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

Please, click here to read this article in pdf format: March 25 2012

During the past week, we think, we witnessed some interesting developments. In our previous letter, we had discussed what was the KreditAnstalt event of 1931. We saw a striking similarity with the current status quo because just like then, we now have sovereigns at the brink of default, whose creditors are other public institutions or countries, rather than private investors.
But there is more to it…

During the past week, we had Fed’s Chairman Ben Bernanke answering questions at the US Congress. It was there that Rep. Dan Burton (Indiana, 5th District) took Mr. Bernanke to task on the issue of the currency swaps the Fed has extended to the European Central Bank. On Thursday, we learned that the amount outstanding, which had reduced to $67BN, has remained there and increased a little bit. All this, in the face of a 7 ½ -month record low in US dollar funding costs for EU banks, given the 3-month cross currency swap basis reached 53bps below Euribor, on that same Thursday. The fact that the Fed currency swap lines are still in demand while the cost of US dollar funding keeps falling tells us that the EU financial system is segmented, with those who can access the market and those who cannot. But it also tells us that there is, paradoxically, an oversupply of US dollars, as we explain below.

R. Dan Burton then asked Mr. Bernanke how would the Fed recover the US dollars it loaned, should the Eurozone break. We made this point at “A View from the Trenches”, many, indeed many times before. You may see our latest letter on this issue at: http://sibileau.com/martin/2012/01/23/. Of course, Mr. Bernanke categorically played down the likelihood of such a scenario. He first lied to everyone saying that the debtor, the European Central Bank, does not finance governments. It was an insulting lie because not only does the ECB finance them indirectly via LTROs, but also explicitly and directly, through its Securities Market Programme, where more than EUR200BN are booked. Mr. Bernanke could not have and does not ignore this fact. Here is the link to the discussion: http://youtu.be/HzejoDbVXXs

On the other hand, we know that exactly this scenario, where the US had to bailout Europe, has already taken place in similar conditions. Back in 1931, when Austria defaulted leaving the gold standard, there was a generalized bank run (which the LTRO of last December prevented) and the United States had to establish a moratorium on the loans it had outstanding to Germany and to others. It was precisely this decision, that later pushed the United States to abandon the gold standard too, in 1932. Obviously, Americans understood that the amount of gold at the Fed, backing those claims now in moratorium, was not enough and they run against their banks as well. We found the video that shows President Hoover announcing the moratorium. It would have been so nice to have it handy to show to Mr. Bernanke before Congress: http://youtu.be/MFdTISc1KG0

Last week too, it was painful for those of us who still hold on to gold. Gold made interim lower lows at $1,628/oz on Thursday and bounced back to $1,665/oz on Friday afternoon. Is it still trading within range or is it consolidating to retake its bullish trend. We have our doubts, but the long term fundamentals support it. Let’s see…

One of the things that really caught our curiosity was to see the Euro appreciate since March 14th, with the simultaneous deterioration in sovereign credit risk. Since then, the sovereign spreads of Portugal, Spain, Italy and even Germany have been increasing. Should we not be looking at a weaker Euro in light of this? Why would we see the Euro flirting with a $1.33 level?

That should be the case, if the US dollar had been the main funding currency. But we think the game may have changed. Since the LTROs (liquidity lines) from the ECB are in place, and we’re talking about more than trillion Euros, it could well be that the Euro is now the main funding currency within the Eurozone. That would explain a lot of the things we saw.
Indeed, if sovereign debt placed as collateral with the European Central Bank widens, margin is called and banks need to sell first Euro-denominated assets or assets denominated in other currencies, to later buy Euros. This hypothesis would explain why the Euro appreciates as EU stocks fall, commodities fall, US stocks have a hard time appreciating and the cost of USD liquidity falls. In fact, it could also explain why we saw (last week) gold depreciate at the open of the European trading session and appreciate later in the day, as the North American markets open.

There are however unexpected, unintended and negative consequences here, as a result of this fundamental change, namely the implementation of collateralized liquidity lines by the European Central Bank. We drew a graph below to visualize this horrible circularity: As the sovereign risk of EU members deteriorates, margin is called by the ECB, assets need to be sold, Euros have to be bought, the Euro appreciates making the EU members less competitive globally (particularly the peripheral countries) and crowding the private sector out of the Euro funding market. With a more expensive Euro, Germany is less able to export to sustain the rest of the Union and growth prospects wane. At the same time, the private sector of the EU looks for cheaper funding in the US dollar zone, which will eventually force the Fed to not be able to exit its loose monetary stance. This is the scenario that R. Dan Burton was proposing to Mr. Bernanke. Again, if this logic is correct, that scenario is not a tail risk, but the base risk.

How do we escape this circularity? With the ECB embarking in plain, good old Quantitative Easing. The collateralization of liquidity lines forces the EU to work within a context similar to that of the gold standard, where liquidity has to be backed by a commodity! In fact, if on the margin the supply of liquidity will only grow from collateralization, the EU would be better off under the gold standard, because gold at least, does not entail any credit risk!!!!Lowering interest rates, weakening collateral rules or extending maturities will not solve this problem.

If the ECB does not embark in Quantitative Easing, the Fed will bear the burden, because the worse the private sector of the EU performs, the more dependent it will become of US dollar funding and the more coupled the United States will be to the EU. These reasons make us feel comfortable holding gold.

We run out of time here, and we wished we had had the opportunity to discuss the fragile situation in two relevant countries: India and Canada. We will in our next letter.

Martin Sibileau