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

Please, click here to read this article in pdf format:october-19-20101

Since our last letter, perhaps the most relevant event has been Mr. Bernanke’s speech, last Friday. Titled “Monetary policy objectives and tools in a low-inflation environment” (www.federalreserve.gov/newsevents/speech/bernanke20101015a.pdf ), this was a speech that made waves. Essentially, it made the case that given an environment with low inflation, there is room to look for alternative policy.  Will it be implemented as so many expect? The market’s belief that it will grows by the day. After yesterday’s release of capacity utilization (74.7% vs. consensus of 74.8%), the strength in the USD began to give way again…

As Mr. Bernanke put it, the topic of his speech was “…the formulation and conduct of monetary policy in a low-inflation environment…”. Interestingly, he introduced the subject reflecting on the fact that: “…From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world…”. We wonder if Mr. Bernanke ever asked himself why it would be the case that since the Great Depression and until the late ‘60s the greatest challenge was to bring inflation under control. In fact, in the case of emerging markets, this challenge lasted well into the ‘90s and is the topic of the day again, as these markets seek to avoid the appreciation of their currencies by “printing” money to buy the US dollars Bernanke prints, thereby importing Ben’s inflation.

If Mr. Bernanke would have asked himself why central banks in the past decades had such challenges, he would have surely found out that it was because his predecessors, just like he today, thought that a little bit of inflation would do no harm, and that the pain of having a high unemployment rate was bigger than that of high inflation.

If Mr. Bernanke did not underestimate our intelligence, he would surely realize that we know that in the end, even that little or high inflation generated no employment. In fact, inflation generates unemployment. Here’s why:

Inflation destroys savings and produces a lower savings rate. This destruction also generates a shortage in the stock of capital, which deteriorates productivity. To be certain, productivity also declines driven by the uncertainty in relative prices generated by inflation. As productivity falls, it is less feasible to maintain a labour force at the existing level of wages. Therefore, entrepreneurs/firms can only survive if they can get access to lower “real” wages or to “cheap” credit, to finance their working capital (i.e. collections deteriorate as clients seek to delay payments to profit from inflation, and inventories rise because firms anticipate future higher input prices). Naturally, with inflation, credit disappears and governments find that the only way to keep the music going is by further debasing the wages of those employed.

This cycle spirals even faster in a global economy, because as a consequence of the fall in productivity and unemployment of resources, citizens of the affected nation must now import those goods that were previously profitably produced in their land. However, as their currency depreciates (“wins” the currency war) against the rest of the world, the cost of those imports rises, further cutting their ability to save. If the nation initially required an increase in the supply of money of $1trillion of US dollars per year (as it is speculated Quantitative Easing 2 will entail) to keep the original demand level for goods, as this cycle runs its course, the need for additional liquidity will increase to replace the reduction in savings, wealth, chasing an even smaller amount of goods produced. The need for additional liquidity grows linearly at the beginning and exponentially at the end. This why it is never “politically” feasible to return to a “normal” state.

Yes, Mr. Bernanke is right. Any central bank has the tools to fight inflation later on. But none, absolutely none, has the political power to assume the cost when inflation is evident and high. It takes radical political change to break the cycle, the likes of which Reagan and Thatcher brought in the ‘80s. We see nothing close to this on the horizon for the next couple of years coming from any country.

Martin Sibileau

Please, click here to read this article in pdf format: march-2-2010

We will be brief today, for nothing of macroeconomic consequence has taken place in the past 24hrs. The action that caught our attention yesterday was in the foreign exchange market (the market that never lies). In particular, we refer to the action in the Canadian dollar. The cross with the Euro gained (i.e. the CAD rose against the Euro) 2.3 cents intraday, and although (or because) the TSX composite closed +0.85% higher, we can only deduct that the demand for Canadian dollars did not reflect a pari-passu demand for Canadian assets. Therefore, our intuition is that with yesterday’s calm, the demand for Canadian dollars that did not end in assets was a demand for reserve purposes, at a central bank. We are open to alternative suggestions to explain this phenomenon but any of these explanations would also have to address how the Canadian dollar did so perform on a day where neither oil nor gold rallied.

Was the CAD rally based on the news that the Canadian economy expanded at a 5%  annualized rate in the fourth quarter (faster than forecasted by the Bank of Canada)? We doubt it because a) the CAD’s sensitivity to interest rate gap (i.e. with the higher than expected growth rate the market revises its forecast on policy rates) has been low, and b) the strength was not uniform but clearly against the Euro.

On another note, in an interesting report, Bank of America estimated yesterday that approximately $160BN will flow to private investors by the end of 2010, as a result of the buyout of delinquent mortgage loans by Fannie Mae and Freddie Mac (refer: “The long and short of delinquency buyouts”, in Situation Room, Bank of America Merrill Lynch Credit Strategy, March 1, 2010). At “A View from the Trenches” we had anticipated the consequences of this operation back on January 4th, when we wrote:

“ …Since (our) 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 (us) that the USD strength will be only a relative notion in 2010. (We) 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)… “

We stand by these comments and the market is proving us right. What we did not grasp back then was the magnitude of this operation ($160BN of private liquidity) under certain loan delinquency level assumptions that can further deteriorate, if the recovery process disappoints. We invite readers to closely monitor activity in the GSE market for this is serious enough to keep the dream of asset inflation alive.

(Note: Mainstream economists use the term “asset inflation” to refer to bubbles, because their theory of inflation is wrongfully based on the non-neutrality of money, as implied by the exchange equation: M*V = P*Q. Therefore, they treat bubbles as an aberration that can only be addressed with regulation)

Martin Sibileau

Please, click here to read this letter in .pdf format: may-4-2009

Finally, Friday came with the data on the ISM Index, which was at 40.1 vs. expected of 38.4. On an absolute basis, main street still looks awful, but everyone makes the case that the so called “second derivative” is signaling there is light at the end of the tunnel. As I have been repeating since March 18th, the positive news relies on the Treasuries, GSE debt and securities purchases by the Fed. On Friday, the sell-off in Treasuries continued. The yield on the 30-yr Tsy is now above 4%. And yield, agency and credit curves have steepened considerably during last week. The news on Chrysler and the delay in the release of the stress tests results have left stocks on a wait-and-see mode. The S&P500 at 877.52pts is up a bit over 1% in the week. The inflationist policy in April has pushed a lot of short-covering in the credit space. The CDX IG12 ended at 163/165bps. But High Grade, High Yield, Loans, Convertibles and Mortgages have all tightened significantly too.

May 1st, 2009: 30-yr Treasury (white) vs. S&P500 (orange)

Source: Bloomberg Analysis: Tincho’s Letter

Some brief comments on 3 issues the markets have lately been paying attention to:

1. Steepened credit curves: Most analysis on this is either descriptive or focused on the specific fundamentals. This is short sighted. The steepening is the natural outcome of the inflationist process. It could also be called re-leverage. The different degrees of steepening and liquidity points we see are another proof of the non-neutrality of inflation, which is also impacting correlation in structured credit. Think of this: Without central banks, the only inverted curves you would ever see would be at the single-name level. But we do have central banks…
2. Sovereign CDS: The recent tightening in this space is purely technical. Like any other spread, the sovereign spread should compensate for expected losses: spread = prob. of default x loss given default. In the case of developed sovereigns, the probability of default would be that of systemic collapse, after which huge inflation surges, resulting in a considerable currency debasement (=loss given default or loss given systemic collapse). Now, this probability has not yet fully disappeared, while the currency debasement is just starting. Thus, from a fundamental perspective, sovereign spreads should be widening. And they are, but this is only taking place in the bond market (i.e. Treasuries), where yields keep climbing.
3. Banks stress tests: The US Govt. wants well capitalized banks. This is all idiocy. In our leveraged world, it is a mistake to think that the banks’ capital’s task is to allow the redemption of funds, when clients have lost confidence in their banks. The confidence that banks and the loans they have issued enjoy is indivisible. No risk management policy or capital requirements adopted on the banks’ initiative or forced upon them can remedy this. Given the ongoing inflationist policy, regurgitating this issue only brings unnecessary political risk to the table = If the Fed will keep bidding on assets and print our way out of this, they should shut up and just do it! Asking for more capital or more lending or even targeting an inflation rate is hypocrisy and it only adds expensive noise (volatility) to a trend!

This week is heavy in Treasury supply: $35bn 3-yr auction (Tues), $22 bn 10-yr (Wed), and $14 bn 30-yr (Thur). With Transmission spreads (LIBOR, LIBOR-OIS and Comm. Paper) collapsing, what could bring a reversal (lower lows in stocks, wider wides in credit)? POLITICS! Behaviour like the one shown in the chart above, between 10:30am and 2pm, when govt. debt and stocks enter or exit for the same doors AND the outlet valve of foreign exchange acts as a thermometer, MUST BE AVOIDED. (What happened on Friday between 10:30am and 2pm, AND AFTER?)

Yesterday was another forgettable session. News of the pig flu, of the Federal Deposit Insurance Corp. Chairman Sheila Bair seeking authority to close “systemically important” financial firms, and of GM’s bondholders’ rejection of the $27BN debt-for-equity swap shaped a tense range trading day. The S&P500 closed -1% at 857.51pts. Treasuries had significantly dropped by noon, but managed to close up in a flight-to-safety move, driven by fears of a pig flu spreading. This same flu pushed Mexico’s credit default from 300bps to approx. 330bps. The Fed bought $7 billion in Sep/13 to Feb/16 Treasuries. Agency debt continued to tighten vs. Treasuries (1 to 2bps) and CDX IG12 finished flat, at 176bps. And we should leave things here.
While we wait for more policy decisions (FOMC meeting today and tomorrow, Fed purchase of Treasury coupons on Thursday), I thought it would be interesting to reflect not on the origins of this crisis, but on the origins of the ideas that shaped the response to this crisis. Most of you would agree that Mr. Keynes’ ideas are behind the policies being implemented these days. Therefore, let’s analyze Keynes’ thoughts on what to expect from a financial crisis.
John M. Keynes’s main work was the “General Theory of Employment, Interest and Money”, published in 1936. Today, we only need to deal with chapter 13. This chapter is titled “The General Theory of the Rate of Interest”.
Keynes was a very practical man. For him: “…the rate of interest is…the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash…” If we follow him, at close of yesterday, the benchmark (Feb/39 Treasury) price for holding USD cash long term was 3.84% p.a.
Keynes warned that: “…circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest…” Yes, this applies to the $300BN Treasury purchase program by the Fed. I let the reader judge the degree of influence this program has had so far (1 month later) on the rate of interest.
Keynes offered an explanation for these circumstances. He wrote that: “whilst an increase in the quantity of money may be expected… to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money” This should be self-explanatory and consistent with the necessary conclusion from our Thesis no.1 “Sell that which the US Govt. is buying and buy that which the US Govt. will buy (Tincho’s letter, April 6th 2009)”. Keynes further added that: “…whilst a decline in the rate of interest may be expected … to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest…” What is the “marginal efficiency of capital”? Basically, it is the (IRR) internal rate of return (refer Chapter 11 of the General Theory). Given a rate of discount, the IRR of a stock is driven by its dividends and final value. Since the beginning of the current crisis, dividends have been continuously cut or eliminated altogether, while stock prices have been falling. It is obvious then that the marginal efficiency of capital was falling until the current rally took place, in late February 2009. Is the marginal efficiency of capital STILL falling more rapidly than the rate of interest? I am not sure, because: a) we still ignore what level of losses the financial system may face in the future b) this ignorance means that we also have uncertainty on how expensive it will be to finance future investments c) given (a) and (b), we don’t know what the final inflation level will be, as the Fed continues to pump liquidity into a broken system. (On September 18, 2008, Goldman Sachs’ US Portfolio Strategy team published an analysis in line with Keynes’ approach. The publication suggested that the implied S&P500 trough for this crisis was at 1,000 points, consistent with a dividend yield of 2.9% for the S&P500 index).
Keynes continued his exposition saying that: “…whilst an increase in the volume of investment may be expected … to increase employment, this may not happen if the propensity to consume is falling off…” If I am right and the Obama administration is guided by these Keynesian ideas, we should therefore expect further policy from the Fed and the Treasury to address the retail credit market and the personal income tax structure, respectively, to boost consumption.
Finally, Keynes says something rather ominous: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…Will we keep wasting money on the auto sector?) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…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…”. THIS STRONGLY SUGGESTS THAT AN EXIT STRATEGY BY THE FED MAY BE COUNTERPRODUCTIVE. INFLATION MAY HIGH ENOUGH FOR US TO NEED TODAY’S INCREASE IN THE QUANTITY OF MONEY TO MAINTAIN THE RATE OF INTEREST AT THE END OF THIS EXPERIMENT.