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

As Easter approached, we began to see a timid sell off in US stocks (but not so timid in Europe or Canada), in corporate debt, and in Treasuries. Treasuries later in the week rallied, but if you ask, we would see them still in a downtrend. This downtrend began with the implementation of the Fed’s latest currency swaps, at 50bps, in mid December. As we argued against public opinion (refer here), the swap is a bailout that actually coupled the fate of the US with that of Europe, and not the opposite. It makes perfect sense to us because just like now, the US was also coupled to Europe in the 1930s, and ended up having to pardon what it was “owed”. Here is the moment when President Hoover announces the moratorium (ie. pardon) of the debt:

People back then took the matter in their own hands and forced the devaluation that ended in the bank holiday of 1933, with President Roosevelt confiscating gold. Here is the announcement by Mr. Roosevelt. Let’s keep both videos in mind, for future reference, because we have the feeling this crisis will be a horrible déjá vu:

As we have done many times before, we offer this excerpt from Jacques Rueff’s “The Monetary sin of the West”, 1971:
“…On 1 October 1931 I wrote a note to the Finance Minister, in preparation for talks that were to take place between the French Prime Minister, whom I was to accompany to Washington, and the President of the United States. In it I called the Government’s attention to the role played by the gold-exchange standard in the Great Depression, which was already causing havoc among Western nations, in the following terms:

There is one innovation which has materially contributed to the difficulties that are besetting the world. That is the introduction by a great many European states, under the auspices of the Financial Committee of the League of Nations, of a monetary system called the gold exchange standard. 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….”

We are starting to get dizzy, disappointed, confused by the manipulation of capital markets, which are slowly and steadily losing liquidity.

The manipulation comes first and foremost from central banks, be it in the FX market, rates or gold. And when they intervene, they generate a volatility that is completely foreign to the “natural” changes that “Main street” (i.e. non-financial sector) would expect from a growing economy. It is this volatility that gets everyone dizzy.

Secondly, governments, via regulations and financial repression, distort the subordination points the market had established for different sectors. What do we mean by this? Every business and in aggregate, the whole economic system, has a capitalization structure, consisting, for example, of equity, preferred equity, subordinated debt, sr. unsecured debt and sr. secured debt. Each participant in these “layers” of the capital structure demands a return for the risk taken. That risk consists of two parameters: The probability of default (i.e. losing one’s capital) and what it expects to recover, if there such default takes place. Well, since the beginning of this crisis, with the bailout of the Chrysler and General Motors in the US, the Asset-Backed Commercial Paper scandal in Canada, the bailout of the financial system in the UK and most recently, the debt exchange of Greek debt with the European Central Bank which subordinated private bondholders without triggering default, both parameters (default and recovery) have been insanely disfigured. The natural consequence is a retreat by investors from pouring funds to the “system” at best, or simply reducing the savings rate, at worst. We fear both processes are well underway (last week, we received confirmation of a slight decrease in the savings rate in the US) and it is this repression that disappoints us.

Thirdly, we are confused by the ignorance leaders show. They should by now see that these policies drive people and companies to save less. We discussed this point on March 18th, when we wrote:

“How can any entrepreneur in these conditions feel encouraged to invest in increasing the productivity of his/her business? They cannot and all they are doing and will be doing is maintain what they have, refinance their liabilities longer term for cheaper rates and use every excess cash they count on to increase their dividends, as a way to cash out in a world where the price of equity, the price of risk, is anything but clear. We remember those times in Argentina when suddenly, bankrupt companies were owned by rich businessmen. One thing is to invest in dividend producing companies, with dividends driven by stable and healthy cash flows. Another thing is to invest under the illusion that those exist, when in fact the dividends are the only outlet entrepreneurs have to cash out with bank debt…”

On April 2nd, Zerohedge.com reproduced comments made by David Rosenberg, supporting this view, under the title: “How The Fed’s Visible Hand Is Forcing Corporate Cash Mismanagement” (We generally tend to disagree with mainstream economist David Rosenberg, but it looks like, over the past years, he may have been quietly reading Austrian economic literature).

Under the status quo, investors, globally, are and will continue to shift slowly their savings out of the “system”. On the margin, why would anyone that is not an insider of the financial markets want to keep their savings there? They will be levered/re-hypothecated or invested in cartelized exchange-traded funds or used to pay fees or futures rolls, or face huge bid/ask spreads or finally, if they produce good results… they will be taxed. Why would anyone want this? Why not just keep savings safely invested in farmland, or collectibles, or physical precious metals, or real estate in unique locations? These assets cannot be re-hypothecated, charged with monopolistic fund fees or unreasonable bid/ask differentials. Returns can be influenced by their owners’ commercial activity and taxes can always be minimized. But if these are the alternatives…how will corporations get funding for their projects or even normal capital expenditures? How will governments keep funding their deficits? Of course, …. Ben Bernanke and Mario Draghi assured us last week that their liquidity pumping policies are only transitory…

In the last days again, we have been exposed once more to the rhetoric of the prospective fiscal unification of the European Monetary Union (“EMU”) but based on new, mega bailout funds. We no longer care about the amounts they come up with (they came up with Eur940MM…nobody bought), even if it was true that the EMU members can raise these amounts. The fundamental issue here is that they want to address a “flow” problem (fiscal deficits) with a “stock” solution (bailout funds). It can’t be done. Flow-driven problems must be addressed with flow-based solutions, like a federal tax (If you have never heard of the terms “flow” and “stock” as used in Economics, please, read this explanation).

In particular, the situation out of Spain is rapidly worsening. Most analysts believe it is serious and a good portion of them think that once it spins out of control, the European Central Bank will intervene with plain monetization of Spanish assets. We have our doubts. Unlike other peripheral countries, Spain is a kingdom with a strong and influential king. Unlike other peripheral countries too, the fiscal deficits that hurt Spain are of a regional nature, and the independence of these regions is strong and ferociously defended. Under these circumstances, there is a high risk that the demands imposed upon Spaniards by the Euro Council be harsh enough to be refused and that upon such refusal, the Euro-zone face its final hour. We think that the fact that gold held above $1,600/oz upon the release of the Federal Open Markets Committee’s (“FOMC”) minutes last week, with stocks and the Euro selling off is a signal that this risk is not to be underestimated.

In light of this, having been stopped out of our position in gold with the release of the FOMC minutes, we bought it back on Thursday, at a lower price, but this time, hedged, shorting North American stocks. We are bearish of stocks or, better said, we think that the ratio of gold to stocks is now in gold’s favor, after a serious correction.

 

Martin Sibileau

Suppose you own a business and 1/3rd of your product is being bought by a single customer. What if this biggest customer tells you that as of June, he or she will stop buying? What do you do with your inventory? Exactly! You liquidate it in a fire sale! You had been selling what this biggest customer was buying, and then buying what you thought this customer would buy next. This has been precisely our thesis No. 1. As the chart below shows, after the Fed’s announcement at 2:15pm yesterday, Treasuries (long-end) sold off. (There was also profit taking in the Agency market):

The FOMC (Federal Open Market Committee) expressed no change in the plans to buy $1.25 Tr of Agency mortgage-backed securities, $200 bn of Agency debt and $300 bn of Treasuries. There was also no change to the fed funds target range. At 1:22 pm, Mr.Volcker, Chairman of the newly formed Economic Recovery Advisory Board and Chairman of the Fed between 1979 and 1983, had said that the current administration was committed to supporting banks. I think that led the market (and me) to believe there was going to be an upsize in Fed’s Treasuries purchases and, as the chart shows, that pushed Treasuries up (for a short time). The FOMC said the economy continued to contracting, but at a slower pace (GDP -6.1% q/q annualized).

I can’t understand stocks. The S&P 500 shot up on the news, and although it ended lower, it was still +2.16% (873.64pts). Why is this hard for me to see? If the long-term (30-yr) risk-free yield rose above 4% post-FOMC and the USD fell against the Euro and the Canadian dollar (=outflow of capital), why are stocks higher? (The USD rose against the yen and Pound, but this reflects and does not explain the rise of stocks). Isn’t a risk-free 4% yield good enough? Maybe it isn’t so risk-free … To make things more interesting, Treasuries in the short-end (2- yrs) had a solid bid, steepening the curve at close. Before I continue, I must say, thesis no. 3 (proposed on Friday) was refuted yesterday (= I was wrong!). There was no announcement of an exit strategy and stocks went up. I could say that to stop buying (FOMC statement) somehow indicates the way out (exit) of this mess, but I think the Fed is only bluffing, and it will keep buying anyway…Perhaps, we may have to first look at the credit markets. The CDX IG12 index finished at 168 bps (-9bps) and the High Yield index also did well, about 2 pts up. Even the leveraged loan LCDX index rose more than 1 pt. What is this supposed to mean? Maybe the market is seeing a light at the end of the tunnel. Perhaps the Chrysler negotiations are positive, the distressed debt exchanges we are witnessing will really avoid defaults, perhaps the bank issuance coming outside of the FDIC-backed program (Goldman Sachs sold yesterday $2BN 6% 5-yr notes priced at T+410bps) is also a good sign. If this is the case, the market may wait for a confirmation this Friday, with the release of the ISM Manufacturing Index, before it moves anywhere (Readers’ feedback is welcome)…On this basis, I will wait until Friday, before I reject thesis No. 3. ONE LAST THOUGHT: If we are comfortable with a 4% long-term yield, with double-digit debt exchanges, with oil going higher on oversupply and stocks higher on awful news, maybe Keynes was right when he said that (refer April 28th letter): “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…” (General Theory, Chapter 13, published in 1936). We may indeed need more money to maintain the higher yields, to repay the double-digit maturities, a barrel of oil, Citibank shares or my morning coffee! I only hope that more money is also needed to pay your and my salary!