Today, we think it would be important to leave the analysis of the latest news aside (including the negotiations on Greece’s debt) and instead, to present a theoretical framework that may allow us to understand the ongoing rally and what may develop during 2012 and beyond. There is nothing more practical than a good theory and a good theory is indeed what we are looking for this morning.

Let’s first examine what we are witnessing today, namely the financing by the Fed and the European Central Bank (“ECB”), of the Eurozone financial system. Below, we describe how it works and we carry the analysis to the extreme. We like challenging models to their extreme implications, because this aprioristic deductive exercise forces us to identify what mainstream economists, many months later than us, usually end up calling “tail risks”.

In step 1 above, we see the first pillar of the EU financial system bailout: The Fed extending US dollar swaps to the ECB, at below market rates. As can be seen, these swaps are an asset of the Fed and a liability to the ECB, which receives US dollars in exchange. With these US dollars, as we explained on December 12th, the Fed avoids a liquidation of US denominated assets by EU banks and the resulting increase in the cost of US dollar funding as well as in counterparty risk, for US financial institutions. These swaps can therefore be seen as vendor financing in favor of US banks, at the expense of American taxpayers and anyone who invests their savings in US dollars (i.e. US banks, via the Fed, provide cheap financing to their trading counterparties, all paid for by a devaluation in the purchasing power of the US dollar. On this matter, please refer our comments on September 12^th, 2011).

However, the extension of USD swaps is not enough to save the status quo. The institutional weakness of the Euro zone, having failed (back in March 2011) the move towards a unified bond and fiscal integration, triggered the jurisdictional arbitrage of deposits (Euro funding). Deposits were taken from banks in the periphery (Greece, Portugal, Spain, Ireland, Italy) and shifted to the core (Germany, France, Netherlands). This situation generated a funding squeeze that was and continues to be addressed by long-term refinancing operations (“LTROs”) by the ECB, as shown on step 2. In these operations, the ECB extends collateralized Euros to EU banks. These are loans, assets to the ECB, and liabilities to the EU banks. Since its inception, the ECB has steadily been decreasing the minimum quality of acceptable collateral and increasing the tenor of the financing. Most of these funds have been returning to the ECB as excess reserves, a disturbing fact. But at one point, the repression by the political apparatus and the temptation to use these cheap funds to buy high yielding EU sovereign debt is too strong and we start seeing the use of these funds to monetize (i.e. purchase sovereign bonds in the primary market) EU fiscal deficits. That is shown, as step 3.

On step 3 too, we see that these funds keep open the window for depositors in weak banks to continue the liquidation of their deposits, in exchange of fresh cash. On the other hand, once the governments sell their bonds to the banks, they distribute the Euros issued by the ECB across the Eurozone.

Finally, on step 4, we see the conversion of these Euros by EU depositors and corporations, into US dollars (or Swiss Francs or gold), as a way to protect their savings from the unsustainable status quo: They know that the EU fiscal deficits will remain alive and have uncertainty on the future of the monetary system. Who provides them with the window of opportunity to exchange their Euros for US dollars? Ultimately, the Fed, with the provision of cheap US dollars to the ECB, via swaps.

This circular process, in extremis, brings us to the final line in the graph above, where we show the balance sheets of the Fed, the ECB, the EU banks and the EU depositors & Non-financials. The Fed will own US swaps against which US dollars will have been printed. Yes, printed! This had occurred in the 1920’s and 1930’s, but at least back then, those US dollars were somehow backed by gold reserves. Today, that’s no longer the case. Who will have the US dollars owed to the Fed? Not the EU banks nor the ECB, but the EU depositors & Non-financials! In summary, the people of the Eurozone!

In extremis too, the balance sheet of the ECB will look like that of a middle man. As assets, it will carry long-term refinancings. As liabilities, it will have the US swaps, that it extended to the EU banks. These EU banks however used the euros to buy sovereign debt, which is now their asset, and owe euros (i.e. LTROs) to the ECB. This is a very unstable situation, because if the fiscal situation of the Euro zone does not improve, these sovereign bonds in possession by the EU banks will remain driving capital losses.

This analytical framework leaves us with questions:

If the Fed ends up being the creditor of the EU depositors and corporations…how will it ever get its money back? What will be needed to repatriate these US dollars? We think there are only two ways to solve this problem. The best case and least likely is to see an improvement in the fiscal situation of the Euro zone. If deficits were stabilized or even reduced, the sovereign bonds held by the EU banks would drive capital gains, euros would flow back again to the EU banks in the periphery and US dollars would have to be sold in exchange, to buy these Euros. The EU banks would be then in a position to both return the LTROs and the US dollars to the ECB. The worst case occurs if the Fed implements an exit strategy, raising US dollar interest rates and US dollars flow back to the US. This is also not likely, at least in the short-to-near term, in our view. This would require, a priori, a strong economic recovery.

Another interesting question is related to the Euros in circulation, supplied by the LTROs: What happened to them? In extremis, we see that the EU depositors and Non-financials first took these Euros from the EU banks and later exchanged them for US dollars. Were they taken out of circulation? No, but the velocity of circulation increased, from the ECB to the banks, to the people, and back to the ECB. This is consistent with the monetization of sovereign debt and a context of high inflation. Once again, we note that this analysis is in extremis…For now, we can see it as a natural logical consequence. To mainstream analysts, this is a “tail risk”. The reader is of course free to take a view on this matter.

Please, note that this analysis implies the survival of the Eurozone with the liquidation of sovereign debts via inflation.

Is this status quo sustainable? If not, what will accelerate its demise? How will gold and the rest of the risky asset spectrum behave? Below, we present a flow chart, where we seek to summarize this process.

As we can see, as backdrop to the process described above, the Euro zone today is crowding out private investments, given the high cost of sovereign debt. In addition, it has and continues to implement higher tax rates and further interventionism and financial repression. With the Fed swaps, as we pointed out on September 12th, the Euro is still artificially stronger than without the swaps, which makes the EU less competitive. Finally, the institutional uncertainty of the EU zone remains unadressed. All these factors only contribute to prolong the recession and a high unemployment rate.

The flow chart is clear: As long as the people of the EU put up with this situation and the EU Council, chaired by Mr. Herman Van Rompuy effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain. If people revolt and the EU breaks up or if the Fed is no longer politically strong enough to force these swaps, the status quo will collapse.

Contrary to popular belief, this status quo is based on the “coupling” and not “decoupling” of the Fed with the ECB. This coupling relaxes correlations, because the US dollars sent by the Fed to the ECB were printed and nobody in the US feels the immediate pain. Hence, we have the rally in stocks and gold, without any correction in the US Treasuries market.

Whenever the political sustainability of the EU is challenged, we will see a run for liquidity. And 2012 will have many of these panic situations, affecting any late longs in gold or stocks.

Finally, when the “decoupling” takes place, the US dollar can only remain strong if the fiscal situation of the US permits. But we fear that the Fed will embark on interest rate targeting. This is a story for another letter…

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.

Martin Sibileau

Click here to read this article in pdf format: december-12-2011

By now, we assume our readers are acquainted with the tragicomic nature of the political events last week. Mario Draghi, the head of the European Central Bank (ECB), during the press conference on Thursday, said that he had been misinterpreted: The ECB was not going to monetize EU sovereign debt. And if he ever was to, it was going to be only after a consistent fiscal pact was agreed upon by the Euro-zone members. Of course, he raised the bar to impossible heights. With that, gold dropped like a stone, markets sold off and 24 hours later, the EU summit ended up with the United Kingdom taking the first steps to abandon the European Union. The rest of the members, agreed that they will agree to very strict fiscal rules, approved or disapproved by a European bureaucracy, which nobody voted for nor has the ability to remove from power. In other words, democracy in the European Union, as we know it, formally died last Friday.

How will the markets react to this? We don’t know and the action in what remains of this year is not a good indicator. We suspect (and hope) that time has been bought till the bond auctions of 2012 take place, in January.

But this is not what we want to discuss today. Today, we want to graphically show the macroeconomic impact of the US dollar swaps extended by the Fed. They are indeed a form of quantitative easing. The action taken two weeks ago to bring from OIS+100bps to OIS+50bps (OIS = overnight index swap) the rate charged on US dollar liquidity lines resulted in over $52BN taken by Eurozone banks from the ECB, last week. This, friends, is Quantitative Easing 3. And below, we explain why.

Let’s first begin by looking at what occurs if there is no intervention from the Fed:

As the figure above shows, we see that in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. Because these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates the risk profile of the Eurozone banks.

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, these banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. After all, we live in a fiat currency world, and banks simply let their loans amortize. There’s no mark to market! With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. Borrowers don’t suffer, because ownership of the loans is only transferred. This is neutral to sovereign risk. Going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment took place: In the FX market, in the value of the bank capital of Eurozone banks and in the amount of capital being transferred from outside the Eurozone to the Eurozone.

Now, let’s look at what occurs when the Fed extends US dollar liquidity lines. As you will see, the adjustment is delayed.

In the figure 2 above, we can see that when the Fed intervenes, it indirectly lends to Eurozone banks, through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30^th, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk.

As we wrote before and can be seen from step 2, the Fed is now a creditor of the Eurozone. As sovereign risk deteriorates in the Eurozone, the Fed will be forced to first keep reducing the cost of these swaps and later indefinitely roll them, to avoid an increase in interest rates in the US dollar funding market. Long term, this can only be bullish of gold. In the short term, the volatility in risk assets will continue to be horribly painful.

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: october-15-2010

We are back after a relaxing and extended Canadian Thanksgiving weekend. We could have written earlier but we thought we would sound like a broken record. Everything we are currently seeing we anticipated long, long time ago. In fact, we anticipated it on our first letters, in April 2009, when we first wrote that

a)    Quantitative easing would only bring inflation, but not economic growth, and hence, we should be long stocks and commodities (refer our first letter: www.sibileau.com/martin/2009/04/14 )

b)    Gold would outperform if central banks could not coordinate their policies  (refer: www.sibileau.com/martin/2009/04/21 )

We wrote about these issues extensively way before anybody else would explicitly think of them. However, all we did was to recite old texts that the world had forgotten or always ignored, from the Austrian school of Economics. The merit goes to all those Austrian thinkers who during the ‘30s came up with a good theory that can make strong predictions.

So far, we are enjoying a good run from the rally that started with the speculation of QE 2. But with yesterday’s action, we have the feeling that the recent strength may have been overdone and that with the upcoming election in the US, profits may be taken sooner than later. Call it intuition…Accordingly, we have rigorous stop loss levels on our positions. The long term trend is however one of careless debasement of currencies worldwide, which at the extreme, can only be good for gold.

Having said this, we want to end this letter bringing collective attention to two concepts, ideas, that are being published these days, which we think are flawed. They are both related to monetary policy, but we will only deal with one today.

The first concept is about monetary policy coordination. Perhaps the best example of this is a research note published by the Foreign Exchange Research team of Barclays Capital on October 7th titled “Be careful what you wish for”, although we have come across other analysts expressing the same concept on Bloomberg TV. We are referring to the idea that a successful coordination has to be able to simultaneously address external and internal balances. We think this is a wrong perspective in a global economy, because it ignores the role of prices in the resource allocation process. The idea of equilibrium of external and internal balances is nothing short of mercantilist, but at the same time, it ignores the fact that today most products are made out of a diversity of inputs produced in different countries. Foreign exchange crosses (i.e. CAD/EUR, CAD/MXP, CAD/RMB) are thus all relevant to every entrepreneur, and not just to those who export their produce. Coordination, in our view, implies that there is an indeterminacy in the levels of foreign exchange crosses that allows the world to keep running without stress.

This idea, first elaborated at a smaller scale by Don Patinkin in its famous paper titled “The Indeterminacy of Absolute Prices in Classical Economic Theory” and published in 1949 in Econometrica , tells us that for instance, the world is today as comfortable with a CAD/USD, EUR/USD, Yen/USD, GBP/USD, …X/USD at (1.0049, 1.403, 1.6005, …,X/USD) respectively as with a level that would be, say twice the current: (2.0098, 2.806, 3.201,….2x/USD).

To achieve this indeterminacy (i.e. flexibility), in our view, is more critical to address the rates (i.e. a dynamic problem) at which money is supplied by all the different central banks via their respective open market operations, rather than to focus on external vs. internal balances or policy goals. This concept is what first moved us to write on April 16th, 2009 that:

“All currencies are being debased in calculated order. It is precisely this order that is denying gold the chance of playing a safe and lucrative asset.  If the debasement had not been orderly, if it had been amid uncertainty and chaos, gold would have had a chance…”(www.sibileau.com/martin/2009/04/16 )

How did that coordination took place back in 2009? Essentially, it was supported by three pillars: 1) There was a genuine demand excess for liquidity by the private sector; 2) the quantitative easing was carried out by only one central bank on behalf of the rest, because US dollars were supplied via currency swaps to the other central banks, and 3) the quantitative easing represented a transfer of assets (i.e. mortgage-backed securities), not fiscal deficits, which afforded other governments the possibility to remain quiet.

Today, there is no genuine demand for liquidity, which is evident by looking at prices in all the liquidity markets. Therefore, the mere expectation of quantitative easing fuels a flight to physical assets, away from currencies. Today, central banks have different goals and quantitative easing is no longer about a transfer of assets from the private sector to the public sector, but the monetization of fiscal deficits, which are intrinsically uncertain in their final size. Thus, coordination is not feasible and expectations are slowly adjusting to this fact, as expressed in the steepening of the US yield curve.

In our next letters, we will also address the other flawed concept that is tightly connected to the idea that coordination is about focusing on balances, rather than the differentials in the rate of money supply by central banks. This is the idea that inflation expectations can be managed by central banks and hence, the notion of a “temporary” inflation above target is possible, with central banks later returning to the “normal” state.

Finally, we leave with what we wrote at the end of our letter on September 2nd, titled “Beware of coordination” (www.sibileau.com/martin/2010/09/02 ):

“…In summary, we are entering the final stakes of this game of musical chairs and with the coordination of central banks to keep the music going, it will be difficult to invest following macro fundamentals. In the US we are faced with technical insolvency at all levels of government (municipal, state and federal) and yet, with the Fed and other central banks buying Treasuries, we can see record low yields and tighter credit spreads.

In this environment, should gold not be able to rise and establish its price beyond $1,250/oz?…”

Martin Sibileau

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

This was a “busy” weekend, and we are left with no alternative but to write about it on a Sunday night…
First, we offer our deepest condolences to the people of Poland on the tragic deaths of their President, Mr. Kaczynski, First Lady Maria Kaczynski, and those who were traveling with them, on the 70th anniversary of the Katyn massacre.

Europe was also on the front pages, with the announcement of a EUR45BN rescue package, consisting of EUR30BN by European Union members and EUR15BN by the IMF. Of course, this money is at below-market interest rates. We suspect that Greece shorts will be squeezed this morning, although much of the rally we saw at the end of last week was on the speculation of this outcome. Personally, we believe this is only buying time for the European Union and we fail to understand the logic behind this package, if it is real. To us, it looks more like a threat, for it seems Greece’s Finance Minister, Mr. Papaconstantinou, said the government still plans to issue debt, without taking up the offer for aid. Another relevant point here is that from now on, we should expect the same kind of response to other worsening fiscal deficits, as in the case of Spain or Portugal. Will the Union be there for them? If so, what kind of exit policy can the European Central Bank (ECB) undertake?
On this note, in our last letter (Thursday, April 8th) we had assumed the graded haircut schedule announced by the ECB was going to include government debt. We were wrong. Details were subsequently released and the program will exclude government debt.

Thus, one more act has closed on the European theater and we have no choice but to think the world can only print its way out of this crisis. This is the reason why we turned bullish on gold last week, for as our market thesis states (refer: www.sibileau.com/martin/2009/04/21 ), every major central bank has now to face internal unique problems that prevents a global coordination in monetary policy. Gold therefore will increasingly play a role as the common denominator for all fiat currencies.

As central banks are (unsuccessfully) seeking to structure their respective exit strategies, governments are looking for a way to build the next line of defense against a future liquidity crisis. Sometimes, the line looks like the Maginot line…

On Saturday, Canada’s National Post reported that Ms. Julie Dickson, Canada’s chief bank regulator, prefers a scheme whereby banks could insure themselves against failure with debt that converts to equity (refer: “OSFI offers conversion as bank shield”, at : http://www.financialpost.com/story.html?id=2785584 ).  If correct, we think Ms. Dickson may be referring to contingent notes, similar to those recently issued by Rabobank. On March 12th, Rabobank issued a EUR 1.25 billion, benchmark 10-yr Senior Contingent Note, at an annual coupon of 6.875%. These notes are contingent on Rabobank’s capital, as a percentage of assets. If this ratio falls to less than 7%,  the notes will be written down to 25% of face value. Therefore, the bank will record a gain on the issue, which increases its capital.

We have no view on this particular debt issue. But we believe that encouraging this type of financing as a buffer against a liquidity crisis is absurd. We cannot mince words here. In fact, the widespread use of this type of debt will only help precipitate a crisis, in a self-fulfilling dynamic.

No investor in any part of the capital structure of a financial institution should feel any safer with this scheme. As soon as an event triggers only the mere likelihood of a liquidity squeeze, noteholders will dump the notes with the proverbial violence. The transfer of wealth from noteholders to shareholders will only be temporary, for immediately after this event, the capital gain will never, ever, offset the liquidity costs financial institutions will face to remain going concerns. Depositors will feel at risk and a serious run against those financial institutions will trigger a swift downward spiral.

Indeed, with senior contingent notes, financial institutions are buying a put from the note holders. However, believing that these notes constitute a solid cushion against systemic risk equals to ignoring the leveraged and correlated nature of financial institutions under a fiat currency system.

Martin Sibileau