Click here to read this article in pdf format: December 2 2012

The intention today was to do a revision of what I had expected in 2012, what happened and what I think will happen. However, we may have to put this aside one more time, given the feedback received on the last post, titled “Anatomy of the End Game”. I seem to have been misinterpreted and to clarify this very important topic, I present a second part to make absolutely clear that:

a)      It is misguided to believe that the end game should be blamed on the shadow banking system. Should regulators succeed in leaving regulated banks the role of funding the commodities and futures markets, the end game would not be avoided and its violence would be even greater,

b)      Fiscal austerity in theUS, if my assumptions (clearly laid out in the previous post) apply, would be irrelevant unless it produces a sizable fiscal surplus,

c)      The approach taken by policy makers addressing this logical outcome (which they mistakenly call tail risk –the tail risk is the reverse: That the game does not end-) is wrong.

The End Game in a world without shadow banking

There are continuous attempts at further regulating money market funds and central counterparties (i.e. clearinghouses), based on the belief that their operations entail risk of a systemic nature. But the systemic nature of the risk is simply due to the leverage built upon the collateral that these players use to provide funding. There is nothing particularly intrinsic to either the players, the markets that use that collateral or the collateral (i.e. sovereign debt, mortgages, etc.) itself, to make them “systemic”. To coerce these players to increase their capitalization or to prevent them from freely disposing of their liquidity as risk varies only increases costs and volatility.

Let’s assume the extreme case where the “shadow banking” sector disappears and banks become the sole providers of funding in the repo market. The figure below describes the situation. In stage 1, we can see the consolidated balance sheets of the financial institutions, traders, and non-financial institutions (private sector). Traders have US Treasuries as assets, which in stage 2, they sell to source cash. This cash is expressed as deposits (in stage 2), which are liability of the financial institutions. Deposits then, are backed by US Treasuries. When these are repudiated (our main assumption) the sustainability of the financial institutions is challenged, precisely at the same time that traders may be suffering a short squeeze on short commodities positions and margins are called. This short squeeze would also affect the commodities and futures markets’ clearinghouses (not shown in the figure). From stage 3, it is easy to see that depositors (non-financial institutions) who are not part of the aggregate “traders” class are the ones who are most at risk. The faith in the US dollar system is lost and a run on the banks is triggered.

We must clarify that the US dollar zone/system is not bound by geographical or jurisdictional borders. A Hong Kong or Brazil based bank that relied on US dollar funding to generate relevant net interest income would be equally affected by the liquidity squeeze, as so many European banks learned in 2008 and 2011.

Under this scenario, and unlike the case where the shadow banking system funds the repo market, the Fed would not have the luxury of choosing whether or not to intervene. It would simply be their duty to do so, and they may believe that they have the option to purchase the US Treasuries from the banks with or without sterilization. But in the end, it would not matter…sadly. Let’s go through the process:

a)      The Fed purchases US treasuries without sterilization

This is the easiest option to understand. As the figure shows below, the Fed purchases US Treasuries from the financial institutions and their reserves grow. As the whole context in which this would occur is not positive for economic growth, to say the least, and the private sector delevers: Loans outstanding, on a net basis, decrease. Deposits decrease and the non-financial private sector increases cash on hand. The equity of the financial sector, naturally, suffers. This cash on hand will keep rising as long as the US debt remains repudiated and US Treasuries need to be monetized by the Fed. Eventually, in the absence of alternative investments (as in the current context, with zero to negative interest rates), the cash is simply spent on consumption. In an environment of financial repression, where companies use whatever liquidity preferably to distribute back to owners via share buybacks or dividends (as we expected back in March), the higher consumption facing lower production ends up driving prices higher.

b)      The Fed purchases US treasuries with sterilization

If the Fed decided to sterilize the purchase of US Treasuries being repudiated, the market would immediately begin to discriminate between those banks who get the benefit of carrying Fed debt and those who don’t. This is similar to what we see in the Eurozone: Deposits flee banks which are seen at risk of being caught on the wrong side of the tracks, should a break up of the Euro zone occur, to banks in the core of the Euro zone (i.e. banks with continuous access to liquidity lines of the European Central Bank). This arbitrage (why carry cash, which pays no interest, rather than Fed debt?) would drive all banks to buy distressed US Treasuries to make a difference exchanging them for Fed debt. This would be a very perverse process, because banks would drive deposit rates higher to maximize the sourcing of US Treasuries.

At this point, I am aware you may be confused: It doesn’t seem to make sense to first assume that Treasuries are being repudiated and later say that banks seek to raise deposits to purchase them. But this makes perfect sense, when we realize that in this context, the market for US Treasuries would be simply broken, segmented. Only banks with the privilege of access to the Fed’s window would be interested in US Treasuries, because only they would have access to the interest-paying debt of the Fed. The US Treasuries, effectively, would be marked to model by the Fed and as the private sector gets crowded out and deposits drop, the need for liquidity and profitability of the financial institutions would demand that higher interest be paid by the Fed on its debt.

You may ask why should the Fed be forced to pay higher rates, when the private sector would seem to be out of investment alternatives. First, we must remember that in this context, commodity prices would be rising and the nominal rate of return in gold would be a benchmark, just like simply holding US dollars in the ‘80s was a benchmark shaping inflation expectations in Latin America. Secondly, the Fed would be forced to pay higher rates to keep deposits from dropping in a context of decreasing trust in the solvency of the banking system. Those living today in the periphery of the Euro zone understand this. Why should deposits not drop? Because if they do, more currency will be circulating and available to buy real assets (i.e. gold) and the outstanding stocks of US Treasuries being repudiated would not be cleared from the market into the balance sheet of the Fed. Their increasing yield (as the price drops) would be a price signal to the market that the Fed would have every reason to kill.

However, if the value of the US Treasuries falls and the interest the Fed has to pay to sterilize their purchase rises, the Fed will face a net interest loss. The Fed may chose to keep accumulating these losses or may also decide to simply convert its debt in legal tender, to end the arbitrage between currency (not paying interest) and its interest-paying debt. In the first case, we end up with a plain monetization of US Treasuries, which we just analyzed above. The second case (enforcing Fed debt as legal tender) would truly mark the end of the game in terms that would make historians of the 21^st century would devote entire volumes…

Why fiscal austerity would be irrelevant without a surplus

A logical outcome, which I think is clear from the two scenarios above, is that no matter how far the spending cuts go, the only way to compensate for the monetization of EXISTING INVENTORY of US Treasuries, is to reach a fiscal SURPLUS. Being only frugal won’t cut it!

In order to avoid being dragged to double digit inflation, there will have to be a fiscal surplus to offset the quasi fiscal deficit of the Fed. However, the implementation of austerity measures (i.e. spending cuts), will necessarily lead to a decrease in activity which would only be temporary if the same are accompanied by a widespread liberalization of markets. It is possible but unlikely, for reasons beyond the scope of this post. All sorts of negative feedback mechanisms could be triggered in this situation, only enhancing the repudiation of the US sovereign debt and the resolve of the Fed to monetize it (For instance, the so called Olivera-Tanzi effect postulates that as inflation rises, access to working capital is restricted and firms delay their tax payments, to get them devalued by inflation. The government therefore receives depreciated tax revenue while its operating costs increase, facing deficits that need to be further monetized, thereby fueling even higher inflation).

In Argentina, this negative feedback was always resolved with the plain confiscation of citizens’ assets: Savings accounts in 1989, chequing accounts in 2001, pension funds in 2008, etc. (I can’t stress enough how important it is for anyone in the financial markets today to study the monetary developments in Argentina between 1972 and 1991)

Policy makers look the wrong way

The natural reaction from policy makers, so far, has not surprised me. Rather than addressing the source of the problem, they have and continue to attack the symptoms. The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free.

This problem truly brings western civilization back to the time of Plato, when there was nothing “…worthy to be called knowledge that could be derived from the senses…” and when “…the only real knowledge had to do with concepts…”.  In the view of policy makers,  the statement “the probability of US sovereign default is zero” is genuine knowledge, but a statement such as “The US government needs to issue about $100 billion per month to finance its fiscal deficit” is so full of ambiguity and uncertainty that it cannot find a place in their universe of truths…(Note: I am paraphrasing Bertrand Russell here. I am certainly not erudite)…and just like since the beginning of the 17^th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21^st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs. The following paragraph, from a speech by Paul Tucker (currently Deputy Governor at the Bank of England) says it all:

“…Two strategies come to mind which I am airing for debate. The first would be ‘recapitalizing’ the CCP (i.e. central clearing counterparty) so that it can carry on.  The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions…”  P. Tucker, Bank of England, “Clearing houses as system risk managers”, June 2011

Policy makers then believe in recapitalization and coercive smooth unwinds. With regards to recapitalization, I will just say that we are not facing a “stock”, but a “flow” problem. US Treasuries would be repudiated because of fiscal deficits, which are flows. No matter how capitalized a clearinghouse is, once the repudiation starts, the break-up of the repo market and the short squeeze would unfold and develop. Whether there is or not a capital buffer is irrelevant to the problem. In fact, in my view, it would be better that there wasn’t: Why would you want to add more resources to a lost cause?

With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be  anything but violent, like any other lie that is exposed by truth. Establishing restrictions to delay the unmasking would only make the unwinds even more violent and self-fulfilling. But these considerations, again, are foreign to the metaphysics of policy making in the 21^st century.

  Martin Sibileau

Click here to read this article in pdf format: September 10 2012

 

We finally heard the intentions of Mr. Draghi, President of the European Central Bank (“ECB”). We only need to know the conditions Germany’s Verfassungsgericht will impose on September 12^th. We believe they will be relevant.

On Thursday, Draghi told us he intends (1) to purchase sovereign debt in the secondary market, (2) that before he does so, the issuing country must submit to certain conditions within a fiscal adjustment program, (3) that when he finally buys the debt, he will buy any debt (new or outstanding) with a maturity lower than three years, (4) that after buying it, he will sterilize the transaction, (5) that the collateral pledged so far for liquidity lines will not be subject to minimum credit ratings any longer, (6) that the ECB will accept to rank pari-passu with other creditors going forward, and (7) that the Securities Market Programme will be terminated, with the purchased debt held until maturity. According to Mr. Draghi (but not toGermany), buying debt with a tenor lower than three years does not constitute government financing. The number three, it seems, is a magical number.

We will mince no words: Mr. Draghi has opened the door to hyperinflation. There will probably not be hyperinflation because Germanywould leave the Euro zone first, but the door is open and we will explain why. To avoid this outcome, assuming that in this context the Eurozone will continue to show fiscal deficits, we will also show that it is critical that the Fed does not raise interest rates. This can only be extremely bullish of precious metals and commodities in the long run. In the short-run, we will have to face the usual manipulations in the precious metals markets and everyone will seek to front run the European Central Bank, playing the sovereign yield curve and being long banks’ stocks. If in the short-run, the ECB is the lender of last resort, in the long run, it may become the borrower of first resort!

The policy of the ECB resembles that which the central bank of Argentinaadopted in April of 1977, which included sterilization via issuance of debt. This policy would result in the first episode of high inflation eight years later, in 1985 and generalized hyperinflation in 1989. Indeed, Argentina’s hyperinflation was not caused by the primary fiscal deficit of the government, but by the quasi-fiscal deficit suffered by its central bank. We will not elaborate on a comparison today, but will simply show how the Euro zone can end up in the same situation. To those interested in Argentina as a case study, we recommend this link (refer section II.2 “Cuasifiscal Expenditures”, page 13 of the document)

Mechanics of the sterilization

In the chart below, we describe what we think Draghi has in mind, when he refers to sterilization. In stage 1, the governments whose debt will be bought by the ECB (EU governments) issue their bonds (sov bonds, a liability), which is purchased by the Euro zone banks (EU banks). These bonds will be an asset to the banks, which will in exchange create deposits for the governments (sov deposits, a liability to the banks and an asset to the EU governments).

In stage 2, the EU banks sell the sov bonds to the European Central Bank. The ECB buys them issuing Euros, which become an asset of the EU banks. The EU banks have thus seen a change in the composition of their assets: They exchanged interest producing sov bonds for cash. Until now, selling distressed sov bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate.

The sterilization is seen in stage 3: The ECB issues debt, which the EU banks purchase with the Euros they had received in exchange of their sov bonds. Currently, the ECB is issuing debt with a 7-day maturity. Should the situation worsen (as described further below), this will be a disadvantage that could make high inflation easier to set in.

We can see the result of the whole exercise in stage 4: The ECB is left with sovereign bonds, with a maturity of up to three years, as an asset financed by its 7-day debt. The EU banks own the ECB 7-day debt, and need a positive net interest income to profit from the deposits (sov deposits and also private deposits) that support that ECB debt (their asset).

What could go wrong

As can be observed in the chart above, at the end of the sterilization, the ECB is left with two assets which will generate a net interest income: Interest receivable from sov bonds – Interest payable on ECB debt.

If the interest payable on the ECB debt was higher than that received from the sov bonds, the European Central Bank would have a net interest loss, which could only cover by printing more Euros. This would be a spiraling circularity where the net interest loss forces the ECB to print euros that need to be sterilized, issuing more debt and exponentially increasing the net interest loss. This perverse dynamic of a net interest loss born out of sterilization affected the central bank of Argentina, although for different reasons, beginning in 1977. It generated a substantial quasi-fiscal deficit which would later morph into hyperinflation in 1989. Without entering into further details about the Argentine experience, we must however ask ourselves under what conditions could the Euro zone befall to such dynamic. That is the purpose of this article.

As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone. Secondly, within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target.

Now, for simplicity, let’s say that the discovered yield cap, which going forward will be a floor, is 4%. This 4% will be a risk-free rate, which in a world of ultra-low interest rates, will look very tempting. The problem is that the risk-free condition holds as long as the bond is bought by the European Central Bank. In the zombie banking system of the Euro zone, where the profitability of banks has been destroyed, banks will not be able to survive if they pass this risk-free yield on to the central bank, unless….unless the central bank compensates them for that lost yield with a “reasonable” rate on the debt it issues during the sterilization. And no, we are not thinking of 75bps!

What is then a reasonable rate? Well, a rate that leaves a profit after paying for deposits. Yes, we know that that is not a problem today, in the context of zero interest rates. But if the floor sovereign rate for the whole Euro zone converged to a relatively significant positive number, banks would only be able to attract the billions in deposits they lost –which are needed in the first place to buy the sovereign bonds in the primary market- at rates higher than the sovereign floor rate received by the ECB. Why higher? Firstly, because unlike the holders of sovereign bonds, depositors do not have the explicit backstop of the European Central Bank on their deposits, which are leveraged multiple times. The liquidity lines provided by the European Central Bank may disappear at a moment’s notice, which is why money left the periphery to the core of the EU zone. An alternative to the European Central Bank, if the deposits from the private sector did not stop falling, would be to keep lending to the EU banks. But this is not feasible in the long run, given the shortage of available collateral. Secondly, as the yield cap becomes the convergence floor, the market’s inflation expectations crystallize into a meaningful expected inflation rate.

Therefore, should fiscal deficits persist in the Euro zone, it is conceivable that as these so-called Outright Monetary Transactions (OMT) develop, we may eventually see net interest losses run by the European Central Bank. It is clear that a net interest loss would be expansionary of the monetary base, because in order to pay for that interest loss, the central bank would have to print more euros, which would need to be sterilized, increasing its debt and interest losses exponentially. It should be noted that once the market’s expectations adapt to this rate of growth in the supply of money, a net interest gain by the central bank, for whatever reason, would be seen contracting the supply of money and therefore, deflationary!

Having said this, we think that the time frame for such a result would be considerable. It would take years for this to unfold and it is very unlikely that it ends in hyperinflation because Germany and the rest of core Europe would leave the Euro zone before it gets there. We present another chart below, to visualize our thoughts:

Additional conclusions

If we were to see a process like the one just described, it would be very hard for the Fed to engage in an exit strategy that would lift interest rates. If it did, the interest rates both the European Central Bank and the EU banks would have to pay on its debt and to attract deposits, respectively, would increase meaningfully. The contagion risk to the USD zone would be very significant and the Fed would have to “couple” its balance sheet to that of the Euro zone via currency swaps. The segmentation seen today in the Eurodollar market, with Libor being a completely useless benchmark, would only accentuate.

This thesis, if proved correct, is bullish of EU banks in the short-to-medium run (before the private sector collapses in a wave of defaults due to higher interest rates, beginning with the sovereign risk-free floor validated by the ECB last Thursday) and very bullish of precious metals and commodities in the long run.

Martin Sibileau

Please, click here to read this article in pdf format: september-23-2010

Continuing with our last letter, which laid out the details of the Yen intervention (ref.: www.sibileau.com/martin/2010/09/23 ) we want to proceed to answer a few questions. But before that, let’s clarify the concept of sterilization…

Under sterilization, a central bank seeks to bring the supply of money back to the original size it had, prior to an intervention in the markets (in this case, in the foreign exchange market). The outcome, after the sterilization is carried out, is a change in the composition of the asset side or the liabilities’ side of the central bank’s balance sheet.

Let’s take, as examples, the last interventions of both the Fed and the European Central Bank (ECB).

When the US dollar spiked in the midst of the liquidity crisis of 2008 or when the Greek problem generated a rush to sell Euro and buy US dollars, the Fed extended cross-currency swaps to the ECB (and other central banks too).

These swaps are an asset to the Fed, which is matched by the creation of a reserve, as Mr. Daniel Tarullo, member of the Board of Governors of the Fed explained to Ron Paul, on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ). The mechanism is shown in the graph below

In step 1, the Fed creates money out of a reserve, which in step 2 debits for a cross currency swap (credited). That cross currency swap is an asset to the Fed, which it extends to the ECB. To the ECB, it is a liability and the ECB credits US dollars. Does anything here seem out of place? If this puzzles you, you are not alone. This was criticized way back in the ‘30s, as Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ), in his book “The Monetary Sins of the West” wrote:

“…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….” (Here is the link, refer page 12 at : www.mises.org/book/monetarysin.pdf )

Anyway, the interesting point here is that at the end of the exercise, on the balance sheet of the Fed, both assets and liabilities are matched in terms of currency. If the US dollars depreciate, this doesn’t impact the assets of the Fed.

The Fed does not need to sterilize this intervention, because the currency swap has a finite term and the rate charged by the other central banks, like the ECB, to their financial institutions (i.e. Euro-zone banks) using this facility is punitive enough to encourage repayment. In fact, the rate establishes an implicit cap in the market, since no bank will pay more for US dollar funding than what they can if they borrow from their respective central bank. The intervention, effectively, depreciates the US dollar.

In the case of the European Central Bank, sterilization did take place this year. We actually described the mechanism in our letter from May 13th (www.sibileau.com/martin/2010/05/13 ) and reproduce the graph below.

In step 2, we see that the ECB purchases government bonds from peripheral countries (i.e. PIGS debt), issuing Euros. To bring the supply of Euros back to the original size, the ECB (Step 3) issues debt, which is bought by the Banks (i.e. the banks place the Euros in deposit). In effect, this debt has been issued under weekly refinancings, using the Term deposit for SMP facility. Deposits (i.e a liability of the ECB) amounted to EUR61.5BN by September 21st.  Here, as can be seen, sterilization consisted in an exchange of liabilities: Euros in exchange of Term Deposits.

How did the ECB manage to depreciate the Euro, even under sterilization? Because it decreased the quality of the assets backing its liabilities: The proportion of riskier sovereign debt backing the Euro increased. Most importantly still, the message to the public was that, if required, that proportion could grow even bigger (as reflected in the current fears about the Irish banking system).

Once again, the important concept here is that both the asset side and liabilities side of the balance sheet of the ECB are denominated in the same currency: The Euro. As in the case of the Fed, there is no mismatch here. If the Euro drops in value, it does affect assets by the same proportion it affects liabilities.

At this point, we are prepared to address the intervention of the Yen. We reproduce here the graph shown in the previous letter.

As we wrote, in order to sell Yen to the FX market to devalue it, the Ministry of Finance issues Finance Bills (i.e. Finance Bills 1), which are “bought” by the Bank of Japan, in exchange for Yen (i.e. Yen1). Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases.  At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1.

Let’s stop for a moment here. As you can see, without sterilization, the Ministry of Finance ends up holding US dollars as assets, and Finance bills, in Yen, as liabilities. They have a mismatch here.

What happens if they sterilize? We show the process below:

To bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills (i.e. Finance Bills 2) in the market. The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2.

Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. (In fact, it sounds inappropriate to call this “Sterilization”, because the Bank of Japan does not participate in it and as a result, there are no changes in either the asset side or the liabilities side of its balance sheet).

But the important thing here is that even after this “sterilization”, the Ministry of Finance still has US dollars on the asset side of its balance sheet. The mismatch, now against Finance bills 2, remains.

This is why we think sterilization is irrelevant here. Why? Because as long as these US dollars continue in the balance sheet of the Ministry of Finance, they will be a source of further imbalances. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:

P&L = D US dollars (in its Assets) / D t – D Finance Bills 2 / D t

(* D = Delta)

As the Fed engages in further quantitative easing, as it clearly stated yesterday in its the FOMC statement, the P&L of the Ministry of Finance will deteriorate. A negative P&L can be bridged with higher taxes (not acceptable), sale of assets (not in question), less spending (not possible) or higher debt.

Thus, the Ministry of Finance, as the US dollar falls further, will have to issue more Finance Bills, to cover the deficit, which may be substantial, given the massive size of its interventions. But as it issues more debt, the interest rate will increase, appreciating the Yen even more against the US dollar. This is a self-feeding, spiraling problem.

How can the Ministry of Finance get rid of the currency mismatch? By selling the US dollars to another central bank!!! This is why we have been saying that coordination with other central banks is more relevant than sterilization.

Which central bank wants to buy US dollars? None at the moment.
The Fed? They can’t! They are actually doing the opposite: They are buying Treasuries to sell US dollars!

What is then the Ministry of Finance to do with the US dollars? Buy treasuries? Most likely and in doing so, the Japanese tax payer will be further financing the American consumption party. With this intervention, finally, the last asset left to serve as reserve for our savings is gold. The verdict is unanimous. The Yen gets the contagion from the quantitative easing policies of the US, the US debases its currency, and those holding Euros are at the mercy of the politicians in the peripheral countries.

What would we have done to weaken the Yen, had we been asked? We would have not intervened the FX market. We would have simply issued bills to the BOJ and with the Yen, we would have bought the most toxic Japanese assets out there, making sure they are really, really, uglier than Greek debt or US subprime mortgages!

Martin Sibileau

Please, click here to read this article in pdf format: september-20-2010

In our last letter, we made the point that the intervention to devalue the Yen was supportive of gold. We explicitly decided to exclude from our comments the details of the intervention, but now in hindsight, believe it was not appropriate. Therefore, we want to start the week going through these details. We think it is important to understand the same because they give us a lot of information and we can deduct important conclusions.

Without further ado, let’s examine how this intervention should work. The operative word here is “should”, because the intervention is still in its early stages and there is speculation about its effectiveness. We refer the reader to the latest research by Bank of America’s G10 FX Strategy team published on September 16th, 2010 (our source), for a slightly different perspective on the mechanism we will describe below. We understand this mechanism is best explained in a work titled “Modern Monetary Theory”, written by Mr. Shirakawa, who is currently the Governor of the Bank of Japan (we have not been able to access it yet). Finally, we wish to devote two letters to the analysis of this event, given its relevance. In today’s letter, we will go through the details and some important conclusions. In the next letter, we will explain the differences between this type of intervention and the one we are used to see, via central banks. We will also examine why coordination with other central banks, which is missing so far, is important and how that in turn gives support to gold. Let’s start…

In Japan, the FX intervention is carried out by the Ministry of Finance, rather than the Bank of Japan. In order to sell Yen to the FX market to devalue, the Ministry of Finance issues Finance Bills, which are “bought” by the Bank of Japan, in Yen. Let’s call these first issuances Finance Bills “1” and Yen “1”, which are issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (graph 1):

Next, with the Yen1, the Ministry of Japan buys USDs in the FX market. In doing so, the price of Yen in terms of USDs drops as its supply increases.  At this point, the amount of Yen circulating in the market is higher than before this intervention took place. This increase in supply is the amount we call Yen1. However, to bring the supply of Yen back to the original size, the Ministry of Finance issues Finance bills in the market. We will call this issuance Finance Bills 2, which are shown below (graph 2). The amount of Finance Bills 2 equals that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:

Of course, as the Ministry of Finance goes to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increases. Given the current market conditions, the impact on price must be minimal. However, as in any other bond market, as supply grows, yield tends to grow (i.e. price tends to fall), to encourage market participants to buy the increased supply.

Once the amount Yen2 is in the balance sheet of the Ministry of Finance, the Ministry uses it to repay its outstanding debt with the Bank of Japan, which we called Finance Bills 1. Therefore, once this payment is done, the balance sheet of the Bank of Japan remains unchanged and Yen1 are taken out of circulation. The Ministry of Finance has USDs on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (graph 3):

The three graphs above show the balance sheets of all the participants in this intervention: The Ministry of Finance, the Bank of Japan, the FX market and the Yen Government debt market. However, we think it may also be interesting to show the intervention in terms of cash flows. Therefore, we show graph 4 below, where we can see that de facto, the Ministry of Finance ends up acting as intermediary between the Government debt market and the FX market. In essence, the intervention “moves” Yen from the Government debt market to the FX market, and this is a “fragile” movement, because it lends itself to arbitrage. Hence, the importance of central bank coordination, to gain “independence” from this source of Yen supply.

Why does this movement of Yen lend itself to arbitrage? Because an asset can never have two different prices in different markets. Whenever that occurs, arbitrageurs fix the problem.

You may question why we think the Yen has two different prices. Well, let us answer that question with another one: Why would the Yen Government Debt market need a “middle-man” (see graph above, graph 4) to provide Yen to the FX market?

It doesn’t!!! The Yen Government Debt market is “not willing” to buy US dollars (i.e. provide Yen) from the FX market at a loss (i.e. buying US dollars at above market prices).

So, who ends up taking the loss? Who ends up buying US dollars at above 82 Yen per dollar? The Ministry of Finance does, which means the average Japanese tax payer! This person is subsidizing the big exporting conglomerates of Japan, so that they can provide “financing” to the American consumer who is broke. The subsidy can be significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen will tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) will lose purchasing power.

In the long term, the Ministry of Finance incurs into a deficit (if the USD depreciates further) which can only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Remember that the Profit/Loss position of the Ministry of Finance will be now determined by:

P&L =

D US dollars (in its Assets) / D t – D Finance Bills 2 / D t

(* D= Delta)

If the Fed undertakes quantitative easing again, the value of the US dollars will fall, generating a loss to the Ministry of Finance. Will they keep buying US dollars then?

Today, we have laid out the general details of the Yen intervention. In the next letter, we will examine other issues/conclusions associated with it: Why is it important to coordinate with other central banks? How would that coordination work? What makes this intervention different to others? Why did Mr. Shirakawa note that under this mechanism the issue of sterilization is meaningless? Is the coordination supportive of gold? Can the intervention affect US interest rates (i.e. Where will the Ministry of Finance invest the US dollars it buys?). These are all important questions and they need answers.

Martin Sibileau

Please, click here to read this article in pdf format: may-13-2010

Perhaps it is very early to tell what will unfold in terms of monetary policy in Europe. Nevertheless we can’t afford to wait for more definitions by policy makers. We are forced therefore to examine two main paths the European Central Bank (ECB) may take in the weeks ahead.
On Monday, M. Trichet repeatedly noted that the ECB was going to purchase PIGS debt in the secondary market, but with sterilization. This means that as the ECB buys these assets, it needs to either sell other assets or issue debt, to withdraw the Euros it printed in the first place, for the purchases.
We looked for official statements indicating what assets could be sold, in exchange of PIGS debt. But we were not successful. However, there has been a rumor since Monday that the sterilizing assets, the assets that will be sold, could be German Bunds. We will take this as a possibility, but we give it a low likelihood. But it is important to examine this scenario and draw conclusions, to gain perspective on what is possible and what is not.
Another way to sterilize the purchases of PIGS debt would be to “issue” short-term debt (i.e. Liabilities to Euro-zone financial institutions). With this, the ECB ends up changing the composition of its liabilities, returning one of its components, the amount of Euros outstanding to its initial level (i.e. the level before the PIGS debt purchases began). The other component would be short-term ECB debt. Let’s examine both scenarios:

Scenario 1: ECB sterilizes PIGS debt purchases selling German Bunds (low probability)
Figure 1

In Fig. 1 above, we see two balance sheets, one for the ECB and one for Euro-zone banks.  For simplicity and illustrative purpose, we included a few main categories in both of them (i.e. Gold, loans, FX reserves, Bunds and PIGS debt).
The purchases of PIGS debt take place in step 2. The ECB debits Euros and credits PIGS debt, while the Euros-zone banks credit Euros and debit PIGS debt. As you can see, on the asset side of the ECB’s balance sheet, PIGS debt increases, matched by an increase in the amount of Euros outstanding (liabilities). The ECB buys this debt from Euro-zone banks, which see a change in the composition of their assets: Higher amount of Euros (liquidity) and lower amount of PIGS debt. As the purchases take place, the supply of PIGS debt decreases, lifting its price, lowering its yield (seen in graph to the right).

Sterilization takes place in step 3. Here, the ECB sells Bunds to the Euro-zone banks, which pay with Euros. The ECB debits Bunds and credits Euros. The Euro-zone banks credit Bunds and debit Euros. At the end of this exercise, the composition of the asset side of the ECB has changed: It has the original amounts of Euros (i.e. prior to the transactions), a lower amount of Bunds and a higher amount of PIGS debt. On the Euro-zone banks side, the asset side composition has also changed. The banks have the same amount of Euros, prior to the beginning of the exercise, but a higher amount of Bunds and a lower amount of PIGS debt. A transfer of risk has taken place, from the Euro-zone banks to the ECB. However, this was not for free. In the process, as shown on the chart to the right on step 3, the supply of Bunds has increased, and so has its yield. The yield of the Bunds is the benchmark rate, the Euro “risk free” rate. This scenario therefore, is recessionary, because it makes borrowing more expensive. It crowds out the private sector.

A few more observations have merit here:

1.-The quantity of Euros remains unchanged, but before the transaction, they were backed by a higher amount of Bunds. Now the Euros are backed by a higher amount of PIGS debt, a riskier credit. Should the “value” of the Euros remain unchanged too? If you got the opportunity to choose, which balance sheet do you prefer, as a holder of Euros? The one in step 1 or the one in step 3? Do depositors in Euros need to be aware of this? No, not if this was a once-and-for-all transaction. But, what if this is carried out indefinitely?

2.- As the Bunds are the Benchmark rate, and the benchmark rate increases when we get to step 3, the transaction is “recessive”. We cynically asked on our last letter (www.sibileau.com/martin/2010/05/10 ) why the market would pay more for Bunds, when one could get a better yield for same risk. Well, it turns out that sometimes reality trumps fiction. The chart below (source: Bloomberg) shows the spread between Greece’s 5-yr credit default swaps (long) and Germany’s 5-yr credit default swap. We were not wrong with our contrarian view. You can see at the far right, how dramatically the spread/risk on Bunds has increased since this Monday, while the gap between Greek and German risk is decreasing.

3.-From points 1 and 2, we realize that sterilizing with Bunds generates recession, hurts growth and deteriorates the value of the Euro. The Euro will drop vs. gold and other currencies. If this is the case, we see a very low likelihood for this scenario.

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Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt (Likely)
Figure 2

Figure 2 above shows the same steps 1 & 2 as in Figure 1. The difference here is in the sterilization process. Instead of selling Bunds, in Figure 2 we see the ECB selling short term debt.
Here, the ECB sells short-term paper to the Euro-zone banks. The ECB therefore credits Euros and the Euro-zone banks credit ECB debt. Effectively, the ECB has changed the composition of its liabilities, leaving the same amount of Euros outstanding prior to the transaction, in exchange for a higher amount of PIGS debt on the asset side of its balance sheet. The banks have also changed the composition of the asset side of their balance sheets. The hold the same amount of Euros, but lower PIGS debt and higher ECB debt.

From this, we can draw the following observations:

1.-The quantity of Euros remains unchanged, but are the deposits of the Euro-zone safer by being now partly backed with ECB debt? Hardly, but this question has to be answered in relative terms. For how long will this persist? If the PIGS sovereigns cannot generate a consolidated net fiscal surplus, and they continue to issue debt, the component of ECB debt backing deposits at the Euro-zone banks will increase, vs. other assets, like Euros or Bunds.

2.-We think this sterilization, at best is benchmark-rate neutral, which means that it should not decrease real interest rates. As the amount of ECB issued increases, its price has to decrease/yield has to increase, as shown in the chart to the right, on step 3. We are not familiar with the European rates markets, but with increasing issuance of ECB debt, the spread between Bunds and this debt will be impacted. How this impact will affect corporate borrowing in Europe is still something we have to work on.

What is the exit strategy under Scenario 2?
We would like now to compare this exercise with the Fed’s purchase of US Treasuries, in 2009. We, at “A View from the Trenches” were perhaps one of the first to emphasize how bullish of risky assets this program was, while others (i.e. David Rosenberg, Paul Krugman) kept telling us it would lead nowhere. (refer our very first letter, on April 14th, 2009: www.sibileau.com/martin/2009/04/14 ).

There are two fundamental, structural, institutional differences between the Fed’s program and scenarios 1 or 2.

a)    The Fed bought federal debt, benchmark debt and in so doing, lowered the benchmark rate. The ECB will not buy a federal debt because there is no such a thing under the current European Union and will not buy benchmark debt, which are the German Bunds. Therefore, how can this program be accommodative? This issue underscores the institutional weakness of the European Union, namely the lack of a unified bond market. What the ECB seeks to do here would be similar to a central bank selling Texas’ debt to buy California’s debt or issuing its own debt, with the implicit guarantee of all the US states, to buy California’s debt.

What could the ECB have done differently?
A similar solution to that of the Fed in 2009 would have consisted in having the ECB buy German Bunds without sterilization, from a trust, administered by the Germans, to fund the trust’s purchase of PIGS debt. In exchange, the PIGS sovereign would have had to ring-fence a cash flow stream to repay the trust. This is similar to what takes place in federal unions, where the federal government collects through federal taxes or alternatively, through specific royalties established with provinces or states. With this structure, the ECB would have been able to carry out an accommodative policy, with specific amounts and repayment sources.

b)    The Fed bought a predetermined amount ($300BN), with a predetermined timeline (until Oct. 2009). With the ECB’s plan, the market ignores both the final amount of PIGS debt in the asset side of the ECB’s balance sheet, its composition itself (i.e. how much from Greece? From Spain?) and nobody knows when it will end.

As can be easily concluded, under scenario 2, there cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system:

a)    What if the so-called “short-term” ECB debt backing deposits is indefinitely rolled over and depositors see the risk and decide not to renew deposits?

b)    If the ECB becomes a riskier bank, its currency will (actually is) no longer be considered an alternative reserve asset and the propensity to exchange it for gold or USDs will increase exponentially. If so, what was the wisdom behind Sunday’s decision by the central banks of the USA , Canada , UK , Switzerland and Japan to provide currency swaps to the ECB? Are currency swaps all of a sudden a “free lunch”? What for were the balance sheets of these institutions compromised? Who pays for it? Should the senior management of those central banks not be audited for decisions of this sort? Who is accountable?

This analysis suggests there could be a generalized run against the Euro as a currency. The Argentinean experience of 2001 offers a analogous case. Back then and there, the central bank did not increase the amount of pesos outstanding. It simply changed the quality of the assets backing those pesos, from USDs (i.e. FX reserves) to government bonds. Argentina did not have inflation. Nevertheless, eventually as in scenario 2, depositors realized that their deposits were not backed by the assets they had expected and decided to rush for the exit door.

Figure 3 below shows the spiraling nature of this process:

Another aspect here is that as this process takes place, the credit quality of the loans held in the Euro-zone banks would quickly deteriorate, further weakening the ECB position.

Would this lead the world to the end of paper money?
We have written many times before, that we were amazed by the fact that regulators did not understand the systemic nature of sovereign credit default swaps. These swaps, which in the case of Euro-zone sovereigns are denominated in US dollars would be the link here, connecting US financial institutions with Euro liquidity problems.

The Fed last Sunday already extended currency swaps to the ECB in a very murky way, which even caused a heated debate in the US Senate. What do you think would happen under a terminal situation, where the European banks’ risk as counterparties would jump exponentially?

And then, friends, would you hold US dollars as a reserve asset, knowing that they are thrown into a hole to fight the last battle?
Doesn’t this actually make gold look like a bargain at $1,240/oz?

Martin Sibileau