Click here to read this article in pdf format: September 16 2012

Last week, after the German Bundesverfassungsgericht decided not deactivate the debt monetization program announced by Mr. Draghi a week earlier, the Italian government sold EUR4BN in 4.75% 2014 notes at an average yield of 2.75%. This compares with 4.65% obtained at a sale of the securities on July 13th.

With the European Central Bank backstopping short-term EU sovereign debt (as long as the issuer submits to a fiscal adjustment program), we should see two trends taking place:

The first one, mentioned in our last letter, is that the market should arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone target yield. The Italian auction mentioned above, together with continuous weakness in Germany’s sovereign debt, the movement of capital out of the US dollar to the Euro zone (lifting the Euro to $1.31) and the rally in EU banks, would seem to indicate that this convergence is slowly materializing. The critical piece here, the one that will really nail this coffin, is the return of deposits transferred to the core of the Euro zone, back to the periphery that originated them. This is what’s behind the ongoing negotiations towards a banking union. Ironically, if the banking union was successful, making deposits return to banks of the periphery, it would make it easier for the Germans to leave the Euro zone, because the current imbalances of the Target 2 system would disappear, radically lowering the cost of the exit!

The second trend, the one we missed last week, consists in that –perhaps- we will no longer be able to talk about “the” risk-free rate of interest, when we refer to the US sovereign yield. If the first trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield. For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the world’s risk-free rate! The big assumption here is of course, that the first trend, above, holds true. Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered.

What would the levels be, for the up-to-3 year yields? As we know, the European Central Bank will not pre-commit to a yield target. Of course, they don’t want to be challenged, because there is only so much they can sterilize before they start suffering a net interest loss, as we explained last week. But from a dynamic perspective, what counts is not the level, but the driver: In the long run, as the sterilization fails (also explained in our last letter and first proposed back on May 13th, 2010), the short-term “risk-free” rate of interest would be driven by the consolidated fiscal deficit of the Euro zone.

 Having said this, the remaining question is what determines the value of the long-term risk-free rate of interest. The Fed, in our view, although not announced last Thursday, will eventually continue to purchase long-term US sovereign debt. Effectively in the beginning, the Fed would set the value of the risk-free yield curve, past the three-year point. When things get out of control and inflation expectations for the US dollar take the lead (in a few years), the fiscal deficit of the US should determine the dynamics of the long-end of the curve….Does that make sense? No! (At least not, if you are not Keynesian) Because if “things get out of control”, we must say good bye to long-term interest rates altogether. That market will evaporate, and the US will only be able to sell short-term debt. At that point, if the Euro zone still exists as we know it, the battle for the ownership of the risk free rate will have been won by the European Central Bank, by definition. Why? Because by definition, if the Euro zone still exists, it is because they succeeded in stabilizing their fiscal problems. Otherwise, the shortening of the term horizon for the US sovereign yield should continue contracting, until hyperinflation completely wipes it out.

Additional thoughts

With these thoughts in mind, one cannot but wonder at the idiocy blindness of those who sustain that both the European and the US central banks removed “tail risks” in the last days, with their new measures. To start, the whole idea that a tail risk exists is simply a fallacy of Keynesian economics. It assumes there is a universe of possible outcomes and, as if humans acted driven by animal spirits, randomly, each one of them has a likelihood of occurring. In all honesty….what else can occur if a central bank prints money to generate a bubble? Why would the bursting of the bubble be called a tail risk, rather than the logical outcome? Why, if that was tried in 2001 in the US, resulting in the crisis of 2008…why would it be any different now, when there is an explicit announcement to print billions per month? Why?

 The splitting of the risk-free interest rates, in short and long terms, and the “moving” of the short-term to the Euro zone somehow sadly reminds us of the division of the Roman Empire, between West and East, when the capital moved to Constantinople. Is this ominous?

Finally, as inflation expectations, post the ECB/Fed announcements pick up, the rally in credit (i.e. IG18 credit default swaps index reaching 83bps) is telling us that banks outside the Euro zone or the USD zone -banks which did not benefit so much from a “portfolio” effect-, will have a hard time remaining profitable, unless they take additional risks, or they get themselves the same subsidy that the ECB and the Fed give to their zombie banks. This suggests to us that the Canadian dollar should not rise significantly above the US dollar.

Martin Sibileau

Click here to read this article in pdf format: June 25 2012

We are as deceived as you are with the policy decisions undertaken by the European Union (EU) and the US. As we muddle through their consequences, today we take a moment to offer a few thoughts…

-On the EU: Banking Union, bailout funds and other tricks

After the second LTRO (i.e. long-term refinancing operation) and the Greek debt swap exchange (in March), the likelihood of the break-up of the European Monetary Union has risen exponentially, and continues to rise. Along with this trend, cross border lending by banks continues to fall and flight of capital from the periphery remains in place. The fear of a final collapse is there and rumours of a pending banking union were thrown at the markets.

A banking union, if true and under whatever form it takes, requires a final omni guarantor, backed by an omni pool of resources, funded by an omni tax. This means that the required step of a EU fiscal union is still the only solution to the (only) problem. As we repeated since 2010: This is an institutional crisis! The same analogy is applicable to any bailout fund that “they” may want to throw at us. EFSF? ESM? You name it, they are all useless. They all need an omni guarantee. To think otherwise is simply delusional and a waste of time. Fiscal union, on the other hand, is not possible overnight. It demands constitutional changes. Any strength in the Euro upon these rumors should be faded.

-The European Central Bank (ECB), its collateral and Argentina:

On Friday, the ECB announced that it will reduce the rating threshold and amend the eligibility requirements for certain collateral. In other words, the ECB is accepting lower rated assets to back its liabilities, i.e. the Euro. This brings the European Monetary Union closer to an “Argentina 2001” moment. Why? Argentina suffered from a fast deterioration because its banks, after years of hyperinflation and the confiscation of the 1989 Bonex Plan could only fund themselves via deposits. The European Union banks are getting dangerously close to that stage: Raising equity is no longer an option, unsecured funding has been subordinated by past bailouts, available assets to encumber are almost non-existent at this point (which is precisely why the ECB had to accept lower rated assets on Friday). Therefore, the only fools still funding the banks, at least  the banks in core Europe (because banks in the periphery live on liquidity lines from the ECB) are the depositors. We want to believe that majority of these deposits come from corporations, whose treasurers deposit other peoples’ (i.e. the corporations’ shareholders’) monies. Otherwise, we would be underestimating the intelligence of the people of the European Union, and we don’t.

Given the circularity in the solution proposed by the leaders of the EU (i.e. banks buy  debt from bankrupt nations; the banks go insolvent and are “saved” by the bankrupt nations, which in turn, are now even more insolvent), it is only a matter of time until the very deposits of EU banks are challenged, after every last asset owned by the banks is downgraded to junk and pledged to the central bank.  This brings us to the next point…

-Who leaves first?

With the outlook of former austerity programs (which never got to be implemented, by the way) being relaxed, to “promote growth”, we now believe that it is likely that Germany be the first to leave the European Monetary. The latest action in bunds (i.e. Germany’s sovereign debt) seems to indicate that we are not alone with this thought. Here is why: If a peripheral country is seen as likely to leave the monetary union, the flight of deposits from that country to Germany’s banks appreciates Germany’s sovereign debt and its yields drop, as it has, to negative territory. But if those countries are perceived to stay, as it was after the Greek’s election during the past weekend, then Germany will have to foot the bill. Therefore, the value of its sovereign debt will fall and its yield rise. This is precisely what occurred in the past days. The question is: When will Germany leave? To which we answer in these simple terms: Germany will leave only when the cost of staying surpasses that of leaving. Under both scenarios (staying or leaving) there is a cost. The cost of staying, is a higher yield on Germany’s debt. How high? Potentially, to the magical 7% that Spain has touched and Italy is on its way to touch. Germany would leave before then, as the unthinkable (i.e.Germanyout of the capital markets) takes place. The cost of leaving would be represented by the defaults of the countries that stay, on their obligations to the Bundesbank (for the liquidity lines they enjoyed under Target 2). We think (and explained in our last letter) that this cost can be mitigated, if no capital controls are imposed and bi-monetarism is embraced. This would allow banks –both in Germany and the periphery- to take deposits in Euros and in the new local currencies. Under this scenario, the European Central Bank would not be dissolved. However, if Germany left first, we doubt there would be any incentive from the rest of the countries to allow the existence of Euro-denominated deposits.

-Operation Twist, Part Two

We are not going to add noise to the decision by the Federal Open Market Committee (FOMC) to extend its purchases of long-term US Treasuries and selling, in equal amount, short-term US Treasuries. We are only surprised (very much) by the fact that every analyst, fund manager or media anchor judges the decisions of the FOMC –past, present and future ones- by their impact on the private sector: On activity, on the labour market, on asset prices, etc. Why is nobody openly saying that in a country where fiscal deficits are higher than $100BN per month, the central bank has no alternative but to buy and monetize fiscal debt? Why is nobody linking the deficit and the purchases? Who can really believe that the US are not kicking the can? Who can really think that there will not be, eventually, straight debt purchases?

-The unintended consequences of zero-rate policies, from a micro perspective.

From our lessons in corporate finance, as students, we remember that equity is the riskiest part of a company’s capital structure. Equity is a call option on the assets of the company, with the value of its debt being the strike price. If the value of the assets increases over that of the debt, the spread goes to the shareholders. Hence, for that to occur, the company must “grow”. Companies that have a high likelihood of growing can be financed via equity. Companies that are not likely to grow, that are established in a mature industry and generate steady cash flows, are better candidates to be financed with debt.

With this in mind, we now turn to the fact that zero rate policies sought after globally by central banks have destroyed any possibility of obtaining a decent yield in corporate debt. This forces those who cannot afford to eat off their savings, to “gamble” them in the stock markets, with the hope that the same central banks will boost equity valuations. However, the zero-rate policies kill growth and those poor peoples who were forced to leave the comfort of corporate debt and transfer their savings to stocks will find themselves invested, contrary to common sense, in the riskiest part of the capital structure, in a call option, exactly at the time when no growth will come. How unfair is this?

-Why this agony can last longer than you or we can think

Unlike financial crises in underdeveloped countries, the one affecting the developed world takes place in sophisticated capital markets. There are futures/derivatives markets, forced savings via pension plans, and legalized Ponzi schemes whereby collateral can be pledged multiple times to support liquidity. These factors can cause a significant delay in reaching the “final outcome” and are subject to manipulation:

To break the futures markets, one needs to see a failed delivery by one of the players. But politicians can always capitalize or inject liquidity to that counterpart and avoid the break-up of that market.

A significant portion of the workforce is coerced to save through collective pension plans. The coerced savings act as a cushion between reality and illusion. Those forced to save believe in the illusion that somehow, their pension plans will provide them with an income in the future. If reality set in and the magic was lost, politicians could (and have done so) simply postpone the retirement age or even hike the savings rates enforced upon them. Even in the case where people realized that the cost of staying in the pension plans was higher than leaving them under penalties, politicians can simply “temporarily” prohibit withdrawals and effectively confiscate the monies.

It will take dramatic events to be confronted with these situations, but we think that this crisis will last long enough to face them.

-Murray Rothbard and his book “America’s Great Depression”

The question is therefore: When is this crisis going to crystallize and what will it take for it to do so? Don’t ask us why but we re-read Murray Rothbard’s “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard tells us that: “…despite the gigantic efforts of the Fed, during early 1933, to inflate the money supply, the people took matters into their own hands, and insisted upon a rigorous deflation (gauged by the increase of money in circulation)— and a rigorous testing of the country’s banking system in which they had placed their trust…”

From this, we take two conclusions: (a) The crisis ends with a rigorous deflation or liquidation of liabilities,  (b) That deflation has to be expressed in terms of a new standard (gold?).

In the ‘30s, the US dollar was still backed by gold. Gold was the Fed’s asset, the US dollar its liability. Today, the US dollar is backed by US Treasuries. Therefore, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. We can now see the implications of such repudiation, but we have written enough for today. We will elaborate more on this topic, in our next letter.

Martin Sibileau

Click here to read this article in pdf format: June 11 2012

As we write, the news is out that Spanish banks will get bailed out in the order of EUR100BN (also reported EUR125BN). We have repeatedly said that bailing out banks whose capital vanishes because they hold junk government debt is an exercise in circular reasoning (see our letter: “The EU must not recapitalize banks”, from October 17tth, 2011). This also applies to those bailouts where the pockets are bigger, as in the case of the Euro zone members. Eventually, without deficit monetization, this will affect the credit quality and spreads of Bunds (i.e. sovereign debt of Germany).

Over the past week, we have been introspective. Recognizing that we have been pessimistic (perhaps since we began writing), we tried to look for policy solutions that would prove us wrong. Let’s see…

Today, even Warren Buffet acknowledges that the problem of the Euro zone is institutional, that fiscal integration is required for the zone to survive. We were, however, maybe one of the first to have openly said that the problem of the Euro zone was institutional, back on February  8^th and 10^th 2010 (yes, more than two years ago!) and that all these bailouts and liquidity manipulations would lead nowhere. We were contrarians back then and wrote in answer to a publication by the Bank of America’s Credit team: “US Fixed Income Situation”, Fixed Income Strategy, February 5th, 2010. In this note, the writers suggested that the crisis was of a short-term nature, driven by liquidity issues, with a longer term solvency problem.

Now, our view is mainstream. Now, with everyone siding with the institutional perspective on the Euro zone, we wonder if it is really impossible for a peripheral country to carry a smooth exit from the Euro zone. Until now, we thought it was and because of that position, we had a consistent view of the problem, whereby the US would step in via currency swaps and end up picking the tab. However, we think we may be wrong here and this is why we just wrote above, that we have been very introspective.

It may be possible that a peripheral country be able to exit the Euro zone smoothly. It may be. We are not saying that it is likely or not, or that it will or will not. But only, that it is possible, technically speaking. And we will use today’s letter to examine this possibility.

When we think about the survival of a currency or related bank runs that precipitate a currency crisis, we are being biased and narrow minded. We view the collapse of that currency as an asset to store value. But in doing so, we neglect the other function money has, which is to serve as a medium of indirect exchange, a medium to transact. Societies can actually live under bi-monetarism, whereby one currency is used to store value and the other, the imposed legal tender, is used to transact. There are multiple living examples of this in the world, and we are particularly familiar with those in Latin America.

The processes in demonetization actually start with this sort of bi-monetarism. The peso, inArgentina, was at one time used to store value and to transact. With the sovereign problems and increasing confiscation via inflationary tax, the peso was dropped as a store of value but continued to be used to transact. The US dollar replaced the peso as store of value. But later, as inflation became more acute, the peso completely disappeared and Argentina was forced to establish a currency board, where the central bank would only issue pesos if they were almost 100% backed by US dollar reserves. And then again, the peso began to be used to transact, while US dollars retained their role as a store of value. As the macroeconomic situation improved in the early ‘90s, US dollar stocks were not exchanged for pesos, but pesos flows (i.e. new savings) were not converted to US dollars.

With this in mind, it is therefore conceivable, that without affecting the status quo under the existing Target 2 structure (i.e. Trans-European Automated Real-time Gross Settlement Express Transfer System), a country like Greece start issuing their own currency with their banks accepting deposits both in Euros, supported by the European Central Bank, and in drachmas. The drachmas would not have to be imposed upon the private sector to transact, but the government could decide to pay all its future debt issuances and operating expenses (including wages) in drachmas, and demand that taxes be paid in drachmas too (A government can also simply default on the euro debt and re-denominate it at an arbitrary exchange rate).

To avoid falling into hyperinflation, the drachma would have to initially be backed by assets that would necessarily have to come from privatizations. In the case of Greece, this is difficult, as most if not all of sovereign assets have been encumbered. But we trust there is always the possibility to create a special purpose trust owning fiscal land, reserves or infrastructure royalties to begin. In other cases, unencumbered gold reserves could be used for that purpose.

It is important here to remember that the price of those drachmas, relative to other currencies, will not depend on the quality of the assets behind, but on the demand, relative to its supply. If the demand is not imposed (if bi-monetarism without capital controls is allowed) and the supply of drachmas will only increase gradually, as wages are paid and redenominated debt is serviced, we could see this currency survive, if the committed austerity programs continue in place. This would represent a scheduled depreciation of the currency, until the fiscal deficits are solved. If they are not, the whole experiment would succumb, just like it did in Argentina, in February of 1981, under the so called “Tablita” (tabla = ledger, and in this case, containing gradual peso depreciations).

The key here is that, after the still ongoing bank runs in Greece, with its citizens having all their savings stocks in Euros, they will afford to keep monetary flows in drachmas (i.e. the cost of having to transact in drachmas will be offset by the fact that their savings are in Euros). This policy would boost the purchasing power of their savings, vis-à-vis, the public services provided by the government, now supplied in drachmas. This policy too, would represent a devaluation of the cost of public workers, for those who managed to convert their savings into euros. And we believe that is the case for the majority of Greeks.

For Germany, this scenario would also be a win-win situation, because the Euros they now subsidize under Target 2 would eventually and gradually be recycled back into the remaining core Euro zone, as the peripheral country imports goods from the Euro zone. In fact, this alternative could well represent a virtuous spiraling process, with the Euro appreciating, Euro sovereign interest rates falling (both in Euros and in drachmas), and stocks (particularly financials) increasing. If that was the case….what would happen to gold ceteris paribus? We think it would plunge, and only be relevant in US dollar, Yen and Yuan terms, as the US and Japanese fiscal cliffs come to the forefront, while China’s situation continues to deteriorate.

In summary, the absolutely necessary conditions for a smooth exit from the Euro zone are:

1)  No capital controls and freedom to convert to Euros in any amounts of local currency, at a market rate

2)  Acceptance of bi-monetary deposits at banks: Euros and local currency

3) The European Central Bank will address liquidity on the Euro portion of deposits/assets, the local central bank will be the lender of last resort for the local currency portion (Otherwise, the experiment is set to fail, like the currency board failed in 2001 in Argentina, because US dollar deposits were not “insured”. The alternative, if the ECB does not cooperate, is to impose a 100% reserve requirement on the Euro portion of deposits)

4) No legally enforced indexation of Euro denominated contracts (let the market sort it out)

5) No definition (silence) by the government, on the future of the Euro denominated sovereign debt (eventually, a non-hostile renegotiation can be done, within the European Union, leading to the fiscal integration that everyone is now seeking)

6) The local government will pay expenses and demand payment of taxes in local currency.

7) Some sort of stock, hard asset back-up of newly issued local currency (gold, privatized assets)

And finally, the most difficult one (the one Argentina failed to comply with in 1980):

8  A credible plan to reduce fiscal deficits, now denominated in local currency.

If only one of these conditions were not met, an exit from the Euro would end in chaos.

Martin Sibileau