Click the link to read this article in pdf format: January 21 2013

In our last letter, I wrote that: “…The case of Wells Fargo and the temporary pause in the flight of deposits from the periphery of the European Union suggest that the process towards a meltdown, if any (and I believe there will be one) will be a long agony. Furthermore, in the short term, at the end of January, European banks have the option to repay the money lent by the European Central Bank in the Long-Term Refinancing Operations from a year ago, on a weekly basis. I expect them to repay enough to cause more pain to those still long of gold (including me, of course)…”

Today, I want discuss the implication of the repayment of loans made under the Long-Term Refinancing Operations. These loans were extended at the end of 2011 and at the beginning of 2012. The first thing that comes to mind, of course, is the irony that last Friday (i.e. January 18^th), a $200 million 7-day repo operation by the Federal Reserve pushed the price of gold up $10/oz, while a EUR529.5 billion 3-yr collateralized loan from the European Central Bank (also known as the 2^nd LTRO) made on February 29^th, 2012 triggered a $100/oz sell-off. Should we expect the price of gold to rise upon the first repayment on January 30^th? J

A Long-Term Refinancing Operation consists in the European Central Bank loaning funds (with a 3-yr maturity) to a bank, against collateral. Banks have the option to begin repaying loans taken under the first LTRO (made for EUR489 billion, at 1%) on January 30^th, and on every week thereafter. The figure below (on the first LTRO only) should help visualize the above:

It is clear that an LTRO is a collateralized lending transaction. Why then is a repayment all of a sudden relevant? Because thanks to the backstop of Open Monetary Transactions, jump-to-default risk on the collateral used in the LTRO is perceived as non-existent. This suggests that the repayments will therefore not affect the assets purchased with the loans from the ECB. In other words, if the assets (i.e. Euro sovereign debt) that the banks had pledged as collateral are now backstopped, upon repayment of the loans, the banks will not feel the urge to get rid of them. Banks will simply have the option to fund their investments elsewhere, if appropriate. And lately, deposits in the periphery of the Euro zone seem to have ceased to flee.

All this means that, as of January 30^th, there will be a demand in the Euro funding market that was absent during 2012. A bank that wants to ensure access to funds at reasonable prices may fall prey to the concept of certainty equivalence. To such bank, guaranteed funding today may seem more valuable than probably cheaper funding tomorrow, as sourcing funds in the fragile Euro market is nothing short of a non-cooperative game. But this means that in the absence of further interventions by the Central Bank, time has value (again)!!! In a world of zero-interest rate policy, such an achievement may have a relevance that goes beyond a steepener curve in the EUR funds market or the new dynamic between the EONIA and Refi rate. At the moment, one can only intuit that it will be supportive of risk and hence the Euro.

Initially, it may very well confuse the market, representing an opportunity to buy risk, including (physical) precious metals for the long term. But as I proposed earlier, in 2013 I expect imbalances to grow, and the most important gauge of these imbalances will be the value of the Euro. The higher it gets, the more difficult it will become for the Euro zone periphery to repay its debt. And I will have more to say about this in coming letters.

Martin Sibileau

Click here to read this article in pdf format: January 15 2013

In the same fashion that I proposed an analytic framework for 2012, I want to lay out today what I think will be the big themes of 2013. Their drivers were established in September 2012, and I sought to give a thorough description of them here, here and here.

An analytic framework for 2013

In one sentence, during 2013, I expect imbalances to grow. These imbalances are theUS fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. A stronger Euro is the consequence of capital inflows driven by the elimination of jump-to-default risk in EMU sovereign debt. Below is a drawing I made to help visualize these concepts:

The drawing shows a circular dynamic playing out: The threat of the European Central Bank to purchase the debt of sovereigns (that submit to a fiscal adjustment program) eliminates the jump-to-default risk of this asset class. As explained and forecasted in September, this threat also forces a convergence in sovereign yields within the EMU, to lower levels. As long as the market perceives that the solvency of Germany is not affected, the Bund yields will not rise to that convergence level. So far, the market seems not to see that (Possunt quia posse uidentur). But the resulting appreciation of the Euro will eventually address that illusion.

This convergence, in my view, is behind the recent weakness in Treasuries. I proposed this thesis last September. However, the ongoing weakness in Treasuries does not mean I was right. In fact, I fear I may have been right for the wrong reasons. The negotiations on the US fiscal deficit and the latest announcement of the Fed with regards to debt monetization quantitative easing to infinity may also be behind this move. But until proven wrong, I will cautiously hold to my thesis.

The above factors drove capital inflows back to the European Monetary Union and strengthened the Euro. I believe this strength will last longer than many can endure. The circularity of this all resides in that the strength of the Euro will make unemployment and fiscal deficits a structural feature of the EMU, forcing the ECB to keep the threat of and eventually implementing the Open Monetary Transactions. The alternative is a social uprising and that will not be tolerated by the Euro kleptocracy.

All this -and particularly the strength of the Euro- is not sustainable. Ad infinitum, it would create a Euro so strong that the periphery would drag coreEuropein its bankruptcy. But while it lasts, the compression in sovereign yield will mask the increasing default risks in Euro corporate debt, specially the one denominated in US dollars. Both have been fuelling the rise in the value of equities globally.

The unsustainable framework rests upon the shoulders of the Federal Reserve, which thanks to the established USD swaps and unlimited Quantitative Easing, has completely coupled its balance sheet to that of the European Central Bank. In the end, as this new set of relative prices between asset classes sets in, it will be more difficult for the European Central Bank to sterilize the Open Monetary Transactions.

History provides an example of the current growth in imbalances

By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth “should be made of sterner stuff”.

Under the current framework, the European Central Bank can afford to engage in the purchase of sovereign debt because the Fed is indirectly financing the European private sector. The Fed does so with the backstop of USD swaps and tangible quantitative easing, which provides cheap USD funding to European banks and thus avoids a credit contraction of the sorts we began to see at the end of 2011.

This same structure was in place between the Federal Reserve and the central banks of France and England in 1927, 1928 and 1929 and, as a witness declared, “(it) transformed the depression of 1929 into the Great Depression of 1931”. Something tells me that this time however it will be different. It will be worse. That little something is the determination of the new Japanese government to devalue its currency via purchases of European sovereign debt (ESM debt).

How fragile is this Entente?

Most analysts I have read/heard, focus on the political fragility of the framework. And they are right. The uncertainty over theUSdebt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible.

However, unemployment is “the” fundamental underlying factor in this story and I do not think it will fall. In the long term, financial repression, including zero-interest rate policies, simply hurt investment demand and productivity. I do not see unemployment dictating the rhythm in 2013, indirectly through defaults. Furthermore, in the meantime, the picture may look different, because “…we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private…”. This is obviously supportive of risk.

No systemic meltdown in 2013?

From earlier letters, you know that I believe quasi-fiscal deficits (i.e. deficits from a central bank) are a necessary condition for a meltdown to occur, and that these usually appear when deposits begin to seriously evaporate. So far, capital is leaving main street (via leveraged share buybacks and dividends), but at the same time, it is being parked at banks in the form of deposits. The case of Wells Fargo and the temporary pause in the flight of deposits from the periphery of the European Union suggest that the process towards a meltdown, if any (and I believe there will be one), will be a long agony. Furthermore, in the short term, at the end of January, European banks have the option to repay the money lent by the European Central Bank in the Long-Term Refinancing Operations from a year ago, on a weekly basis. I expect them to repay enough to cause more pain to those still long of gold (including me, of course).

 

Martin Sibileau

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

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

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

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

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

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

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

b)       The amount of loss can be reasonably estimated

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

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

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

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

 

Martin Sibileau

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

On Friday, out of the office and away from the screens (we are currently visiting the US capital), we were spared the enormous volatility in gold. Gold tried to break through the lows made since a public institution liquidated bullion on Februrary 29^th but closed making a higher high (since the sell-off, of course).  This, in light of a jobs report taken mildly positively by the market and the drop in the Euro post Greek debt swap, is encouraging to gold bulls (not bugs, but bulls) like us.

The Greek resolution of their debt exchange, with its credit default swap triggered, was a real slap in the face to anyone who was educated under the mainstream portfolio theory, where the existence of a risk-free asset is cornerstone. (We don’t belong to that group of thinking, because we have always recognized that implicitly, modern portfolio theory rests on the Walrasian (refer: http://en.wikipedia.org/wiki/L%C3%A9on_Walras) view of general equilibrium and in the world of central banking, where banks lend multiple times other people’s real savings, general equilibrium theory looks like Ptolemy’s geocentric model of astronomy. But then again, Ptolemy’s model survived centuries and while it lasted, those who dared to challenge it were threatened with death and hell. We want to survive, which is why we are gold bulls, but not gold bugs J).

Indeed, the Greek debt developments, together with monetary policy in the European Union, are writing a new chapter in the history of financial crises. But first things first, we must say that those who seek to compare the situation in Greece with that in Argentina in 2001 are misled, very. When Argentina defaulted, the price of 1 USD rose from 1 peso to above 4 pesos. It was the devaluation that brought subsequent growth, not the default itself. Devaluation has so far been absent in Greece and as we wrote before, it can last as long as the Greek people are willing to put up with the austerity measures being imposed upon them by the EU Council.

Our next step is to recognize that from now on, if you are a holder of sovereign debt, you risk being deeply subordinated by a supranational institution (like the European Central Bank) and, on top of counterparty risk, you will suffer from a high degree of uncertainty related to the usefulness of credit default swaps you may own. Along the same path, you will have learned that whatever holdings you had in unsecured bank debt will also be deeply subordinated to the collateral taken by the European Central Bank to keep your borrower (i.e. the banks) solvent via long-term refinancing operations. You will also have found out that this collateral too, can be created out of thin air, as banks (as in the case of Italy) may obtain government guarantees on their debt issuance, post it at the central bank’s window and receive new, freshly printed Euros!

Capital is therefore flowing out of the European Union and the flow is set to increase, perhaps exponentially. Nobody should be surprised by the fall of the Euro last Friday. Where does that leave the European private sector? Those big conglomerates able to issue bonds in other currencies (mostly in USD) will be able to borrow. The small businesses who depended on the EU capital markets will struggle. The lesson here is that to defend their currency, the European Monetary Union has destroyed their capital markets. And we do not know which one will be easier to rebuild. If run uncontested, the European Union will end like an emerging market of the ‘80s, where foreign funding is needed to support private investments. In light of this, what are the chances that the Fed will raise real interest rates? Very slim we think, for if they are actually raised, currency swaps to the Eurozone will be needed, and that may not be politically sustainable at that time.

After this debt exchange, the public sector (ECB, IMF, etc) will be the majority owner of the debt of the public sector in Greece, and in the future, in the rest of the European Union. The way out of this mess can only be debt monetization.

We want to end with another comment on something that we think the markets may have not paid enough attention to. China is reported to start extending loans to other nations (Brazil, India, Russia) in their own currency. We are witnessing the start of a “reserves war”, where the supremacy of the US dollar will be challenged on the margin. We know so far that above 90% of the US Treasury’s issuance in long-term debt has been purchased by the Fed, while Russia and China have been selling it. What if the loans in Renmimbis from China are funded with the sale of stock in US Treasuries owned by the People’s Bank of China? What if the sale by a public institution of gold at the fixing on February 29^th was a warning to the other public institutions that are accumulating gold as reserves? What if that warning had been guessed by the Bank of Israel, influencing their decision to allocate up to 10% of their reserves in US equities, rather than in gold?

What if we are wrong? What if we are right? Should gold at $1,714/oz not look cheap? Should 30-yr US Treasuries not be a good short?

 Martin Sibileau