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: June 4 2012

The loyal reader knows by now that we have been, perhaps since the start of our publication, expecting a dynamic like the one seen last Friday, namely, lower stock prices and a higher gold price. The last time we insisted on such a forecast was on April 9^th, under the title “We’re getting closer”. But no, we are not like the oracle of Delphos, supplying pagans with loose predictions. We have been very precise in laying out what the drivers for the upcoming collapse are. At the beginning, in 2009, we were alone (read, for instance, our letter from May 19^th, 2009) . Today, we are only one of many to side with this view.

We want to throw a word of caution. Last Friday also, Treasuries ended higher (i.e. yields lower), which means that the status quo, although challenged, is still the status quo. There are now many, including Peter Schiff or George Soros, who assume that from now on and incarnated by the reversal in gold, we start a new phase. This phase would lead us to a crash, followed by unseen amounts of money printing and ending in hyperinflation.

This is a simplistic, 10,000 ft above ground perspective, we think. Undoubtedly, and as per our last two letters, liquidity seems not to be an issue and the intervention of central banks will do little to prevent what we think will be a crash. This crash will be nothing else than the repudiation of the uncertainty provoked by and the misleading nature of zero interest rates, as well as of the increasing financial repression. But exactly for this reason, the status quo will not leave without a fight that will involve more capital controls, price controls, unilateral currency devaluations and a diversity of other interventions.

On this basis, we think it will be wise to be cautious taking a trading view. We will not only have to protect our savings, our assets “nominally”, but physically as well. Coming from Argentina, we have the dubious benefit of knowing a thing or two about this, but it may not be all that handy. After all, the developed world has its own methods and (going by the experience in the manipulation of the price of gold) one of them is the manipulation of prices via the futures markets.

In the futures market, prices can be affected on an unfunded basis, that is…without actually having to own an asset or all the cash to own it. As long as futures markets exist and regulators impose a risk weight on the assets that serve as collateral, the defenders of the status quo will have a tool to inflict pain on those who want to seek refuge in real assets. Therefore, it is valid to ask what could bring the collapse of the futures markets. High inflation would be one of the factors, but in our view, it is a longer term one. A simple answer to the question is this: Futures markets will collapse when an asset that was supposed to be delivered, cannot be delivered in the quantities and at the time it was going to be delivered. Most likely, due to the failure of a big counterparty, followed by that of the corresponding clearinghouse. This event, if it takes place and we think there is an increasing likelihood that it will, will really boost the flight from nominal to real capital.

Why do we think there might be an increasing likelihood of it happening? Because it would be the unintended consequence of the same manipulative actions governments are taking to affect spot prices. As these manipulations increase, their unintended consequence is more likely to occur, just like it did happen to the derivatives position of a well-known, global bank.

With these words of caution, we can only add that the future weeks, months, will be horribly volatile and that one will have to sit tight, and on the margin, move nominal capital to real capital at each opportunity. Policy makers believe they are still in control, but they are not. And by the time they find out, it will be too late for us to take any protective measures. The European periphery, for all practical purposes, is already out of the Euro zone. The US, for all practical purposes, is insolvent. The creditor countries of the world, for all practical purposes, are heading towards deception, as they find out that their mercantilist view of reserves management has destroyed wealth and misallocated capital. The Middle East, for all practical purposes, is heading towards complete anarchy and the commodity countries likeCanadaorAustralia, have left their fate in the hands of hope, unable to steer a course on their own, at the mercy of global capital flows…and hope is seldom a good strategy.

Martin Sibileau