To read this article in pdf format, click here: April 21 2013

Over the past week, I had three main topics in my mind. Perhaps, I should have considered more, but these are them: The plunge of precious metals, the policy of the Bank of Japan, and the debate on the Fed exit tools. I don’t want to write about the latest manipulation of the precious metals, but I have to say that I came across what seemed to me a lot of nonsense.  Maybe the weakest explanation is the one that simply states that “a correction was due”. And this explanation does not only come from those who don’t believe in gold. You have Marc Faber and Jim Rogers giving it too.

Below is a chart I used in a past letter. It shows the value of the US dollar in terms of Argentine pesos, both in the official and black market (blue line).

How do you think an Argentinian would react if I told him that the blue line is “due for a correction”? He would obviously laugh at me without mercy. Why can he afford to laugh at me? Because the US dollar market in Argentina is broken, and the paper USD market (i.e. certificates of deposit in US dollars), is no longer driving the market dynamic. The USD market in Argentina can therefore not be manipulated. It is driven by physical USD bills hidden under mattresses.

What about the value of the Deutsche Mark in gold during the ‘20s or the Yugoslavian dinar, in USDs, during the early ‘90s? Were those also not due for a correction? (charts below)….Just askin’…..

Technical analysis, both when the markets are broken (as in Argentina, Germany in the 1920’s or Yugoslavia in the ‘90s) or when they are rigged, is useless.

Let’s now concentrate on the events out of Japan. I know I am late to the party but after reading volumes of comments on this, I feel there is still something to be written. Most publications were limited to simply enumerating the changes in policy of the Bank of Japan (BOJ), while others just pointed out immediate, tactical consequences (i.e. volatility in Japanese Government Bonds, JGBs)…and then…then we had Robert Feldman, from Morgan Stanley, telling us that  Japan may still be saved.

The main take away for me is that the BOJ shifted from a tactic of interventions (under former Governor Masaaki Shirakawa) to one of monetary policy (under current Governor Haruhiko Kuroda) . What strikes me is that the monetary policy is precisely to….well, destroy their money and in the process any chance of having a monetary policy.

How the Shirakawa intervention worked

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, under Shirakawa, the Ministry of Finance issued Finance Bills, which were “bought” by the Bank of Japan, in Yen. Let’s call these first issues Finance Bills “1” and Yen “1”, which were issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (step 1). The Ministry of Finance was issuing “on credit”, because the issuance was going to later be repaid with funds obtained from the market:

Next, with the Yen1, the Ministry of Japan bought USDs in the FX market (step 2). The price of Yen in terms of USDs dropped as its supply increased.  At this point, the amount of Yen circulating in the market was higher than before this intervention took place. This increase in supply is the amount I call Yen1.

To bring the supply of Yen back to the original amount in circulation, the Ministry of Finance issued Finance bills in the market. I will call this issuance Finance Bills 2, which are shown below (step 3). The amount of Finance Bills 2 equaled that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:

Of course, as the Ministry of Finance went to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increased. As in any other bond market, as supply grew, yields tended to rise (i.e. price tended to fall), to encourage market participants to buy the increased supply.

Once the amount Yen2 was in the balance sheet of the Ministry of Finance, the Ministry used it to repay its outstanding debt with the Bank of Japan, which I called Finance Bills 1. Therefore, once this payment was done (with a lag), the balance sheet of the Bank of Japan remained unchanged and Yen1 were taken out of circulation. The Ministry of Finance had US dollars on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (step 4):

The 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. But it is also be interesting to show the intervention in terms of cash flows. In the graph below, we can see that de facto, the Ministry of Finance ended up as intermediary between the Government debt market and the FX market. In essence, the intervention “moved” Yen from the Government debt market to the FX market, and this was a “fragile” movement, because it was simple arbitrage.

Whenever an asset has two different prices, arbitrage arises and fixes the “anomaly”. You may wonder why I imply that the Yen had two different prices. I want answer with another question: Why would the JGB market need a “middle-man” (see graph below) to provide Yen to the FX market? It didn’t!

The JGB market was “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). Who ended up taking the loss? Who ended up buying US dollars at above 80-82 Yen per dollar? The Ministry of Finance did, which meant the average Japanese tax payer! The Japanese taxpayer subsidized the big exporting conglomerates of Japan, so that these would provide “financing” to the American consumer who remains broke. The subsidy was significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen would tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) lost purchasing power. Given the demand for JGBs, the temporary nature of the interventions (which did not shape inflation expectations) and the short-term of the debt purchased, the marginal effect of issuing Finance bills 2 was not relevant (i.e. on interest rates).

In the long term, with these interventions, the Ministry of Finance had P&L risk (i.e. the risk of having a loss, if the USD depreciates further) which could only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Under intervention, the Profit/Loss position of the Ministry of Finance was determined by:

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

Whenever the Fed undertook quantitative easing and the value of the US dollar fell, it generated a negative mark-to-market to the Ministry of Finance’s position (if they indeed mark themselves to market).

How the Kuroda policy works

Under Mr. Kuroda’s leadership, the BOJ will not be manipulating interest rates (i.e. price), but will target the monetary base (i.e. volume). The problem is that he pretends to be in control of both, when the fact is that this ancient truth holds: One can only control price or volume, but not both simultaneously.

The new policy consists of:

1.- Increasing the monetary base at an annual speed of JPY60-70 trillion (stock of JPY200 trillion by Dec/13 and JPY 270 trillion by Dec/14).

2.- To accomplish No. 1, the BOJ will purchase approx. JPY7 trillion in JGBs/month, on a gross basis. On a net basis (i.e. net of repayments), holdings of JGBs will rise by JPY50 trillion/year.

3.- JGBs purchased will include long-term issues (incl. 40-year, previously limited to 3-year maturities), raising the average remaining tenor of the BOJ holdings from 3 to about 7 years.

4.- Achieving a 2% inflation level as soon as possible

5.-Purchases will include also ETFs and REITs (Japanese)

With the Shirakawa intervention the market had to assume that the devaluing efforts were temporary, or at least not within a specific time frame, and consistent with a policy of keeping interest rates at zero. Challenging the BOJ was a frustrating experience. Under Mr. Kuroda however (and here is where I disagree with mainstream analysis), Japan is entering the uncharted waters of a Latin American-style inflationary spiral (very similar to the plan implemented by the late Martinez de Hoz, also called “La Tablita”).

The chart below shows the balance sheets of the involved economic agents:

As you can see, there is nothing fancy here. Given the magnitude of the monetary expansion, what is a big unknown is what will the net aggregate reallocation of JGB holdings be, outside the Ministry of Finance. Because the BOJ will not only buy issuance of the Ministry of Finance, but also existing stock of JGBs. For now, it is all speculation and the flows are monitored closely. The reader will find plenty of research material on where Japanese banks, pensions, insurers and households will reallocate the JGBs that they sell (if they sell them). I think they are and will be exponentially selling them, because the pace of the devaluation in the Yen will generate tangible profits to those doing so.

When one owns a fixed income asset with a negative interest rate, it is difficult to grasp that purchasing power is being destroyed. The asset is benchmarked against an arbitrary consumer price index. If at the same time there is a certain, known rate of devaluation in the currency of denomination of that asset, there is still difficulty in assessing whether if, in terms of other goods in the same currency (but not in terms of imports), value is being destroyed.

However, there is no doubt that under a known rate of devaluation, if that fixed income asset is swapped for another one denominated in the appreciating currency, there will be a profit. In the case of Kuroda’s policy, because the devaluation is not a one-and-for-all event but a certain, over-no-less-than-2-years process, the devaluation of the yen morphs into a “rate” of appreciation of foreign assets and prices of imported goods.

This rate of appreciation is therefore fungible into another magnitude: Yen-denominated yields. Therefore, a circularity ensues: Yen-denominated yields/spreads will incorporate devaluation expectations. As yields/spreads rise, the Bank of Japan will be forced to buy more JGBs, to keep yields within a level that it deems tolerable. As the BOJ buys more JGBs, the devaluation will likely accelerate.

It is important to understand that this circular, spiraling process can take place regardless of the RELATIVE reallocations done by the Japanese banks, pensions, insurers and households. What matters is that as more Yen is printed, more Yen is available and it devalues vs. the USD. The speed of devaluation will indeed be influenced by the relative reallocations above.

Additional observations on volatility and growth

Kuroda’s policy has and will continue to generate enormous volatility in the JGB market. That same volatility was likely a factor enhancing the effects of the manipulation in gold.

With regards to volatility in JGBs, I found interesting a suggestion made by Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, dated April 11^th. According to the authors, the volatility could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, it would help if the BOJ would improve its communications strategy. What I find of interest in this suggestion is that it is contrary to an increasing common belief regarding exit strategies available to the Fed. Indeed, when it comes to assessing the possible impact of balance sheet management by the Fed, analysts advise that we look at its US Treasury holdings in terms of 10-year duration equivalents. The actual distribution of maturities in the Fed’s holding is perhaps not so relevant. Ironically, this wisdom also comes from the Bank of America, although from a different team (i.e. Brian Smedley, Global Economics Rates & FX, “The consequences of a “no sales” Fed exit strategy”, April 10^th, 2013), as well as from BMO Capital Markets (Dimitri Delis, March 25^th, 2013). Personally, I side with the view of Ohsaki and Fujita: To me, distribution matters as much to the BOJ as it will to the Fed.

With regards to the impact on real growth of the Kuroda’s policy, I cannot mince words: It will be disastrous. Whenever the medium of indirect exchange of a nation is destroyed, no growth can ever be expected. The coordination process needed to allocate resources is seriously impaired. And to explicitly have the central bank tell their people that the monetary base will be doubled within two years is nothing short of destroying their medium of indirect exchange.

For some reason (unknown to me), Robert Feldman (Morgan Stanley, April 4^th and April 17^th, 2013) is more optimistic. He believes that Japan still has a chance, if the country implements what he refers to a “third arrow” policy. Feldman’s third arrow policy is a list of actions that would promote growth, in agriculture, medical care, energy, employment and electoral system….I wonder whether Mr. Feldman seriously asked himself why any initiative in these fields would require that the monetary base of the country be doubled by the end of 2014…

Conclusions

With the interventions under Shirakawa, the Bank of Japan did not need to sterilize, as it is clear from the mechanism previously described. The BOJ’s balance sheet remained unchanged at the end of the intervention. This supposedly meant that the BOJ was independent.  However, given the resulting long USD risk position by the Ministry of Finance (see step 4 above), in the long term, coordination with the Fed would have been required. In my view, it was exactly because the Fed’s (undisclosed) intention was to engage in never ending Quantitative Easing, that Japan was forced to implement the policy undertaken by Kuroda. Coordination with the Fed was impossible.

With Mr. Kuroda’s policy, we now have the BOJ with a balance sheet objective, the Fed with a labour market objective (or so they want us to believe), the European Central Bank with a financial system stability objective (or a Target 2 balance objective) and the People’s Bank of China (and the Bank of Canada) with soft-landing objective . It is clear that any global coordination in monetary policy is completely unfeasible. The only thing central banks are left to coordinate is the suppression of gold.

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

Suppose you own a business and 1/3rd of your product is being bought by a single customer. What if this biggest customer tells you that as of June, he or she will stop buying? What do you do with your inventory? Exactly! You liquidate it in a fire sale! You had been selling what this biggest customer was buying, and then buying what you thought this customer would buy next. This has been precisely our thesis No. 1. As the chart below shows, after the Fed’s announcement at 2:15pm yesterday, Treasuries (long-end) sold off. (There was also profit taking in the Agency market):

The FOMC (Federal Open Market Committee) expressed no change in the plans to buy $1.25 Tr of Agency mortgage-backed securities, $200 bn of Agency debt and $300 bn of Treasuries. There was also no change to the fed funds target range. At 1:22 pm, Mr.Volcker, Chairman of the newly formed Economic Recovery Advisory Board and Chairman of the Fed between 1979 and 1983, had said that the current administration was committed to supporting banks. I think that led the market (and me) to believe there was going to be an upsize in Fed’s Treasuries purchases and, as the chart shows, that pushed Treasuries up (for a short time). The FOMC said the economy continued to contracting, but at a slower pace (GDP -6.1% q/q annualized).

I can’t understand stocks. The S&P 500 shot up on the news, and although it ended lower, it was still +2.16% (873.64pts). Why is this hard for me to see? If the long-term (30-yr) risk-free yield rose above 4% post-FOMC and the USD fell against the Euro and the Canadian dollar (=outflow of capital), why are stocks higher? (The USD rose against the yen and Pound, but this reflects and does not explain the rise of stocks). Isn’t a risk-free 4% yield good enough? Maybe it isn’t so risk-free … To make things more interesting, Treasuries in the short-end (2- yrs) had a solid bid, steepening the curve at close. Before I continue, I must say, thesis no. 3 (proposed on Friday) was refuted yesterday (= I was wrong!). There was no announcement of an exit strategy and stocks went up. I could say that to stop buying (FOMC statement) somehow indicates the way out (exit) of this mess, but I think the Fed is only bluffing, and it will keep buying anyway…Perhaps, we may have to first look at the credit markets. The CDX IG12 index finished at 168 bps (-9bps) and the High Yield index also did well, about 2 pts up. Even the leveraged loan LCDX index rose more than 1 pt. What is this supposed to mean? Maybe the market is seeing a light at the end of the tunnel. Perhaps the Chrysler negotiations are positive, the distressed debt exchanges we are witnessing will really avoid defaults, perhaps the bank issuance coming outside of the FDIC-backed program (Goldman Sachs sold yesterday $2BN 6% 5-yr notes priced at T+410bps) is also a good sign. If this is the case, the market may wait for a confirmation this Friday, with the release of the ISM Manufacturing Index, before it moves anywhere (Readers’ feedback is welcome)…On this basis, I will wait until Friday, before I reject thesis No. 3. ONE LAST THOUGHT: If we are comfortable with a 4% long-term yield, with double-digit debt exchanges, with oil going higher on oversupply and stocks higher on awful news, maybe Keynes was right when he said that (refer April 28th letter): “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…” (General Theory, Chapter 13, published in 1936). We may indeed need more money to maintain the higher yields, to repay the double-digit maturities, a barrel of oil, Citibank shares or my morning coffee! I only hope that more money is also needed to pay your and my salary!