Click here to read this article in pdf format: July 9 2012

Markets had a quiet week, with a holiday in Canada and another in the United States. We will therefore be brief today.

In our last letter, we presented how we think, the end of this crisis will be brought about: With the collapse of the futures markets. It is important that these markets really break because they are the ones used to manipulate commodity prices (not just gold) and as long as commodity prices can be controlled, the flight from fiat money to real assets will not be triggered and the global depression will stay with us. We know that, “they” know that and that’s why when that critical moment approaches, the repression to avoid it will be phenomenal, of a kind nobody in the developed world has ever witnessed. We leave it here…

Last week, the central bank of Argentina declared that at least 5% percent, we understand, of deposits held by local banks “must” be lent to businesses. Everyone laughed at this ridiculous measure. Everyone knows that it is useless and that the government of that country can do nothing to prevent their eventual fall. Last week too, the central bank of the European Union declared that it will pay nothing, (zero percent rate) on deposits from Euro zone banks. Yet nobody laughed at this measure and still… it is nothing else but a twisted version of what the Argentines did. It is as ridiculous and it will be met with the same answer: Less lending and more recession.

As we wrote months ago, in order to save their currency, the Euro zone destroyed its banks. And with this last measure, it will have ended its money market. For all practical purposes, the European Central bank made sure that its liabilities, the Euro, will never be able to reach a global reserve status. The damage these irresponsible central bankers are doing is immense because until now, Euro banks were not lending to each other for a genuine reason: Very high counterpart risk within a currency zone that is falling apart. They were taking heavy capital losses on the sovereign debt holdings they had been coerced to invest their funds in but, at least, they were able to earn 25bps on immobilized monies. Now, they won’t even have this “risk-free” income, a situation that actually enhances counterpart risk, as solvency is further crushed.

At the same time, if the banks cannot afford to have funds immobilized, they will discourage the growth of deposits in the Euro zone, precisely when they are most needed. The way markets welcomed this measure shows we are not alone with this view.

On another note, last week too, Robert Diamond, ex-CEO of Barclays was called a criminal during a testimony before the British Parliament. The reason? His former employer was accused of manipulating the London inter-bank offered rate (LIBOR). We can only ask this: Why are bankers called criminal when interacting in the market to get a price for their product, while central banks, who actually “set” the rates….are not? Who is the criminal? After all, would any other business not try to move a price to its benefit? If it is successful, it’s because the demand for that product is there. The point is: They were not, which is why Libor, after all, has become an irrelevant rate. Was that criminal? Did bankers really ever force other banks or businesses to borrow by way of bank debt, rather than bonds or raising equity? Yet, central banks do actually impose rates on the market, regardless of demand. Who is the criminal? Who is it?, we ask…

Lastly, in our letter of June 25^th, we argued that it was now conceivable to see Germany leave the Euro zone first. We think that the latest actions, both by the central bank and the Euro Summit, make this outcome increasingly likely.

Martin Sibileau

Click here to read this article in pdf format: May 29 2012

In our last letter, we dealt with the issue of (EUR/USD) liquidity in the capital markets and although we described some facts, we did not mention a relevant one: That while the 3-month EURUSD swap basis has not risen, the 3-yr (and longer term) has. In other words, the spread between the two bases has widened, as the chart below shows (source: Bloomberg).

This steepening, in our view (and we welcome readers’ feedback), is caused by the existence of the 3-yr LTROs (Long-term refinancing operations), established by the European Central Bank (ECB) at the end of 2011, beginning of 2012, coupled with the 3-month Fed currency swaps. As is also visible from the chart, in the past, the widening (i.e. steepening) of this spread  of the EURUSD basis curve was corrected with (i.e. preceded) interventions. Is there one coming soon? A long-term currency swap? For three years? We doubt it, given we’re only a few months away from the US presidential election, and not only do we doubt it: We also think that should there be one, its effect would be very marginal.

During the past week, one rumored alternative intervention was a blanket guarantee on euro denominated deposits, across the European Union. We will explain why we think it would not work:

A guarantee is a contingency. According to generally accepted accounting principles, they way to record a loss contingency is to show a liability, against a loss. This means that in the balance sheet of the corporation issuing the guarantee, liabilities will rise and the value of equity, by the same amount, will fall.

In corporate finance, these contingencies must be shown every time that the following conditions are simultaneously met:

a)       Information available prior to issuance of the financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred,

b)       The amount of loss can be reasonably estimated

Indeed, national accounting is not corporate accounting. But principles are principles and at the end of the day, it is the private sector, people, that end up holding euros to be guaranteed by Bunds.

Should, as the rumor spread, Germany and others from core Europe, offer the guarantee to the ECB to back liquidity, the value of their own liabilities would fall, helped by the corresponding downgrade of the ratings agencies. In other words, the benchmark rate of the Euro zone, the bund yield (i.e. German sovereign bonds), would increase. The asset, the Bunds, would have been impaired, as condition (a) states. This would fuel the ongoing recession within the Union, possibly buffered a bit by the fall in the value of the Euro and capital gains (stock gains) in Euro financials.

An answer to this would come from the ECB, via purchases of Bunds. With them, the expansion of Euros would be driven by the purchase of Bunds and all and any support left for Bunds from the private sector would be lost, just like it was lost for the long-term US Treasury bonds: As you may know, under Operation Twist, the Fed purchased 91% of all 20-30 yr gross issuances!!

At the end of the day, Germany would have run a bigger deficit (i.e. coming from the losses reflecting the guarantees), higher interest rates, lower ratings, a weaker financial system with bigger deposit runs (now affecting core European banks), and a currency of lower value….The question is…..What makes you think  Germany will want to go for this?

 

Martin Sibileau