Click here to read this article in pdf format: June 11 2012

As we write, the news is out that Spanish banks will get bailed out in the order of EUR100BN (also reported EUR125BN). We have repeatedly said that bailing out banks whose capital vanishes because they hold junk government debt is an exercise in circular reasoning (see our letter: “The EU must not recapitalize banks”, from October 17tth, 2011). This also applies to those bailouts where the pockets are bigger, as in the case of the Euro zone members. Eventually, without deficit monetization, this will affect the credit quality and spreads of Bunds (i.e. sovereign debt of Germany).

Over the past week, we have been introspective. Recognizing that we have been pessimistic (perhaps since we began writing), we tried to look for policy solutions that would prove us wrong. Let’s see…

Today, even Warren Buffet acknowledges that the problem of the Euro zone is institutional, that fiscal integration is required for the zone to survive. We were, however, maybe one of the first to have openly said that the problem of the Euro zone was institutional, back on February  8^th and 10^th 2010 (yes, more than two years ago!) and that all these bailouts and liquidity manipulations would lead nowhere. We were contrarians back then and wrote in answer to a publication by the Bank of America’s Credit team: “US Fixed Income Situation”, Fixed Income Strategy, February 5th, 2010. In this note, the writers suggested that the crisis was of a short-term nature, driven by liquidity issues, with a longer term solvency problem.

Now, our view is mainstream. Now, with everyone siding with the institutional perspective on the Euro zone, we wonder if it is really impossible for a peripheral country to carry a smooth exit from the Euro zone. Until now, we thought it was and because of that position, we had a consistent view of the problem, whereby the US would step in via currency swaps and end up picking the tab. However, we think we may be wrong here and this is why we just wrote above, that we have been very introspective.

It may be possible that a peripheral country be able to exit the Euro zone smoothly. It may be. We are not saying that it is likely or not, or that it will or will not. But only, that it is possible, technically speaking. And we will use today’s letter to examine this possibility.

When we think about the survival of a currency or related bank runs that precipitate a currency crisis, we are being biased and narrow minded. We view the collapse of that currency as an asset to store value. But in doing so, we neglect the other function money has, which is to serve as a medium of indirect exchange, a medium to transact. Societies can actually live under bi-monetarism, whereby one currency is used to store value and the other, the imposed legal tender, is used to transact. There are multiple living examples of this in the world, and we are particularly familiar with those in Latin America.

The processes in demonetization actually start with this sort of bi-monetarism. The peso, inArgentina, was at one time used to store value and to transact. With the sovereign problems and increasing confiscation via inflationary tax, the peso was dropped as a store of value but continued to be used to transact. The US dollar replaced the peso as store of value. But later, as inflation became more acute, the peso completely disappeared and Argentina was forced to establish a currency board, where the central bank would only issue pesos if they were almost 100% backed by US dollar reserves. And then again, the peso began to be used to transact, while US dollars retained their role as a store of value. As the macroeconomic situation improved in the early ‘90s, US dollar stocks were not exchanged for pesos, but pesos flows (i.e. new savings) were not converted to US dollars.

With this in mind, it is therefore conceivable, that without affecting the status quo under the existing Target 2 structure (i.e. Trans-European Automated Real-time Gross Settlement Express Transfer System), a country like Greece start issuing their own currency with their banks accepting deposits both in Euros, supported by the European Central Bank, and in drachmas. The drachmas would not have to be imposed upon the private sector to transact, but the government could decide to pay all its future debt issuances and operating expenses (including wages) in drachmas, and demand that taxes be paid in drachmas too (A government can also simply default on the euro debt and re-denominate it at an arbitrary exchange rate).

To avoid falling into hyperinflation, the drachma would have to initially be backed by assets that would necessarily have to come from privatizations. In the case of Greece, this is difficult, as most if not all of sovereign assets have been encumbered. But we trust there is always the possibility to create a special purpose trust owning fiscal land, reserves or infrastructure royalties to begin. In other cases, unencumbered gold reserves could be used for that purpose.

It is important here to remember that the price of those drachmas, relative to other currencies, will not depend on the quality of the assets behind, but on the demand, relative to its supply. If the demand is not imposed (if bi-monetarism without capital controls is allowed) and the supply of drachmas will only increase gradually, as wages are paid and redenominated debt is serviced, we could see this currency survive, if the committed austerity programs continue in place. This would represent a scheduled depreciation of the currency, until the fiscal deficits are solved. If they are not, the whole experiment would succumb, just like it did in Argentina, in February of 1981, under the so called “Tablita” (tabla = ledger, and in this case, containing gradual peso depreciations).

The key here is that, after the still ongoing bank runs in Greece, with its citizens having all their savings stocks in Euros, they will afford to keep monetary flows in drachmas (i.e. the cost of having to transact in drachmas will be offset by the fact that their savings are in Euros). This policy would boost the purchasing power of their savings, vis-à-vis, the public services provided by the government, now supplied in drachmas. This policy too, would represent a devaluation of the cost of public workers, for those who managed to convert their savings into euros. And we believe that is the case for the majority of Greeks.

For Germany, this scenario would also be a win-win situation, because the Euros they now subsidize under Target 2 would eventually and gradually be recycled back into the remaining core Euro zone, as the peripheral country imports goods from the Euro zone. In fact, this alternative could well represent a virtuous spiraling process, with the Euro appreciating, Euro sovereign interest rates falling (both in Euros and in drachmas), and stocks (particularly financials) increasing. If that was the case….what would happen to gold ceteris paribus? We think it would plunge, and only be relevant in US dollar, Yen and Yuan terms, as the US and Japanese fiscal cliffs come to the forefront, while China’s situation continues to deteriorate.

In summary, the absolutely necessary conditions for a smooth exit from the Euro zone are:

1)  No capital controls and freedom to convert to Euros in any amounts of local currency, at a market rate

2)  Acceptance of bi-monetary deposits at banks: Euros and local currency

3) The European Central Bank will address liquidity on the Euro portion of deposits/assets, the local central bank will be the lender of last resort for the local currency portion (Otherwise, the experiment is set to fail, like the currency board failed in 2001 in Argentina, because US dollar deposits were not “insured”. The alternative, if the ECB does not cooperate, is to impose a 100% reserve requirement on the Euro portion of deposits)

4) No legally enforced indexation of Euro denominated contracts (let the market sort it out)

5) No definition (silence) by the government, on the future of the Euro denominated sovereign debt (eventually, a non-hostile renegotiation can be done, within the European Union, leading to the fiscal integration that everyone is now seeking)

6) The local government will pay expenses and demand payment of taxes in local currency.

7) Some sort of stock, hard asset back-up of newly issued local currency (gold, privatized assets)

And finally, the most difficult one (the one Argentina failed to comply with in 1980):

8  A credible plan to reduce fiscal deficits, now denominated in local currency.

If only one of these conditions were not met, an exit from the Euro would end in chaos.

Martin Sibileau

Please, click here to read this article in pdf format: March 18 2012

We are back from Washington DC and realize that we could choose different titles for today’s letter. Let’s try a few…

Title No.1: “The market proved us wrong”

Indeed, we have been, and continue to be, long term gold bulls. We have been buying dips in gold and find ourselves having averaged down on our holdings, as gold did not find a floor in the low $1,700/oz, nor $1,695/oz or even $1,660/oz. Averaging down is the sure way to ruin and wisdom calls for trimming rather than increasing one’s exposure to a falling asset. And we trimmed only a bit and stopped buying, with the belief that it will prove a wrong decision, but with the unemotional duty to survive. As we write, we learn that there’s an article on the Financial Times telling us that central banks (not the Fed, of course) have been doing the same, only better than us: They really added!

We have no doubts that the plunge in gold on February 29^th was simple manipulation and it is only this reason that encourages us to hold on to what we have. With respect to stocks, we continue to remain neutral of them, not willing to buy but also, not willing to short them. From conversations with friends and readers, we noticed that we have not explained ourselves appropriately. Therefore, we want to briefly stop here to provide these short comments:

The popular view on inflation is that which sees it coming from a steady increase in the supply of money spilled over onto assets, lifting investments, increasing employment, wages and later the price of every consumption good. If the price of assets and the employment rate rise, it is understood that the original goal by the central banker, that of lifting the level of activity with monetary easing, is working and that soon, that easing will disappear, followed by an increase in interest rates.

The problem we have with this view is personal. Unfortunately, we lived through inflation and remember it differently. Inflation is a steal. It is a tax charged by the government. And they charge this tax because they run a deficit. No government would nor will ever target inflation under surplus or balanced fiscal conditions. Inflation is the distortion of relative prices, and it always starts with that of the cost of capital. It is a manipulation first of the cost of capital, then of commodities and followed by price controls: First on goods and later on salaries. It entails control on capital flows (which we are currently seeing everywhere in the world), currencies, and financial repression. Therefore, our view is different: Inflation does not bring full employment. That’s a myth. Inflation creates unemployment. Under inflation, production does not rise lifting prices. That’s another myth. Under inflation, production falls, creating shortages of goods, which is what further shifts the inflationary process to hyperinflation. If a country like the US manages to have the rest of the world finance that shortage of goods, that’s another story and it will last as long as the rest of the world wants it to last. But we should be clear on the underlying process. If you have any doubts, just drive around the former industrial areas in the outskirts of Buffalo, Detroit, Boston, Pittsburgh, Philadelphia, etc. and you will picture what we’re talking about here.

As we explained at the beginning of the year, the rally in stocks and in gold was expected. It was only three weeks ago that the world was injected with more than half a trillion Euros in 3-yr liquidity lines!!! But gold was manipulated and stocks were not. And we have gold at below its 200-day moving average and the capitalization of Apple Inc. at higher than half a trillion US dollars, without Steve Jobs as CEO. Take this as you wish. In the meantime, on Friday we saw a violent increase in US yields, followed by demand, that kept the 30-yr Treasury yield below 3.5%, which is what brings us to the next possible title, for today’s letter…

Title No. 2: “Financial repression, Stage 1”

Perhaps the most clear exposition of financial repression occurred this week, when President Obama and Prime Minister Cameron openly threatened to manipulate crude reserves to lower the price of oil. The sense of embarrassment is gone. The leaders of two world powers meet and tell us in our faces that they contemplate manipulating the reserves of a commodity? What is going on? We, at “A View from the Trenches” take signals of repression like this one seriously.  It was only a few years ago that governments started running after people’s assets in other jurisdictions. They followed with open repression in the foreign exchange markets (Switzerland pegging the Franc, Brazil controlling capital flows). They kept on directing the lending activities of banks. They manipulate the reserves in gold. They wiped out investors in sovereign debt and this is a trend that will not weaken but strengthen. Perhaps our readers don’t, but we do see union strikes more often these days vs. in past years. 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. We think we are witnessing the latter case but, as followers of Von Hayek, we can understand the confusion, because the price system is broken and the signals sent by prices are misleading. We need to quote the great Friederich A. Von Hayek here, on the price system:

“…The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coordinated utilization of resources based upon an equally divided knowledge has become possible. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do…(…)… I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind…” F.A. Von Hayek, “The Use of Knowledge in Society”, American Economic Review. XXXV, No. 4., September 1945

The actions of central banks have totally annihilated the price system, in relation to both the inter-temporal allocation of resources and the capitalization structure of economic systems. This brings us to our last title…

Title No. 3: “Remember the KreditAnstalt”

Since the debt swap of Greece’s sovereign debt, in terms of the capitalization structure of this sovereign, we understand that more than two thirds of it is in the hands of the public sector (European Central Bank, IMF, other governments) and highly collateralized. This is a point we have been thinking during last week because it painfully reminds us of the KreditAnstalt crisis of 1931. We highly recommend readers to do their own research on this topic and to reach their own conclusions. On our part, we are interested in one angle of it.

The KreditAnstalt of 1931 had been created in October of 1929, as the merger between the bankrupt Bodenkreditanstalt and the Öesterreichischekreditanstalt. However, the distressed assets of the Bodenkreditanstalt’s were too distressed to deal with. Given the Austrian regulations on capital requirements, when on May 11^th, 1931 the KreditAnstalt disclosed a 140MM Schilling loss, it immediately suffered a run on deposits. The Österreichische Nationalbank intervened, loaning 152.5MM Schillings. The Bank of International Settlements loaned an additional 100MM Schillings three days later. But by June, more funds were needed and this time….this time the Bank of International Settlements, under a request from the French, would only provide them if the Austrian government aborted a customs union with Germany, which was underway. The Austrian government did not accept the political condition and instead only received a third of the funds needed, from the Bank of England, on June 16th.

In the meantime, the Austrian government had been forced to guarantee the bank’s foreign deposits and imposed exchange controls to sustain the convertibility of the Schilling to gold. But the violence of the capital outflows was so strong that Austrialeft the gold standard on June 17^th. Unlike Greece, Austrians in 1931 did not have the 3-yr liquidity lines from Mario Draghi at the European Central Bank. These events triggered a wave of bank defaults in Eastern Europe and Germany. Gold eventually also was withdrawn from London. In July, the Federal Reserve Banks and the Bank of France saved the Bank of England with currency swaps of US$650 million and £eq.25 million, respectively. But this was not enough and Great Britain had to leave the gold standard on September 21^st. The countries that held sterling pounds as foreign reserves suffered heavy losses.

Fiat currencies were no longer to be trusted and the run on deposits was now taking place in the United States. Think of this: As Europe owed the US payment in specie and Europe had gone off the gold standard…who was the Fed going to recover the loaned money (approx. the equivalent of 465 metric tonnes of gold) back from??? We have written about this before too, in relation to the swaps extended by the Fed to the European Central Bank. If the Eurozone breaks up, who is the Fed going to recover the money from? They will not. But unlike back in 1931, the US dollar is not backed by gold and depositors are not going to run for their funds to exchange them into gold. However the Fed will need to undoubtedly print more US dollars and the devaluation, eventually, will happen anyway. The year 1931 was the year of bank failures in America. In 1932, after a bank holiday that lasted a week, the US government confiscated gold from its citizens.

The question you may have in mind now is what similarity do we see with the current situation? Well, this whole series of events was triggered because France, a public sector creditor, introduced a political condition to Austria, in exchange for a bailout of the KreditAnstalt. Today, like in 1931, in the Eurozone, the public sector is increasingly the creditor of the public sector. In 1931,England andFrance were creditors of Austria and demanded conditions that no private investor would have demanded.

Private investors live and die by their profits and losses. Politicians live and die by the votes they get. Private investors worry about the sustainability and capital structure of the borrower, the collateralization and the funding profile of their credits. Politicians worry about the sustainability of their power. It’s a fact and we must learn to live with it.

In 2012, Greece and increasingly other peripheral EU countries owe to other governments, the IMF and the European Central Bank. Private investors have been wiped out and will not return any moment soon. We fear that just like in 1931, when the next bailout is due either for Greece again or Portugal or Spain, political conditions will be demanded that no private investor in his/her right mind would ever have demanded. Think of it…What in the world had the customs union between Austria and Germany in 1931 had to do with the capitalization ratio of the KreditAnstalt??? Nothing! Yet, millions and millions of people worldwide were condemned to misery in only a matter of days as their savings evaporated! Ladies and gentlemen, welcome to the world of fiat currencies! You have been warned! If months from now you read in the papers that the EU Council irresponsibly demands strange things from a peripheral country in need of a bailout, remember the KreditAnstalt. Remember 1931…

Please, understand that this is not a tail risk. The tail risk is precisely the opposite. The real tail risk here is that when the next bailout comes due, politicians think like private investors and give priority to economic rather than political considerations. That’s the tail risk! If such a crisis occurred, the media will speak of increased correlations and tell you that everything is actually fine on this side of the Atlantic. But if you read us, you will know that all that led to such a situation was perfectly foreseeable and nothing is really fine on this side of the Atlantic either. You will have remembered 1931…

Martin Sibileau

Please, click here to read this article in pdf format: march-1-2010

Over the weekend, we came across an article from U.S. Congressman and former Presidential Candidate Ron Paul, with whom we sympathize (refer: www.ronpaul.com ). The article was titled “Are U.S. taxpayers bailing out Greece?” and published on February 16th (refer: http://www.ronpaul.com/2010-02-16/ron-paul-are-us-taxpayers-bailing-out-greece/ ).
Briefly, Mr. Paul wrote: “…Is it possible that our Federal Reserve has had some hand in bailing out Greece? The fact is, we don’t know(…)Unless laws are changed to allow a complete and meaningful audit of the Federal Reserve, including its agreements with foreign central banks, we might never know if this is occurring or not…”
Mr. Paul left us thinking, and after careful consideration, we realized that the implication of this exercise may (or not) be in contradiction with what we wrote on Friday. Let us explain:

To begin with, we believe that indeed, there would be a cost to U.S. taxpayers, if Greece defaulted. We don’t think Greece will default, at least not in the near term, but there would be a cost nevertheless. The cost is not explicit and it would show its ugly face if a credit event was triggered under a sovereign (i.e. Greece’s) credit default swap.

Why?

Any US financial institution with a net long exposure to Greece’s sovereign credit default swaps would face an immediate funding problem. Therefore, the Fed would be pressed to rescue such institutions, while at the same time, it would have to provide currency swap lines to the European Central Bank, to avoid a collapse of the Eurodollar market.

The cost regarding the financial rescue would be on US taxpayers. This would be an unnecessary and most disappointing cost. After so much “quatsch” on regulation, how would the current US Administration justify having missed a flag as big as that of sovereign credit default swaps. There is currently a lot of quatsch about sovereign credit default swaps, but all superficial. The economic ignorance of politicians prevents them from understanding what these derivatives really imply. As we wrote earlier, under a system of fiat currency, allowing banks to sell insurance on sovereign debt is no different than allowing children to sell insurance on the financial risk of their parents. But politicians focus on the greedy side of those who trade these swaps, which is really idiotic, because these derivatives represent a huge boost to systemic risk, even if they were traded for the most morally justifiable reasons. If somebody bought credit insurance on the parents of the seller of that insurance, be it the most educated, hardworking or honest kid, he or she would still be dreadfully misled by the formal aspects of the contract, which lacks any solid content. The solution does not reside in prohibiting them, but in requiring that collateral on such trades, at least on non-Emerging markets credit default swaps, be posted in gold. (Note: Why do you think I believe that a commodity collateral would not be required on credit default swaps on emerging market countries?)

On the other hand, the cost needed to save the Eurodollar market would be global. The global feature of this cost is driven by the violent foreign exchange volatility the world would have to bear, where the notion of a global reserve currency would be clearly challenged. This brings us back to the point made last Friday, when we wrote that a sovereign credit event would be deflationary, and that liquidity preference, in particular a strong demand for USD, would challenge the value of gold.

We kept and keep thinking about this one. Given the hypothetical nature of this event, we can only speculate as to what conditions would be necessary for gold to rally. The first one that comes to mind is a catastrophic situation, where the Fed actually bails both the financial institutions and the Euro market but the market no longer trusts monetary authorities and every USD facilitated by currency swap lines is swiftly bought with Euros and immediately exchanged for gold.

If you think this twice, you will acknowledge it would not be the first time a flight to safety of this nature takes place. In fact, it would make sense. But again, this should occur under a total lack of monetary policy coordination and something else: The firm conviction that stimuli programs are useless. This would be a true capitulation. What is the probability for this scenario? Not too high for now, but not too low either, in our view.

Martin Sibileau

With yesterday’s fears of a rating’s downgrade on Greece’s sovereign debt and weak US jobs market data, the markets (except in Canada or Mexico) sold off. However, we could not make sense of the simultaneous rise in the price of gold.
 
We’ve seen this pattern before too, but it did not go too far, when it happened in 2008. Indeed, one could explain the behaviour by pointing at Mr. Bernanke’s comments yesterday, who made every effort before the Senate’s Banking Committee to be clear on the Fed’s intention to maintain a level of liquidity consistent with that of economic activity (weakness = low rate environment). Or maybe his comments on the possibility of reviewing MBS purchases, if required? But if that was the case, why would stocks not also rise, along with gold and oil? Why would the USD not weaken as well?
 
Clearly, the above factors cannot explain what happened yesterday. But if gold was bought as a way out of future currency debasements, then we have some comments to add here this morning.
 
If you have been reading “A View from the Trenches” long enough, you will remember that we turned neutral to bearish on gold (in USD) after the Dubai event, at the end of November 2009. Essentially, we believe the power of monetary policy coordination is a formidable challenge on gold’s prospects as a reserve currency. Therefore, if yesterday’s rally on gold and gold mining stocks was due to the increasingly likely fall of the Euro, as a consequence of the peripherals’ problems, we think gold bugs could later be disappointed.
 
Why?
 
In the 21st century, there are two global social classes: Politicians and taxpayers (This social stratification truly has global characteristics). If you think politicians will let you taxpayers get away from the inflation tax easily, think it twice. Let’s specifically consider the scenario where the Euro plunges. We think that if this happened, there would be an immediate increase in liquidity preference, expressed as a flight to the USD and the Treasuries markets. In that case, gold and stocks would be sold in favour of liquidity.
To those who disagree with this view, believing this chaotic situation would get off hands, we suggest that the Fed would be able to establish again, as it did in 2008, currency swap lines with other central banks, cushioning the impact of this move. This would be a deflationary event and no central bank would hesitate to provide extra liquidity. In summary, we fail to see a compelling story to be long of gold. And yet we are indeed worried, because the market proved us wrong yesterday and will prove us wrong today too, for gold is already at $1,112/oz.
 
For an historical perspective on this dynamic, let me quote below part of an interview M. Jacques Rueff gave to The Economist (Jacques Rueff: (http://en.wikipedia.org/wiki/Jacques_Rueff ). The interview was published on June 1965, and titled “The Role and the Rule of Gold.” The entire interview was reprinted in Jacques Rueff’s book “The Monetary Sin of the West”, MacMillan Co., New York, 1971, Part III. Its online version can be found at (www.mises.org/books/monetarysin.pdf ):
 
 
The Economist: …one of the countries that saw the biggest constriction imposed by the gold standard was, of course, Britain, which held no foreign exchange in its reserves. And, as we have always recognized, Britain at this time suffered precisely because of the harsh and inflexible disciplines of the gold standard, which you now want to restore.
 
J.R.: Let me tell you that you touch a point on which I have quite a few personal recollections. In 1930 I was financial attaché in the French Embassy in London, and in that capacity I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.
 
The Economist: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances, that was in part responsible for the general collapse later on?
 
 J.R. Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. There is a very interesting document from this period, a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed. We were too gentle in complying with official appeals not to convert our sterling balances into gold…
 
 
The analogy here consists in that France did the same we suspect the US would do in case the Euro plunged: Providing Europe with USD currency swaps is the same as having France in the late 1920′s not withdrawing their gold deposits from London. Think about it. I know it sounds counter intuitive at first sight, but ask yourselves what was backing the sterling pound then, and what would the Euro be exchanged for if it plunged? If the USDs are there for the Euro as gold was for the pound, we will be only delaying a painful adjustment. But politicians only care about the present.
 
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