Click here to read this article in pdf format: August 19 2012

What do USD money markets have to do with gold? Money market funds invest in short-term highly rated securities, like US Treasury bills (sovereign risk) and commercial paper (corporate credit). But who supplies such securities to these funds? For the purpose of our discussion, participants in the futures markets, who look for secured funding. They sell their US Treasury bills, under repurchase agreements, to money market funds. These repurchase transactions, of course, take place in the so-called repo market.

The repo market supplies money market funds with the securities they invest in. Now…what do participants in the futures markets do, with the cash obtained against T-bills? They, for instance, fund the margins to obtain leverage and invest in the commodity futures markets.

In summary: There are people (and companies) who exchange their cash for units in money market funds. These funds use that cash to buy –under repurchase agreements- US Treasury bills from players in the futures markets. And the players in the futures markets use that cash to fund the margins, obtain leverage, and buy positions. What if these positions (financed with the cash provided by the money market funds) are short positions in gold (or other commodities)? Now, we can see what USD money markets have to do with gold!

Let’s propose a few potential scenarios, to understand how USD money markets and gold are connected:

If money markets have liquidity, there is abundant cash to buy US Treasury bills (i.e. the repo market is more liquid), and to finance those who short commodities in the futures markets. This is negative for the spot price of gold. If money markets lack liquidity, shorting commodities becomes more difficult. This is positive for the spot price of gold.

If the US Treasury bills become riskier, on the margin, the incentive to buy them will be lower and either money market funds will reallocate the cash towards commercial paper or they will face redemptions from fearful investors. The repo market will then lose liquidity. This is positive for the spot price of gold.

Alternatively, if the rate paid by the US Treasury increases AND the risk of these bills is NOT perceived to be higher (something possible in these rigged markets with doubtful ratings), investors will be more eager to place their cash with money market funds (falling prey to an illusion) and the liquidity of the repo market will increase. This is negative for the spot price of gold.

Why do we bring this up? To be honest, it is not the first time we do so. We have introduced the topic in our letters of July 2nd, July 30th and August 6th. We bring this up today because we want to raise awareness on some measures under consideration by the US Treasury and the Federal Reserve, that will have a direct impact on the USD money market, and hence, the repo market and the price of commodities. These policies are:

1) Minimum Balance at Risk (MBR): Kills USD money markets = lowers liquidity in repo market = Positive for gold

This has been in the works since 2010, but is only now taking shape. On August 15th, Bloomberg had a post on this under the title “Fed’s Dudley backs money fund rules to protect US Economy”. If enforced, there will be a minimum balance, which holders of money market fund units will not be able to redeem, but after a lock period. Effectively, under distress, redemptions will be restricted. As well, there are other potential measures, like floating the funds’ Net Asset Value and capital requirements. But the MBR one is the most relevant: It will make market participants see money market funds as a risky investment.

Personally, we do not see the motive behind this move because if, as some deduce, policy makers in all honesty believe that the savings currently in these funds will be reallocated as a result to bonds or stocks (boosting asset prices), they are being naïve at best and utterly idiotic at worst. Whoever invests in money market funds does so to make an extra buck on liquidity. If he/she cannot make it, then the funds will simply remain in a chequing account. Would banks use these funds in the chequing accounts to lever up their investments? Into what? Money market funds? The recent experience in the Euro-zone (discussed further below) shows it is not the case. Banks will not lend more just because they have more deposits available.

In any case, this policy would drain liquidity from the repo market and financing positions in the futures markets (i.e. shorting gold, for instance) would be more expensive. This would be positive for the spot price of commodities.

2) Introduction of Floating Rate Notes by the US Treasury: Positive for USD money markets = Negative for gold in the short-term, positive in the long-term

We introduced this point in on August 6th, after reading a series of articles at Zerohedge.com. Floating Rate Notes are variable rate notes. If floating rate notes were issued and interest rates rose (either driven by the Fed’s policy or by the market) they would have a strong bid from money market funds, bringing liquidity to the repo market. This could continue supporting speculative shorts in the futures markets, which would be negative for spot commodity prices in the short term.

However, if these rates are seen to be sticky, the Fed would have to intervene, targeting rate caps. But to guarantee the cap on the price of a good, one has to offer unlimited supply of that good. If the Fed had to guarantee a cap on NOMINAL interest rates, it would have to offer unlimited supply of US dollars. It is now easy to see why, in the long run, issuing floating rate notes would therefore be positive for the spot price, in US dollars, of commodities.

3) Zero interest on excess reserves: Would kill USD money markets (just like it did in the Euro zone) = lowers liquidity in repo market = Positive for gold

After the July 5th decision by the ECB, to pay nothing on its deposit facility, Euro-zone banks’ deposits at the European Central Bank plunged (see below, source: Bloomberg), by the tune of EUR484BN!!!

Did this money go to stocks? No! To bonds? No! Where did it go then? To a chequing account at the ECB. In the process, the Euro money markets died and the repo market suffered heavily. We had warned here that this measure would only make Euro banks less profitable and hence, riskier.

Because commodities are not traded in euros, this has not impacted the commodities market. But should a zero-interest-on-excess-reserves policy be implemented in the US dollar zone, the effect on the repo market would be to drain liquidity, a negative for futures markets and a positive for spot commodity prices.

In conclusion, there are currently three potential policy measures that would have a relevant impact in the commodities markets. Forewarned is forearmed.

Martin Sibileau

Click here to read this article in pdf format:  August 6 2012

Today is a holiday in Canada and our letter is published later than usual. We will make a few comments on what we believe were the most relevant events impacting capital markets (do these still exist, by the way?) last week:

No news on monetary policy

During the past week, both the Fed and the European Central Bank had the opportunity to execute on new policies, be it price or volume driven. As we anticipated in our last letter, these banks decided to past on such an opportunity. There is really nothing else they can effectively do, except explicitly monetize sovereign debt. If they opt for unconventional policies, the medicine will have a worse effect than the sickness, although we want to make this clear: Monetizing sovereign debt is also not the solution. However, it buys time and is the less distorting of all available measures. Having said this, if we are right, the rally we saw in the Euro was only short-covering and soon, we will have to enter a new downward leg.

Relevering of corporate balance sheets: Rich shareholders, poor corporations

A few months ago, we warned that: “…in the past 10 years, you have seen the S&P500 index fluctuate, nominally, without making any “improvement”. This has huge ramifications and one of them is that businessmen who would want to monetize the fruit of their labour would not be able to do so, on average, because if they are lucky, they only break even when they sell their businesses. If you were one of them, what would you do in the face of the recent monetary expansion?

I for one would leverage my company with cheap credit lines and distribute (or increase the distribution of) dividends, to cash out. And this is precisely what we are seeing and will continue to see: Leverage seems to have bottomed and now is reverting in corporates. This is not positive for growth and hence, we don’t want to own shares. We don’t want to own mining companies. We understand that the recent rally was fully driven by the expansion of the Fed (via swaps) and the European Central Bank (via Long-Term Refinancing Operations). We are simple investors and are humble enough to know that we will not be able to call the exact day in which the reversal in stocks takes place…”

This trend is increasingly becoming more evident, as new multi-billion shares-buyback programs and dividend raises are announced every week. Who’s financing this? Banks mostly and they will be sorry for it by the time interest rates (i.e. real interest rates go up). In the meantime, let’s enjoy the party!

Reconsidering our last comments on the repo market: Why we may be proven wrong

At the end of our letter on June 25^th, we brought up what we thought was a sharp comment from Murray Rothbard, in his book “America’s Great Depression”. In its Chapter 12, under the section titled: “The attack on property rights: The final currency failure”, Rothbard told 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…”

We concluded therefore that this crisis has to end with a rigorous deflation or liquidation of liabilities, which must be expressed in terms of a new standard. In the ‘30s, the US dollar was still backed by gold and gold was the Fed’s asset. Today, the US dollar is backed by US Treasuries. Therefore, we concluded, “to insist upon a rigorous deflation” is to repudiate the US Treasury notes. On July 2^nd, we made the case that such a repudiation was going to take the form of lower volumes in the repo market. By that, we meant illiquidity in the repo market. The same was going to make harder to short commodities naked, brining eventually one net short position in the futures markets to bankruptcy. In the process, counterparty risk would rise exponentially endangering the respective clearinghouse and forcing the Fed to intervene. The key conclusion here was that from that point on, spot prices of commodities were no longer going to be manipulated, given the broken futures markets, opening the door to high inflation.

As the title of this paragraph suggests, we may be wrong in this analysis. What makes us think so? New information: Namely, the potential massive use of floating rate notes (FRNs) by the US Treasury, starting 2013. We want clarify this: The introduction of FRNs will not suppress the process described above. It will only delay it and make the fall even more catastrophic.

The new information came to us upon reflection, based on a series of anonymous articles published on Zerohedge.com, regarding the upcoming change in the funding policy of the US Treasury. Please, find the links to these articles below. Give yourselves some time to read them carefully. They are worth it. We present them in chronological order:

1. www.zerohedge.com/print/446207
2. www.zerohedge.com/print/446655
3. www.zerohedge.com/print/447068
4. www.zerohedge.com/print/447126
5. www.zerohedge.com/print/452769

Floating Rate Notes are variable rate notes. If you hold them and rates increase, for instance, you don’t suffer a capital loss. Since the beginning of the crisis, the US Treasury has basically issued fixed rate debt. The long term portion of it, courtesy of Operation Twist, is being massively bought by the Fed. The short end, is accumulating in the balance sheets of the primary dealers. If interest rates were to rise, these dealers would suffer untold capital losses, and it would be politically difficult to bail them out. Therefore, the same dealers are pushing the US Treasury to slowly start refinancing this short-term fixed rate notes in their inventory with floating rate notes. That way, by the time interest rates rise, the problem will have already been transferred to the US taxpayer, who will be in a deeper hole.

What does all this have to do with our previous analysis of the repo market? Well, if floating rate notes are issued, they will have a strong bid from money market funds and liquidity will be enhanced in the repo market, which would continue funding the commodity futures markets.

However, with the US Treasury facing a higher fiscal cliff, the Fed would be forced to intervene buying not only the long-term, but the also short-term debt, to ensure that inflation transforms these higher nominal short-term rates into lower “real” rates. The Fed would not do this only to save the US Treasury, but also the private sector. Why? As short-term liquidity shifts from commercial paper to government-issued floating rate notes, levered companies (and we just said companies are pushing leverage) would have a hard time finding short-term working capital funding. Potentially, and only years ahead, this could well end in situations seen in Latin America, where banks offered weekly or weekend guaranteed investment certificates at high rates. Gold, again, would end up being “the” store of value. But this, this is years ahead and in the making.

The consequences of high frequency trading and the myth that it is needed to bring liquidity to markets

High frequency trading was brought back to light in the past week, after the tremendous losses suffered by the Knight Capital Group. We don’t have much time but want to simply say this: The whole idea that high frequency trading brings liquidity to markets is born out of a misconception of liquidity. And here, we go with the Austrian school: Liquidity is not and should never be intrinsic to an asset, but is the result of preference by acting men.

Secondly, High frequency trading does not even provide liquidity. It just plays the operational weaknesses of markets. In a casino, when the croupier says “rien ne va plus”, all the real bids are locked. In a stock exchange, it appears that this doesn’t happen, allowing high frequency traders to introduce false signals to trigger stop losses or profit taking. If that is liquidity, our markets are broken. It is another Ponzi scheme, with no real cash at the end, played within mili-seconds.

But the underlying point here is that we should not force liquidity into all stocks. If some are not liquid, it is for a reason and providing fake demand via high-frequency trading is an expensive mistake. If the world allows high frequency trading to continue, it will end, paradoxically, in illiquid markets. The real money will leave markets and flow to real assets, because if liquidity means being exposed to the manipulation of high frequency trading….why pay a premium to be liquid?

Martin Sibileau

Please, click here to read this article in pdf format:january-21-20111

We had our hesitations about writing today, for nothing new has occurred in the past sessions, right? Or has it…Well, yes, we know, you must be thinking that the recent sell-off in commodities, stocks and rates should be enough proof that perhaps the three key assumptions for 2011 that we presented in our last letter are weak at best…Well….think again.

Has anything happened this week that may challenge the assumption of further consolidation in Europe? No. In fact, we have heard and read many times about Spain’s resolution to inject more capital to its savings banks (i.e. “cajas”) and Ireland may end up paying a lower interest rate on the bailout fund. In the US, the weekly jobless claims data showed that at least, they did not increase. Anecdotally also, the S&P National AMT-Free Municipal Bond Index has withstood the sell-off in risk. Existing home sales data also surprised with a stronger than expected rise. The Philly Fed manufacturing survey remained strong, and leading economic also provided positive news. However too, a weak TIPS auction shadowed the UST market.

Ah, but of course, it seems that the main concern comes from China. Apparently, given the last release of activity data, China is growing even in the face of incipient inflation (officially gauged at around 5%) and investors fear that an interest rate increase is on the works…Who spread this rumor? Why was it spread coincidentally with China’s Jintao visit to the US? We have no idea. Has China not been increasing interest rates unsuccessfully? Yes, they have. Has China not just manipulated the cost of capital (i.e. rates) but also its quantity via increases in the reserve ratio requirements (RRR)? Yes, they have.

Any basic textbook of macroeconomics will teach us that when a country decides to fix the value of its currency, it loses control over interest rates. At least the “real” interest rates…The same applies to credit controls. History shows they have always, always failed. Why would China ignore these facts? Because they have nothing to lose with trying. Because they seek to delay the inevitable. However, today we want to show that these manipulations can actually have the opposite effect, if they are abused. For instance, let’s take their policy of increasing RRR to the extreme. Below, we show the balance sheets of the People’s Bank of China (PBOC) and the Yuan banking system, in a very stylized way. On the asset side of the PBOC’s balance sheet, we find mostly US Treasuries backing the Yuan. On the liabilities’ side, banks’ reserves. On the asset side of the banks’ balance sheet, we find reserves and interest-bearing assets (loans). On the liabilities’ side, deposits and their net worth.

We have divided the process of taking the reserves requirement ratio to 100%, in three stages. In the second one we can see that as loans mature, their net issuance decreases, to boost reserves. We assume here that the process is neutral: Higher funding costs have no effect on defaults and the banks’ aggregate net worth does not need to change. The overall impact is simply a change in the composition of the banks’ asset side of their balance sheet.

As aggregate leverage decreases to the extreme, as we can see in stage 3, the PBOC is simply left with US sovereign debt fully backing reserves. Effectively, all deposits have been invested in these securities. The financial savings of the Chinese people have been coercively “loaned” to the US sovereign. With this extreme example, you start to realize the folly of this monetary policy.

Implicitly, once leverage is taken out of the picture, the PBOC is irrelevant. Legally, it continues to serve as a lender of last resort, but China is left entirely at the mercy of the US Treasury. As the US approaches default, the value of its debt will collapse…and so will the value of the deposits of Chinese citizens! The irony here is that a run against China’s financial system would not be triggered by an internal development. Nevertheless, if the PBOC had to bail out a financial institution in this context (by extending loans and/or decreasing reserve requirements), the increase in money supply would be felt much more than if there was leverage. For on the margin, the new quantity of Yuan being printed by the PBOC would truly stand out.

Therefore, the Yuan would depreciate and it would do so at the worst time, exactly when the world would need a strong reserve currency. The contagion from the US to the rest of the world would be widespread and more violently than necessary.

How would the rest of the world sort this out? Gold would have to fill the void, which is why the recent weakness represents an opportunity to us.

Martin Sibileau