Why? Because for this rally to be interpreted as bullish, the Euro should have rallied as well! It didn’t and in fact plunged from a tall cliff, specially against the Canadian dollar. A reduction in the purchasing power of the Eurozone should not be seen as something positive for global growth (= for oil demand and hence for the Canadian market!)

Interestingly enough, Freddie Mac yesterday announced that it will buy practically all 120+days delinquent mortgage loans from its fixed rate and adjustable rate mortgage Participation Certificate securities. We had foreseen a move of this type and discussed it in December and on our first letter of 2010 (www.sibileau.com/martin/2010/01/04 ). This is what we wrote then:

“…As credit spreads are already very low again, the increase in sovereign risk (yield) should make debt a less profitable investment, when compared against equity. In December, I associated this process with USD strength. Now, I am not so sure. Since my last letter of 2009, the US Treasury announced it would lift the cap on the Preferred Stock Purchase Program (refer Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited support”, Bank of America’ “US Agencies” report of Dec 29/09). This explicit show of support for agency debt (which I assumed it was going to smoothly disappear in 2010) tells me that the USD strength will be only a relative notion in 2010. I say relative because the strength should show vs. those countries that explicitly decide to import USD inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro zone), while the weakness should show vs. those countries that will profit from the credit-inflated recovery (Emerging markets or commodity currencies, like the CAD)…”

Back to the impressive strength shown yesterday by the Canadian Dollar. At yesterday’s open, you needed 1.0621 CAD to buy 1 USD. At close, 1.05 were enough. The CAD was even stronger of course vs. the Euro, finishing at 1.4383 CAD/EUR, from 1.4591 at open. What granted such a move?  In our view, the strength in the CAD was not fully reflected in the stocks market (TSX 60), which closed +1.32% higher, at 11,435.49pts. We think instead this movement may have mostly reflected a shift in central banks’ reserves, out of the EUR and into the CAD. What makes us think so? The relatively flat performance of crude oil, which still doesn’t break through its bearish trend.

Martin Sibileau

Please, click here to read this article in pdf format: february-11-2010

The world is speculating on the outcome of the meeting of European leaders later today, in Brussels. In the meantime, yesterday Mr. Bernanke made clear his intention to raise the discount rate, sooner than later. Furthermore, yesterday also, the 10-yr $25BN US Treasuries auction was weak. It’s true, there were a lot of other problems markets were focused on, including the weather on the east coast, but then again, are Treasuries not supposed to act as a safe haven in times of chaos? We took note of this and of the fact that yields rose in parallel (shift upwards), with the 2y10y curve ending at 281.1bps, flat. We will be watching this market closer as well as its impact on swaps and Agencies, for we feel this may be signaling an upcoming tectonic shift. It’s pure intuition for now, we acknowledge, but sometimes intuition has merits too…

On another note, we continue to insist with the view that Europe is facing an institutional crisis, rather than the short-term liquidity crisis seen by so many mainstream analysts. What is the difference? Here is a defining point:

If the crisis was indeed about short-term liquidity (with long term solvency concerns), then it should not matter whether it is the IMF or the European Union that bails out stressed peripherals. If the problem was only short-term liquidity, form should be subordinated to facts. Yet facts are subordinated to form. It is precisely because nobody seems to be able to come up with a sustainable and acceptable “form”, that we see no facts! (Facts = Risk mitigating actions, like loan guarantees)

If the crisis was only about short-term liquidity also, the Euro should have not been impacted as it has. How measurable is the impact of the liquidity situation in California on the USD? How can therefore Greece have such an impact on the Euro? It is the very sustainability of the European Union that is at the core of this crisis.

Why is this relevant? Because it tells us something: Today, it is likely that no long-term credible path will be announced.

Lastly and related to this crisis too, we want to draw collective attention to an issue that in our view has not received enough consideration. Much has been made and written on financial regulation necessary to prevent financial crisis. We, at “A View from the Trenches” have also written many times that regulation is useless and counterproductive, for the root of the problem is the monetary system that the world is embracing. A central banking system is intrinsically weak, arbitrary and leveraged, and attacking the distributors of a currency (i.e. financial institutions) will not make the system any stronger. However, there are other issues regulators can positively address, which we think have not been addressed yet. One of those is the potentially destructive nature of sovereign credit default swap contracts, which are currently booming.

In our opinion, these swaps are true weapons of mass destruction. Essentially, if a sovereign defaults, the party that bought protection should be compensated for the loss on the corresponding reference securities. But who thinks any counterparty would have enough liquidity to honor these contracts, if say, we see a default in the US or the UK, for instance? What would be the value of billions of credit protection on US sovereign risk sold by Citi or Goldman, if the US defaulted on its debt? What would be the value of credit protection on German sovereign risk sold by Deutsche Bank, if Germany or France actually defaulted? Zero! Given the fiat monetary system we live in, no financial institution would be able to have enough liquidity to fund the increasing margins, even before such defaults are declared, because the value of the collateral denominated in USD or Euros would drop materially, as jump-to-default risk rises. Under such scenario, things would spiral out of control and it would be evident that either central banks end up bailing out both the financial system and the sovereign, triggering a massive hyperinflation in the process, or the biggest of all depressions would be upon us.

Restrictions on this market would be useless, because they would not acknowledge the intrinsically leveraged nature of the contracts. The solution, in our opinion, is that counterparty risk be collateralized with gold, instead of fiat currency, for those sovereigns with the strongest currencies (=the most leverage!).

Martin Sibileau