Please, click here to read this article in pdf format: december-21-2010

 

This is our last letter of the year. Briefly, we want to go over the main themes that we leave with, to touch upon a subject that we have already expressed our concerns on. Let’s see…

To give structure to our first point (i.e. main themes), we will classify the themes according to their respective currency zones. Starting with the US, we must say we’re impressed by the level of optimism expressed in the many research notes we’ve read in the past week. The outlook for 2011 is too good and shared by too many, which is a recipe for deception. Most of it is based on the fact that from a fundamental perspective, 2011 will “suffer” from a negative net issuance in almost every credit/fixed income class, exacerbated by the Fed’s announced purchase of $600BN in Treasuries.  This shortage in net issuance is to us the main theme, the basis of an expected asset reflation trade. Do we agree with this view? No! This view is not dynamic. This view assumes market participants will be comfortable once the negative net issuance is over and we enter 2012. This could never occur, because once the force behind the reflation weakens, the pain will be even less tolerable and a new source of price inflation will be sought.

For the European Monetary Union, next year will be quite the test. We differ with those who see indecision in European politicians to take the next step towards a fiscal union. But we fear more the idiocy or lack of understanding by politicians, of certain economic fundamentals. To tell sovereign debt investors they will be subordinated to supranational debt (i.e. European Financial Stability Facility), to threaten those they call speculators but provide liquidity to the market, will only take the pricing of future badly needed issuances to unsustainable levels, seriously jeopardizing any chance of survival.

In the meantime, in 2011, we think the UK will keep playing its Keynesian game of debasing real wages (i.e. inflation) and cutting fiscal spending, as long as investors allow it. The UK has an enviable sovereign debt maturity profile (i.e. long-term skewed), where the benefits of a small inflation surpass the political costs of frugality….for now…

We see China’s oligarchy further condemning the masses to coerced saving, by increasing the segmentation of its capital markets. Hong Kong will profit, while mainland Chinese labour will foot the bill, continuing to work at suppressed wages for the party to continue in the West. How do you segment capital markets? You disrupt the credit multiplier raising the reserve requirement ratios, forcing exporters to clear payments in Hong Kong, taxing capital inflows, raising the exit costs for foreign capital. All in the name of a pegged Yuan. Can this last another year? We think it can.

Finally, Emerging markets and the “other dollars” will walk the tight rope, as they try to keep their economies open and at the same time, seek to prevent the import of inflation from Helicopter Ben. This, as David Hume back in 1752 wrote, is futile. It’s a losing proposition. In the case of Canada, we would not be surprised if the Bank of Canada abuses its repurchase agreements or the if Canadian Home Mortgage Corp., on behalf of the export lobby, injects liquidity in the market by repurchasing mortgages. All this to keep the Canadian dollar from going beyond parity. It will be sad, but it will happen.

Now, to our second point. We have followed and continue to follow with utmost interest the political career of US Congressman Ron Paul. We sympathize with Mr. Paul’s cause for sound money, but he and his political life reminds us of Cicero in the face of Rome’s final days as a Republic. Mr. Paul may be remembered by historians of the United States, just as Cicero is remembered by historians of Rome. There is however a small but relevant difference between Cicero and Congressman Paul: Cicero took sides. Cicero, in the end, sided with Octavivs. Yes, Octavivs betrayed Cicero, but Cicero, also saw that neutrality was a sterile path.

Congressman Paul is not taking sides. Having been repeatedly asked lately what his plan is as the new chairman of the Financial Services Subcommittee on Domestic Monetary Policy, with Congressional oversight of the Federal Reserve, Mr. Paul replied that he would simply seek to allow gold or any other asset to compete as legal tender with the US dollar (in addition to audit the Fed, that is). We understand the noble intention behind this, but we can’t support it. We have no idea as to what the real chance is for this innocent proposition to be enacted. But we can say that this plan will only have the unintended consequence of creating unnecessary discredit to the Austrian economics tradition. Why? Because it is no plan! No, we are not advocating to plan monetary policy. That is also very un-Austrian. We are simply noting that to “end the Fed”, a plan is required.

A simple example (among many others that this short space doesn’t allow us to elaborate on) should help visualize our point. If gold has a chance as an alternative asset, in simultaneous competition with the US dollar, it will only be natural that we witness once more Gresham’s law at play. Gresham’s law, simply put, states that bad money displaces good money out of circulation. In a leveraged system like the one we live in, this means that market participants would arbitrage the system. They would simply borrow in US dollars and save in gold . To some degree, this is starting to slowly occur, but today the speed of this change is driven by the deterioration of the paper money, not by the quality of gold as legal tender. However, if gold was allowed to compete, this process would take place faster. This would quickly lead to the bankruptcy of the entire financial system, as we know it , for the cost of borrowing would increase exponentially, in real terms (i.e. in gold). But, if Mr. Paul does not end the Fed, as long as this institution survives, it will be forced to provide liquidity to the financial institutions, creating hyperinflation along the way.

What is the problem with hyperinflation? That those who still earned wages in paper money would see their income (and possibly their wealth too) destroyed. Please, note the following:

1.-Fiscal deficits, as long as the government does not bail out banks, would have NOTHING to do with this hyperinflation Mr. Paul’s plan would bring.

2.-The Fed would create hyperinflation by providing liquidity, not bailing out banks as in 2008, when it bought defaulted liabilities. In fact, as inflation spikes, it would be extraordinary to see defaults in paper money (i.e. bad loans), for the cost of paying off US denominated debts would decrease along with the higher rate of inflation

The only way to prevent hyperinflation would be to create fiscal surpluses and use them to buy gold to back the US dollar, for the Fed to be able to compete against gold-backed notes. Now, if you think the public and the financial lobby would allow monetary developments to get to this stage, you really are an optimistic in life. In the process, Mr. Paul and the rest of the Austrian movement would be blamed for creating inflation and making the poor poorer.

Given the impossibility to save the Fed, the next stage, which would see the Tea Party ousted from Congress for decades, would be to unwind the Fed. And the United States would have a multitude of unregulated banks issuing gold-backed notes, lending more than they have in deposit. It would only be a matter of time, until the next Ponzi scheme is uncovered and by then, given the absence of a lender of last resort, the public would seek to solve the problem with regulation. Someone would remind Americans of the good old times when there was a lender of last resort and the United States was the global power, and we would see central banking back in place.

We can’t let that happen, Mr. Paul. We need a plan to unwind the Fed without creating hyperinflation. The good news is that it is technically possible.

We want to thank everyone for accompanying us on our second year and wish you all a great 2011!

 

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

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

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

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

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

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

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

Martin Sibileau

Please, click here to read this article in pdf format: november-9-2010

Having dealt with the implications of QE2, the market has repriced and now shifted focus to the situation in Europe. We should have published yesterday about this, but we had already anticipated problems in Europe when last week, right after the US Federal Open Market Committee announcement, we wrote:

“…the creation of a crisis resolution mechanism without addressing the root of the problem, namely the absence of a real federal structure in the European Union with a unified bond market, only adds one more layer of complexity to the still alive uncertainty generated by potential contagion from the periphery to the core of the Union. A crisis resolution mechanism is buzzword for confiscation, for wealth redistribution from bondholders to governments. There is no other rationale for bringing this up, except to ensure that in the future, investors in sovereign risk see their seniority status diminished, subjected to the arbitrary designs of a crisis resolution council. This idiocy or naïveté, we don’t know which, will do nothing but make Euro sovereign debt more expensive to raise, in a more volatile, less liquid market, if the reform advances. It will certainly put a cap to the value of the Euro and a cloud of doubt to its prospects as a secondary reserve currency…” (www.sibileau.com/martin/2010/11/04 )

We stand by these comments, which differentiate us from the mainstream explanation of the ongoing situation within the European Union. While some (refer D. Gartman in his letter of Nov 8th, 2010) see US dollar strength rather than EUR weakness and others attribute the weakness to the fiscal situation in Ireland, we strongly believe that the weakness which commenced right after the announcement of QE2 was triggered by this institutional development that Germany is working on behind the curtains. Germany has brought this unnecessary bout of sovereign risk entirely upon itself, for one has to be insane to go public suggesting that in the future, investors in sovereign risk will be considered as participants in future bail-ins.

True, the article by Prof. Morgan Kelly on the Irish Times (http://www.irishtimes.com/newspaper/opinion/2010/1108/1224282865400_pf.html) only made matters worse at yesterday’s open but it is clear to us that the weakness started with the speculation of a ridiculous “orderly” bankruptcy mechanism for EU sovereigns. Was somebody surprised to see that nobody has a real grasp on what the actual debt burden on Ireland will be? Was anyone in awe to learn that the final bill of the bank bailouts is pharaonic? Who did ignore the problem mortgages represent there? No, this was not news. The German draft on “orderly” bankruptcies is the news. The Euro turned to the downside on last November 4th and more importantly, the recent spike in sovereign risk has not yet been transmitted to the broader Euro financial sector, as the Euribor – OIS spread continues to be in the low 20s bps.

Is there time to revert this? Possibly, but only if Germany really shows leadership. Peripherals debt, like any other debt upon which hesitation grows requires an increase in the collateral or a guarantee. In this case, increasing the collateral would mean opening the door to future privatizations, just like what the Brady bond restructuring brought about in Latin America. That, for now, seems not to be in the cards. Therefore, the only way out here is to show a guarantee. The fact that we see a recent spike in sovereign risk is proof that the European Financial Stability Facility (http://en.wikipedia.org/wiki/European_Financial_Stability_Facility) cannot be trusted, in our opinion. We already wrote, back on September 9th:

“…Another interesting perspective is that which finds strength in the Euro, from the fact that peripheral countries can now access the European Financial Stability Facility, which is now effectively operational. We actually see it the other way: Precisely because the weak countries will access this facility, the break of the European Monetary Union will be accelerated, as the rich countries are faced with true costs; costs which until now were being piled under the big rug (the balance sheet) of the ECB…” (www.sibileau.com/martin/2010/09/09 )

Lastly, we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis.

Martin Sibileau