A View from the Trenches

A View from the Trenches, June 25th, 2009: On the state of confidence

Growing up in an arid ranch in northwestern Patagonia (Province of Neuquén), I remember that one summer evening, I noticed a very small crack in one of the many irrigation channel gates that we had for the alfalfa lots. Only a thin thread of water was running through it. I was too tired to fix it and went to bed thinking I would take care of it, first thing in the morning. In the middle of the night, I heard somebody knocking on the door. This person had come to tell me the thin thread of water had grown into a river, flooding the whole field, and compromising the foundation of one of the warehouses. By the time I arrived to scene, the small crack looked like a strait in the ocean; and I had to fix it in the darkness of night. This happened about 22 years ago, but the lesson was well learned and is still remembered. Today’s FOMC’s statement (http://federalreserve.gov/newsevents/press/monetary/20090624a.htm ) reminded me of that night 22 years ago. The Fed knows it has a p! roblem, but seems to have decided to ignore it. Or have they? I don’t want to waste intellectual capital here, but an alternative way to interpret this is to think that the Fed wants to keep some freedom to surprise us. There are literally thousands of papers in the Theory of Games that analyze the benefits and disadvantages of predictability in monetary policy. In my humble opinion, when policy makers engage in these games, investors are left with only one winning move: Not to play! Certainly, not everyone has the luxury of choosing to abandon. However, the verdict was unanimous. With yesterday’s announcement, the yield curve steepened (see chart below). Besides this, the markets are trying to recover from last Monday’s plunge: The S&P 500 ended 0.65% up at 900.94, while the CDX IG 12 tightened 4 bps to 141 bps. Oil is trying to get back to the $70/bl level (closed at $68.52). The recovery was helped with the release yesterday, of Durable Goods! orders coming higher than expected, up 1.8% month/month in May Vs. consensus of -0.9% month/month.

More generally and following the concept above, it looks like the “not-to-play” move is becoming popular. I can think of the share price of Citigroup, for instance. In my view, we could see this price way higher, if Citi was not so sensitive to the US government. It is, and the market does not want to play with Citi. Another example is the latest shows of wisdom by Mr. Carney, governor of the Bank of Canada. He surprised the markets first with his public concerns on the sudden appreciation of the Canadian dollar and later (on Tuesday), with the declaration that “Canada’s recession is as deep as in the US”. What did the market do? Decided not to play and the Canadian dollar plunged.

When investors decide not to play, naturally, investments are delayed. What follows is an interesting comment on this issue, from John M. Keynes, in his famous work “The General Theory of Employment, Interest and Money” (Ch. 12): “…The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms. In particular it has not been made clear that its relevance to economic problems comes in through its important influence on the schedule of the marginal efficiency of capital. There are not two separate factors affecting the rate of investment, namely, the schedule of the marginal efficiency of capital and the state of confidence. The state of confidence is relevant because it is one of the major factors determining the former, which is the same thing as the investment demand-schedule…”

(I will be traveling next week and will not be able to write this daily letter. “A View from the Trenches’ will be distributed again on July 6th. Have a nice week!)

UST Yield Curve: June 23rd (red) vs. June 24th (white) 2009

(Source: Bloomberg)

(If you wish to subscribe to this daily blog and receive it by email and in pdf format, please go to: www.sibileau.com/martin ...It's free!)

A View from the Trenches, June 24th, 2009: "How do you sort this out?"

(On yesterday’s letter, there was an error. On the first sentence, I meant to say that the Treasury was auctioning $104BN in T-bills and coupons this week. Instead, I said the Fed was. This is what happens when I write at midnight!)
I don’t usually follow macro statistics, but monetary aggregates and cash flows. However, two metrics left me thinking yesterday. First, it was the May release of Existing Home Sales. After reaching record lows for 30-yr mortgage rates in May, the months’ supply of unsold homes fell only to 9.6 months, from 10.1. With mortgage rates going up since then, further improvement in residential real estate is only a leap of faith away!
Secondly, I suddenly remembered that at the Facultad de Ciencias Económicas, in Buenos Aires, one learned that, as a rule of thumb, an ongoing government deficit that represents more than 5% of GDP is only a time bomb. Now, if only the gross US Federal debt is supposed to reach $10 trillions by 2010, it may be licit to think that servicing the US aggregate fiscal debt (federal + state + municipal + agencies) should easily represent more than 5% of GDP…I say “should” because unfortunately I could not find in any website precise data on this. Interestingly enough, this issue is altogether ignored in research reports, which usually make reference to fiscal deficits of other countries…
In summary, the fundamental dilemma we face on June 24th 2009 is how to effectively keep mortgage rates at a low level to encourage refinancing, which will drive home purchases and put a floor to home prices, while simultaneously the Fed monetizes deficits ($300BN scheduled for 2009), pushing nominal rates up (ref. www.sibileau.com/martin/2009/06/03 ). See, the problem lies in the deficits. We should not be focusing on what the Fed will say tomorrow at the close of its FOMC meeting. They cannot change the bottom line. Instead, we should be demanding from Mr. Geithner a healthy budget. Now, investors don’t think that will happen (and I agree) and therefore have retrenched, trying to defend every penny they made in this “rally”.  Equity and credit markets managed to keep relatively flat yesterday: S&P 500 up 0.2%, while CDX IG12 was 1 bp tighter at 144 bps. If you have been following the letters, you should not be surprised. Since day one, our thesis has been that as long as the Fed and all the other central banks keep flooding us with liquidity and feed us with daily announcements, we can see prices NOT falling (See www.sibileau.com/martin/2009/04/14 ), which would suggest that, in order to solve the aforementioned dilemma, in the continuous presence of deficits, asset prices NEED to fall, to make room for the government deficit. How do you think will this be sorted out? In the meantime, I thought I would show the “evolution” of the on-the-run UST yield curve, from June 8th, when we first sensed the current plateau, until yesterday. As we’ve been proposing, a sell off in equities should not bring an inversion of the curve, because the sell off would not be caused by illiquidity: 3-month LIBOR is at 0.6075%.

(If you wish to subscribe to this daily blog and receive it in your email and in pdf format, please go to: www.sibileau.com/martin )

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 23rd, 2009: "Is Credit the new Maginot line?"

This week, the Treasury is scheduled to sell $104BN. Yesterday, the Fed bought $7.5BN of them. As our last week’s letters suggested, the Fed has run out of time, governments are playing déjà vu policies, the markets “castled” on Thursday and yesterday, they retrenched…The chart below shows a “panoramic” view of the situation (left side) and the micro view of it (right side, source: Bloomberg). The left side of it was already described on April 14th (www.sibileau.com/martin/2009/04/14 ). Unfortunately, since the beginning of the month, in the absence of clarity (on an exit strategy) and the presence of regulatory noise (stress tests, TARP funds, credit derivatives markets, regulatory frameworks, etc.), the inflationary process has reached a plateau. We absolutely need to see, as soon as possible, bond issuances that will finance capital expenditures or M&A. Yesterday’s announcement of Xstrata’s proposal for a “merger of equals” with Anglo American was a good start (Anglo’s board rejected it already). But it was not enough to prevent the massive flight to Treasuries. Equities sold off (S&P 500 dropping 3.06% to 893.04pts), as crude had a serious plunge, from $73/bl last week to $66.93. Volatility spiked, with the VIX index jumping 11.36%, from 27.99 to 31.17…

Is there any hope left? If so, we will have to look at the action in the credit markets. Both the CDX Inv. Grade and High yield indices finished unchanged yesterday (at 4pm). But they are certainly wider compared to last week. The right side of the chart below shows how the USD strengthened vs. the Canadian dollar, a commodity currency, as the 30-yr Treasury rallied. There was not a lot of volume in Treasuries and, yes, it is true that the Canadian dollar in particular owes its weakness to Mr. Carney’s public concerns on the impact of the currency’s appreciation. We cannot blame Mr. Carney, since his is a difficult task (if not inconsistent): The Bank of Canada’s Act of 1934 (http://www.bankofcanada.ca/pdf/act_loi_boc_bdc.pdf ) says that Mr. Carney’s goals are: 1) To control and protect the external value of the national monetary unit; 2) To mitigate by its influence fluctuations in the general level of production, trade, prices and employment and 3) To promote the economic and financial welfare of Canada! Thus, expressing his concerns on goal no. 2, Mr. Carney failed us on goal no. 1. His public declarations since last week have very much depreciated (by my account at least) our currency 7 US cents/CAD (from 1.08 to 1.15). This mark-to-market “tax” on our purchasing power, was not approved by Parliament, obviously!

If credit is the last line of defense, can we see credit rally with Treasury yields rising? (As you notice, I am already assuming that yields will continue to rise) In JP Morgan’s June 19th issue of “Credit Market Outlook & Strategy”, the question is raised. In the report, it is suggested that as Treasuries yield rise, bond yields rise too. This increase in bond yields should encourage investors to invest in credit. The increase in Treasury yields, suggests the report is due to “increased inflationary concerns”.
What is the main assumption behind this thesis? Defaults don’t increase, as yields increase. Therefore, we are left to believe that the increase in bond yields is only reflecting future inflation. Under which circumstances does inflation NOT lead to defaults? In the theoretical construction of mainstream economists, inflation does not lead to defaults because it is neutral: The “general” level of prices rises, as ALL prices rise at the same time… But this is not realistic. Therefore, if inflation does bring defaults, do you think credit can rally with Treasury yields rising?

(Please find chart in pdf document at www.sibileau.com/martin )

(A View from the Trenches is not published on Fridays. Have a nice weekend! If you wish to subscribe to this daily blog and receive it in your email and in pdf format, please go to: www.sibileau.com/martin )

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 22nd 2009: "Retrenchment"

The chart below, which shows last Friday’s intraday action in 30-yr Treasuries vs. the S&P500 Index, says it all: Retrenchment. Indeed, personally, I don’t think we have made any progress last week. This is perhaps reflected in wider credit spreads (CDX IG12 20 bps wider, to 143bps), lower equity prices, and the action in mortgages last Thursday.

I have recently been thinking at the ultra-macro level. Bear with me, please. I’ve come to realize that since the French Revolution, humans have been growing up, have been raised, have been educated and are educating their children under the paradigm that proposes that value can be added by “creation”, by “innovation”. When we don’t innovate, when we don’t create, we assume no value is created.  But now think of the children in Ancient Greece: They grew up listening to the story of the sacking of Troy. Pillaging was honorable and Achilles was legendary three thousand years ago. There was honor in conquering. Value was added by taking, not creating. This notion must have lasted a while, because even under Elizabeth I, people were fascinated with characters like Francis Drake (and understandably so, given what Sir Drake contributed to the kingdom’s coffers). However, in those days, there was consistency between politics and economics. The political apparatus, the legal system, encouraged monopolies, sacking, taking from other nations, while our current “value creation” paradigm is not consistent. We are told we add value innovating. But our legal systems encourage oligopolies every time our central banks and governments decide to bail out dinosaurs; mediocrity, when economic success is taxed at increasing rates; and paralysis, when relative prices are manipulated and we ignore the future value of today’s medium of exchange. But value creation only works if people can accumulate capital. To accumulate capital, people must save. To save, people must know, ex ante, that what they save will be safe. Saving is boring and hard. It means restricting consumption today, in favor of consumption tomorrow. The British played this game right for a century, between say 1815 and 1914, thanks in many ways to David Ricardo. But then, then people thought they could cheat a bit. We thought we could get away without the hardships of saving, as long as we managed an “optimal” speed of money supply. We experimented a lot with it, particularly after World War II. Today, the latest expression of this illusion is the famous Taylor’s rule (http://en.wikipedia.org/wiki/Taylor_rule ). The illusion continues as we anxiously await now the FOMC meeting to tell us, on June 24th, what the monetization speed will be, what assets it will use (Treasuries, agency debt, mortgages). Uncertainty is preventing investors from putting their savings to work. More so, when we read of major regulatory reforms every week. The bottom line? I think we can step to the sidelines in equities and Treasuries. Will sellers of Treasuries continue to reallocate funds to credit? I don’t know. The waters are divided here, with some analysts on either side, both in investment grade and high yield. But under uncertainty and inconsistency, liquidity gains relevance once more, favoring index positions, vs. single names… What is left to trade this week? Event risk? I don’t like it…

June 19th, 2009 Intraday: 30-yr Treasury vs. S&P500 Index (orange)

Source: Bloomberg                                Analysis: A View from the Trenches

(A View from the Trenches is not published on Fridays. Have a nice weekend! If you wish to subscribe to this daily blog and receive it in your email and in pdf format, please go to: www.sibileau.com/martin )

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 18th, 2009: "The markets are castling"

One has the feeling the markets are sort of “castling”, as in a chess game. Castling is an interesting move. It allows reassigning resources (the rook) but also, in my opinion, it puts the ball back in your opponent’s court (the Fed). So, the recent rally in Treasuries, mortgages and the USD looks like castling to me. Castling is a defensive move. Thus, equities are lower (S&P500 closed at 910.71pts or -0.14% and credit is wider (the CDX IG 12 index has widened 17bps so far this week).
But we should never compare the capital markets with a chess board. They are not a zero-sum game and they are not determined, but are instead full of uncertainty. Therefore, I question the efficiency of castling this time!

Perhaps the most bizarre thing is the performance of Canadian risk assets. Only a few weeks ago, there was euphoria with Canada and the Canadian dollar. Today, the 2.33% drop in the S&P TSX Composite index to 10,067.26 was remarkable, when compared to the US action. It is clear by now that the insinuation of the official party to run a deficit is hurting. But maybe the rumor, the speculation that the Bank of Canada will manipulate the foreign exchange market is hurting more. On top of that, pessimistic economic data fuels the idea that the government will welcome demagogic policies. Which brings me to my next thought: How can the Fed dream of (as reported by Bloomberg yesterday) committing to a period of stable rates, while it simultaneously has to monetize deficits with purchases of uncertain final size? It is inconsistencies like this one that in the long term generate conflict…

As we outlined on June 2nd (“Meanwhile in Canada”, www.sibileau.com/martin/2009/06/02 ) and June 1st (“What can China do?”, www.sibileau.com/martin/2009/06/01 ), Canada will only profit from this crisis as long as two conditions are confirmed: 1) The Canadian dollar remains within a free and flexible exchange regime (and this includes no further regulation on Canadian banks) and 2) The government does not distort relative prices by running into deficits to save unprofitable businesses. Both conditions have NOT been met so far. We have heard from the Governor of the BOC concerns on the appreciation of the Canadian dollar and we have seen taxpayers’ monies being compromised to save unsustainable jobs in the automotive industry first, and in the pulp and paper sector now.
Why is Canada afraid of a strong currency? A strong currency means we can consume more of that the rest of the world produces. It means we can obtain capital goods from overseas at cheaper prices to improve our productivity. We deserve it! We earned it! Canada is presented with a great opportunity, but refuses to take it.  The equity and foreign exchange markets are speaking loudly of this.

Yesterday’s announcement on enhanced regulation in the US financial markets brought the equity price of financials down, as we naturally expected. While the BRIC nations meet, engage in stronger multilateral trade and capital flow exchanges, the reaction in the US is to continue the hostility towards capital markets. Special reference is always made to the credit derivatives market. Even defenders of capitalism like George Soros, who has also been influenced by the Austrian School of Economics (thanks to Karl Popper), believes that credit derivatives are instruments to blame for this crisis. Let me say this about the issue: Bureaucrats hate the credit derivatives market because derivatives tell it like it is! Derivatives provide transparency; allow a multiplicity of investors to express a view. Therefore, the full force of regulation is going to fall hard upon non-banks.

Credit derivatives are necessary, add value, provide efficiency and speed economic recovery. How? The current deleveraging process has generated a lot of idle capacity. To make sense of this extra capacity, companies need to achieve economies of scale. To get this scale, firms usually merge with or acquire competitors, to reduce costs and defend the prices of their output…
Who is going to finance the necessary M&A activity when the time comes? Banks? With what capital? If banks are denied capital relief by hedging leverage buy-out transactions in the credit derivatives markets, large syndicated deals will become very expensive or avoided at all. And that, friends, that is a huge burden on any economic system, particularly those that depend heavily on leverage. The burden is ridiculous, because after so many years of financial innovation, human beings are not going to profit from it. Rejection of credit derivatives based on volatility concerns sounds as idiotic as rejecting marriage to avoid the risk of having a divorce!

(A View from the Trenches is not published on Fridays. Have a nice weekend! If you wish to subscribe to this daily blog and receive it in your email and in pdf format, please go to: www.sibileau.com/martin )

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 17, 2009: "What if new Fed debt is the exit strategy?"

Last Friday, June 12th, Barclays Capital’s “Global Weekly Rates” report suggested that a possible exit strategy for the Fed may consist in the Fed’s issuance of debt. The hypothesis is not new. But from all the publications I read, this one seemed to me the most optimistic on this alternative. As I have not yet read any other work discussing the implications of the alternative, I will give it a try myself. To understand this process, I divided it in three “acts”. Let’s see…

-Act 1: We’re still in Act 1. The Fed is buying mortgages, agency debt and Treasuries. (In total, including the Term Asset Backed Lending facility (TALF), it will have bought $3 trillions by the end of 2009) In exchange, the Fed gives liquidity, US dollars (a liability for the Fed) to the sellers of the assets (the Treasury, agencies, financial institutions). This liquidity is inflationary. This liquidity, instead of distressed assets, is now backing deposits.

-Act 2: After obtaining congressional approval, the Fed issues its own debt, changing the composition of its liabilities: Less USD, more Fed certificates. Who buys these certificates? Holders of US dollars. Will they do so willingly? (Perhaps, Obama’s announcements today on financial markets supervision will open the door to allow the Fed to “direct” USD deposits). This could have a counterintuitive impact. The reduction in US dollars would tend to appreciate the USD and weaken Treasuries, because every US dollar that buys Fed debt is a US dollar that doesn’t buy Treasuries. Will Gresham’s law apply and further boost the value of the USD? What about interest rates? There would be a crowding-out effect here: Every US dollar that buys Fed debt is a US dollar that doesn’t buy corporate debt. Credit spreads should widen, as higher rates push leveraged players closer to default. If banks are forced to buy Fed debt, should their equity prices not fall? Who is going to fund US banks from overseas? Should Libor fall, as USD overseas become abundant, because foreign investors don’t want to invest their USD in the US jurisdiction? These are some of the numerous questions that would arise, if the Fed issued its own debt.

-Act 3: The Fed could eventually exchange its debt for Treasuries (with congressional approval). But the final picture is that of US banks backing their USD deposits with Fed debt, not US dollars. Should this not trigger another sort of Creditanstalt collapse? Should gold not reach $2,000/oz?

(To directly receive "A View from the Trenches" in your email inbox every day, please visit: www.sibileau.com/martin )

A View from the Trenches, June 16th, 2009: "Déjà vu "

Yesterday, investors looked for every excuse to rush to the exits. No definitions from policymakers, no confidence from investors. It is a very simple formula, very rational. On top of this, at 8:30am we had the release of the Empire Manufacturing Index, coming at -9.41 vs. an expectation for -4.60. Before the bell, equities in Europe and Asia were already down. But with this new piece of data, there was no doubt markets were going to sell. The S&P500 closed at 923.72pts (-2.38%). It was good day for the USD, after Russian Finance Minister Alexei Kudrin said that Russia has confidence in the USD and that there are no immediate plans to switch to a new reserve currency. Tomorrow, we have the BRIC nations meeting…Consequently, oil came down to $70.55, yields dropped, mortgages gained and swaps compressed. And gold…well, well, gold is at $932!

Let me put Mr. Kudrin’s statement in historical context. This weekend, after some heavy gardening work, I tried to follow the example of Niccolo Machiavelli, as described in that emotional letter of December 1513, to his friend Francesco Vettori. Machiavelli wrote:“…On the coming of evening, I return to my house and enter my study; and at the door I take off the day’s clothing, covered with mud and dust, and put on garments regal and courtly; and reclothed appropriately, I enter the ancient courts of ancient men, where, received by them with affection, I feed on that food which only is mine and which I was born for, where I am not ashamed to speak with them and to ask them the reason for their actions; and they in their kindness answer me; and for four hours of time I do not feel boredom, I forget every trouble, I do not dread poverty, I am not frightened by death; entirely I give myself over to them…”

I didn’t exactly enter any ancient court. I went to this link (from the Ludwig Von Mises Institute): http://mises.org/books/monetarysin.pdf , where I “spoke” with M. Jacques Rueff (1896-1978), who played a key role in the monetary history of France, in the 20th century. Thus, I fed my curiosity with the famous interview he gave to “The Economist”, on February 13th, 1965. The interviewer was the distinguished Assistant Editor, Fred Hirsch (FR). Among other things, M. Rueff had this to say:

“…In 1930 I was financial attaché in the French Embassy in London, and in that capacity I was responsible for the deposits of the French Treasury with British banks. They were the direct result of eight years of the gold-exchange standard, because we had kept the pounds sterling in London, as my colleagues in New York had kept in the American market the dollars that had been pouring into the French Treasury from 1927 onward. Then, in 1931, the failure of the Austrian Creditanstalt caused successive waves of repatriations; and it was this collapse of the gold-exchange standard that, without any possible doubt, transformed the depression of 1929 into the Great Depression of 1931.

FR: While you are on this historical episode, what would your comments be on the very widespread view that it was to a substantial extent French pressure on London at that time, through the withdrawal of sterling balances that was in part responsible for the general collapse later on?

Rueff: Let me tell you that, unhappily for the world, the French pressure did not exist, or was so mild that it had no effect. There is … a letter from Sir Austen Chamberlain, who was then Foreign Secretary in London, to M. Poincaré, who was Prime Minister and Finance Minister in France; it must be of 1928. Sir Austen said, “We know that you are entitled to ask gold for your sterling, but in the frame of the close friendship between Britain and France we ask you, so as to avoid trouble for the City of London, not to do that.” And we were, I must say, weak enough to comply with this request and not ask for gold. The fact that I had such important sterling deposits in London shows that we did not use this right to ask for gold. The adjustment, which would hardly have been felt if carried out on a day-to-day basis, was not made, and we had the fantastic boom of 1927, 1928, and 1929. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed. We were too gentle in complying with official appeals not to convert our sterling balances into gold. It is exactly the position in which we are now. We are moving without any doubt to the same kind of outcome as in 1931, because it is so clear that the dollar is approaching the end of its acceptability for payment abroad, and we shall have the same disruption of the existing system (Note: This disruption occurred on 17 March 1968). But in delaying it through various devices—by the increase of the quotas of the International Monetary Fund, the Roosa bonds, the central banking swap credits, the Basel agreement, the agreement of the Group of Ten, and all the rest—we are doing exactly the same thing, namely, delaying the correction of the U.S. balance-of-payments deficit. If we acted as genuine friends of our friends, we should do exactly the reverse.”

I would like to end today’s letter with a question: Do you think history repeats itself? Why?

(To directly receive "A View from the Trenches" in your email inbox every day, please visit: www.sibileau.com/martin )

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 15th, 2009: Running out of time

We continue the discussion from Thursday (“A View from the Trenches”, a.k.a “Tincho’s letter”, is not published on Fridays during the sailing season in Lake Ontario).  Since the start of the month, my tone has been more and more negative. On June 2^nd (published on June 3^rd: www.sibileau.com/martin/2009/06/03 ), I first proposed the idea that equities (S&P500) should stagnate. The notion was fleshed out again on Thursday. The chart below shows the market is telling us we’re right on this one…I wonder how long this can be sustained. We cannot say this market call was “luck”, for the suggestion was fully rationalized. I do not profess to call the markets, but whenever I propose a thesis, I fully elaborate on the reasons that drive me to such proposal. In this particular case, I said that behavior in equities is driven by a) Fed’s action and b) corporate credit’s dynamics. We thoroughly described this on June 10^th (www.sibileau.com/martin/2009/06/10 ) in terms of balance sheet transfers among the main stakeholders and summarized it all back again last Thursday. Let’s see...

a)       Fed’s action: Perhaps the best way to characterize the Fed in June so far is by its “lack” of action. The market is tired of rhetoric and wants certainty. Participants want to know whether the Fed will or will not upsize its Treasuries purchase program. The longer it takes to announce this, the more painful it will get. Speculation in this front gives birth to and also nurtures the perception that debt refinancing (maturities swapping) is nothing but a window of opportunity, which brings us to the next point:

b)       Corporate credit’s dynamics: The debt refinancing process has diminished the jump-to-default risk, which created a relative gap between Treasuries and corporate credit, pushing investors to sell Treasuries and buy credit. But again, this was only to account for the decrease in short-term default risk. In the long term, defaults caused by over leverage are still waiting for us, and it may not be pretty. Delays often give way to sudden and violent drama. (For the theoretical background of this, please refer to the concept of “malinvestments”, by the Austrian school of Economics. We elaborated on this idea on May 11^th: www.sibileau.com/martin/2009-05-11 )

Now, let’s ask again: How long can the stagnation in equities last, without a resolution (either up or down)?

I don’t think equities will plunge as a result of the Fed not pushing liquidity. Simply, because I don’t think the Fed will stop pushing liquidity. But in the next weeks, we may realize that investment demand did not pick up. And then? Well, then investors would really push the line, forcing an exit strategy from the Fed. But I think they will be disappointed, because a true exit strategy would have to be announced by Mr. Geithner, instead of Mr. Bernanke. And it should read a bit like this: “We will cut spending on the following areas…” If this scenario unfolds, the ugly picture of corporate defaults around the corner would show up, fueled by higher Treasuries yields. Equities would start to sell. 

WHAT WOULD BE DIFFERENT THIS TIME VS. 2008? THE SELL OFF IN EQUITIES MAY NOT BE DRIVEN BY FINANCIALS; IT WOULD NOT BE ABOUT ILIQUIDITY.  WHY IS THIS RELEVANT? BECAUSE DEFAULTS COULD NOT BE CORRELATED, CORPORATE CREDIT CURVES COULD NOT BE INVERTED.

(To directly receive "A View from the Trenches" in your email inbox every day, please visit: www.sibileau.com/martin )

A View from the Trenches, June 11th, 2009: A brief summary so far

Please, click here to read this article in pdf format: www.sibileau.com/martin/2009/06/11

This is a relevant week in the story of the crisis. I therefore think there is merit in taking a break to examine where we are at:

-Treasuries, agency debt and mortgages:
As I wrote yesterday, I think a big milestone in this story will be the repayment of TARP funds by banks. Approximately $68BN of the $200BN used to capitalize banks will be repaid. The big problem the US government has is the lack of an exit strategy. As an exit strategy can only be reliable if it comes from the fiscal side (lower spending), the US Treasury could take advantage of the circumstance to use TARP repayment proceeds to cancel debt. It would send and encouraging signal. BUT, at the same time, if they don’t send that signal, they will be sending another one, the wrong one. There is no midpoint here. If Mr. Geithner is not part of the answer, he can only be part of the problem. There really is no margin here. As for agency debt or mortgages, my view is that their respective pricing dynamics will be increasingly dominated by the scenarios laid out in Treasuryland. We saw a big sell off yesterday in the long end, pressing mortgages and swap spreads. The impact on main street is visible: Mortgage applications fell once again (although less than last week), by 7.2%.
On top of this, as we wrote on Monday (http://sibileau.com/martin/2009/06/08 ), politics is playing an increasingly relevant role. Yesterday, a substantial part of the action was driven by Russia’s concern on their US Treasury holdings and their public interest in reducing them. There will be a meeting next week in Yekaterinburg, Russia, where officials from Brazil, India, Russia and China will discuss the role of the USD as reserve currency. In the meantime, Bloomberg reported that Russia and Brazil announced plans to buy $20BN of bonds from the IMF, to diversify their currency reserves. On April 16th (http://sibileau.com/martin/2009/04/16 ), we quoted Jacques Rueff’s article on Special Drawing Rights, published on June 6th, 1969. It’s worth revisiting it. Let me add this: If the IMF starts issuing bonds to back reserves of creditor countries, they will be only acting as the “clearinghouse” for currency swaps between central banks. Why would the world need a clearinghouse? To better coordinate a smooth debasement of currencies. Like any other clearinghouse, the IMF would monitor “margins”. If they keep them low enough, the leverage party can go on…Not forever, but for a longer time. WHO WOULD BE THE BIG LOSER IF THE INITIATIVE TAKES OFF? GOLD!

-Corporate credit:
Given the lack of space, please let’s go back to yesterdays’ letter, where I posted a chart with the balance sheets of the main stakeholders in the TARP mechanism: http://sibileau.com/martin/2009/06/10 . As you can see, from step 1 to 4, the net position of the Non-financial sector resulted in an increase in their holdings of Treasuries and bank bonds and a decrease in cash. It was so, because when the crisis started, the flight to safety drove this sector to buy Treasuries, which were supplied to capitalize banks. And after the March 18th announcement by the Fed, when the refinancing window opened, Treasuries became expensive vs. corporate debt (and still are), which triggered profit taking. Given the dim prospect for Treasuries, the NEXT STEP may well be the net exchange of Treasuries for bank bonds. Even more so, if more institutions announce the intention to repay TARP funds. Ok, I know what you’re going to ask next…Who will buy then the Treasuries? My guess is governments, central banks. It must be so, to globalize, to diversify losses. This stands in sharp contrast with the aforementioned meeting of the BRIC nations to coordinate a smooth sell off of their Treasury holdings. What is the bottom line here? Credit can still rally, as the described reallocation out of govt. debt into financials takes place.

-Equities:
We’ve repeating that: a) Equities will not plunge as long as the Fed/ Central banks keep pumping liquidity. On this, I stand out as contrarian vs. mainstream economists, who focus on statistic data and believe in the neutrality of monetary expansion (i.e. changes in relative prices don’t matter, what matters is the changes in the general level of prices, which depends on the output gap of an economy); b) For equities to give another jump, we need to see a reliable exit plan from the Fed; and c) we will know equities can leap higher, when we see a change in the purpose of debt refinancing: less money for restructuring of maturities and more money for capital expenditures and acquisitions. In the absence of (a), equities will plunge. In the absence of (b) and (c), equities will stagnate and orbit into oblivion. It will be agony and expensive range trading!

-Commodities (or the opposite face of the USD):
The value of the USD is determined by the relative speeds of the Fed’s purchases of securities, vs. that of other Central banks’. It would seem other Central Banks want to take a break. However, the increasing yield in Treasuries is starting to play a counterbalancing force. What is the bottom line? There will be more volatility in FX crosses. In the meantime, we may see crude oil outperforming. Yesterday, the inventories data release were bullish (-4832k vs. +100k expected), which took oil to $71+/bl.

Disclaimer:The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person. All rights reserved.

A View from the Trenches, June 10, 2009: TARP funds repayment: What will the Treasury do with the money?

(This article can also be read in pdf format in my website: www.sibileau.com/martin )

Good morning,

Yesterday was a relatively quiet day, and judging by the closing of the session, ominously bullish. At close, swap spreads had
compressed with mortgage prices regaining some lost ground across the curve, and equities, as we had been expecting,
remained stagnant. The CDX IG12 and the High Yield 11 indices closed 1bp and 17bps tighter respectively. At 4pm, crude
oil touched $70/barrel and the S&P500 was +35%, at 942.43pts. Treasuries, however, resumed their falling trend, with the
curve steepening. Apparently, the market is now realizing an increase in interest rates is almost impossible in 2009. With this
calm environment, the VIX (implied volatility of S&P500 options index) fell to 28pts.
As much as you, I keep thinking what we can expect next. In this regard, I thought that perhaps there is an event that the
market is not paying attention to, but which is relevant nonetheless. I am speaking of the repayment of TARP funds. The U.S.
Treasury confirmed that 10 of the financial institutions participating in the Capital Purchase Program qualify for repaying the
TARP funds, an expected $68BN. These institutions, including JPM, GS, MS, AXP, BNY, BBT, COF, NTRS, STT and USB
indicated that they will repay the TARP funds…This is what I ask myself: If that the mechanism through which the Capital
Purchase Program was put in place had a profound economic impact, should we not also expect some lateral effects, if the
TARP funds are returned to the Treasury? If so, what technicals can we expect from the repayment of TARP funds?
I review the process, in the graph below, where I look at the balance sheets of the stakeholders involved in the transaction, at
an aggregate level: the Treasury, the US Financial sector, the Fed, and the Non-Financial Sector (US and non-US):

Steps 1 & 2: The US Treasury issued debt to raise cash, and buy warrants from insolvent banks. The cash was provided both
by the Fed (inflationary) and the Non-financial sector. This was bullish of the USD, now demanded, and prevented the credit
and equities markets from further bleeding. With the raised cash, the US Treasury purchased the warrants, capitalizing the
banks. The net effect was a transfer of cash from the Fed and the Non-Financial sectors to the Financial sector. This
capitalization reduced systemic risk: Libor decreased, the LIBOR-OIS spread tightened, credit rallied and equities stopped
plunging. Those with access to TARP money gained a competitive advantage over those who didn’t (as we always say,
inflation is non-neutral). Loans underperformed, as they were sold to clean balance sheets.
Step 3: The reduction in systemic risk and credit rally opened a window of opportunity for the institutions to issue non govt.-
guaranteed debt to repay TARP funds. The market favors the banks that can repay TARP funds over those who cannot. The
credit rally made Treasuries expensive: Profit taking took place in Treasuries, triggering convexity hedging in mortgages.
Equities can only remain stagnant, given the effect of rising yields in mortgages over home prices.
Step 4: The banks that issued bonds, use the proceeds to buy the warrants from the Treasury, repaying TARP funds…WHAT
WILL THE TREASURY DO WITH THE MONEY? HOW FAR CAN $68BN GET YOU IN THIS MARKET? If the
money is used to withdraw debt, will that be bullish of the USD. If it is bullish of the USD, could this trigger a
spiraling recovery process this summer? What if more institutions apply to repay TARP funds?

Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. The comments expressed in this publication provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments. The comments expressed in this publication are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.

"A view from the Trenches", June 9, 2009: If you can't explain it, blame it on "expectations"

"A view from the Trenches", June 8, 2009: The answer is political = Exogenous

(This blog is also posted on my personal website: www.sibileau.com/martin , where you can read this article in pdf format)

Since last Thursday (Tincho’s letter is not published on Fridays), the world has gotten a bit more complex. We have been saying since March that we do not take the myopic, mainstream view, that inflation is an increase in the general level of prices, or that it depends on the level of capacity utilization (the so called output gap, as abused by Paul Krugman) or that it is a function of something called “velocity of circulation”. Since March, we have proposed the view that inflation is a “process”. It is a chain reaction set out by an exogenous event, the issuance of liquidity that affects a particular market (Treasuries and mortgages in 2008/09). Inflation is not an increase in the general level of prices, but the distortion of relative prices (i.e. Treasuries vs. equities and credit). It has NOTHING to do with capacity utilization or output gaps, since regardless of their respective levels, the intervention of the central banks affects the fixed income markets all the same (otherwise, you end up not understanding how you can see the S&P500 index rallying from 667pts to 940pts).

Finally, the concept of velocity of circulation is also misleading. Most analysts are now amazed that the Fed may not only not size up its initial $300BN Treasuries purchase program, but also not even complete it! What is the reason? The yield curve is too steep! What amazes these analysts? That if the Fed carried out the announced Treasuries, Agency debt and mortgage-backed securities purchase, it would still have to add another $1,075BN (excluding other TALF, etc.). The velocity has not picked up yet, they still have another $1,075BN to go AT LEAST, and the yield is already bastardized with what they call “inflation expectations”, as in Friday’s front-end sell off in Treasuries.

Inflation is like pregnancy. You cannot be just a little pregnant (= you cannot target inflation). And just as you cannot say a baby was born without pregnancy, you can also not say that inflation was born all of a sudden. It started way before. What we’ve been saying for months, is in the newspapers now. It’s history. So, what do we focus on now? Let’s see…

I cannot give you a precise forecast. I do not profess to call the markets. But I can tell you this much: Most analysts may be up for a surprise. Why? I think they are reading the news the wrong way. In the past trading sessions, we have started to see the markets reacting to fundamentals. Let’s forget for a moment about the fixed income markets and credit (Credit is perhaps the new bubble, the new price distortion being fueled by the ongoing liquidity creation). Let’s focus on equities:

There is a widespread, mainstream view that we may well see lower lows in equities. This means that the S&P500 may fall below the 667pts March low. How? These analysts believe that because we have not yet seen positive activity data, but only “less bad” data, in the second half of 2009, when earnings are reported and the real ugly picture proves to still be there, equities will sell off. This sell off will also trigger a sell off in credit (bonds, loans) and the crisis will look even worse, with no other solution at hand than a bath of good old asset deflation…I respect this view. However, when you dig deeper, you realize this view explains future events in an “endogenous” way. The best way to show how it is endogenous is by negation: Because it is not exogenous. It does not involve, it does not include an external force. Central banks, politics, have no say in this. And I think this is wrong. The rally was due to an exogenous force: The Fed’s intervention. The sell-off, if any, may also well be due to an exogenous event. And if the cause of the problem is different, the results of the problem may also be different. Under an endogenous sell off, commodities underperform. Under an exogenous sell off, commodities outperform!(because if the cause is exogenous, investors can only vote with their feet)

Mainstream economists are so blinded by the mathematical approach of their analysis, that when you suggest a political influence in macroeconomics, they refer with despise to it as a “soft” explanation. Yet, their “hard” explanations have horribly failed them (They predicted a depreciation of the Canadian dollar to C$1.34/USD only a month ago, they recommended short positions in credit, etc.). Thus, in answer to the question above (“What do we focus on now?”), I think the answer is easy: “Politics”. What will decide if the Fed sizes up its purchase program (devaluing the USD) or not (increasing rates)? Politics! What will decide the GBP/Euro cross? Politics! What will drive the asset allocations of China’s central bank? Politics! Will the Bank of Canada start quantitative easing to soften the Canadian dollar’s appreciation? Politics is the answer! Which emerging markets will be most favored by easy USD-backed lines provided by the IMF to delay devaluations? Will banks in the US ever reach independence from the government, even after they repay their TARP debt? Will deposits at Citigroup be used to fund the Treasury’s deficit, now that Citi is government owned? Again, politics will answer this…If I deceived you with a lack of details on what we may see next, I have succeeded. Often times, questions are more important than answers.

"A view from the Trenches": Time to fly low: Hunters don't have enough ammo = They will aim better

(This blog is also posted on my personal website: www.sibileau.com/martin , where the article can be read in pdf format)

Yesterday, the markets found the excuses they were looking for to retreat into the so-called safety of Treasuries. I find it ironic, because there is nothing as fundamentally clear as Treasuries are the debt instruments of an insolvent debtor. Nevertheless, the excuses were essentially these:
-Mortgage applications: -16.2% vs. prior of -14.2%. Subito, the window of mortgage refinancing seems to have disappeared.
-Employment change: -532k vs. expected of -525k
-Weekly oil inventory data: +2.66MM bb vs. expected -1.5MM bb + lower refinery utilization (1.5% vs. 3.3%), sent oil down to $66s.
Beyond these excuses, the fact is the air is becoming rarefied. There are a lot of political manifestations that force investors to demand a premium on their liquidity. Everybody is by now aware of the precedents set by the General Motors’ bankruptcy process. Mr. Obama’s belief in the role of the Federal government to efficiently allocate its taxpayers’ moneys is even concerning Mr. Bernanke, who yesterday said that “large U.S. budget deficits threaten financial stability” and that “the government can’t continue indefinitely to borrow at the current rate to finance the shortfall”. This is nothing particular to the U.S. I am afraid. Perhaps a good example of how widespread the problem is can be found in the inevitable devaluation of the Latvian currency, the lati. On Wednesday, the Latvian Treasury failed to sell about 50 million lati ($99.9MM) in Treasury bills at auction. They got no bids! Zero! This situation immediately compromised the financial system of Estonia, the currencies of other Eastern European nations and the share prices of Swedish banks.

In Canada, we are playing with fire. I cannot believe how lightly the bailout of GM was taken by the public. Are the Conservatives so weak that they need to run into major deficits to hold power? Or are Canadians not represented at Parliament Hill, where the opposition claims to own such representation and pushes Conservatives into deficits? The pullback in the Canadian dollar to $0.9009 (or C$1.11/$) was mainly driven by oil data and USD repatriation. However, it has become evident that at the speed Treasuries are issued, the Canadian dollar will reach parity. This fact and the current 25bps target rate prevent the Bank of Canada (BoC) from taking any action. If the BoC wants to stop the Canadian dollar from further appreciating, it will have to raise rates. Politically, this is not feasible. If the BoC wants to further relax its policy, it cannot bring rates lower. The only way out is to play the Quantitative Easing rhythm. Is Canada prepared for it?

Back to yesterday’s letter, I want to repeat this: The market does not share my view that if the Fed was not to upsize its $300Bn Treasuries purchases, a horrible, ugly sell-off in this market will take place, with devastating consequences. The Fed currently buys approx. 1/3 of the issuance (Yesterday, a $7.5BN purchase of 7 to 10-yr, in line with previous buying in this range. The Fed already bought $138BN). Do you think the other 2/3rds of the issuance the market is currently demanding will still be there once the Fed stops buying? If you do, please, I’d love to hear why. Strategists at Bank of America/Merrill are contemplating the wisdom of the Fed not stepping up on the current program (Refer: “Situation Room”, BofA, May 29, 2009), while at Morgan Stanley, they conclude yields are only back to normal, as if this crisis could be approached by a “reversion to the mean” methodology (Refer: “The Global Monetary Analyst”, MS, June 3, 2009).

Finally, let’s push ourselves to think the unthinkable, that which can happen so sudden, we won’t have time to react:
1) Assumptions:
-The current political developments push protectionism to new levels, monetary policy coordination fails (this is not too far from reality lately).
-The transfer of risk from the private to the public sector has effectively taken place worldwide. The previous situation of IMBALANCES within the private sector is now extrapolated to the public sector.  Until 2007, financial institutions had misallocated private sector’s savings into unprofitable leveraged investments. In 2009, the property rights of such unprofitable ventures have been transferred to governments, creating IMBALANCES among nations. There are now creditor nations and insolvent debtor nations (or currency zones).
2) Thesis:
If one nation defaults on its debt (or cannot place it even in local currency) and/or pushes other nations into default, given the current shape of public finances, a real trade war would begin and we can see: a) Lower lows in equity; b) Wider wides in credit; c) lower commodity prices (oil back to $30s?) d) Gold’s best performance so far. FROM TODAY, I GIVE THIS SCENARIO A REASONABLE PROBABILITY. If it doesn’t take place by October/November (based on the Fed’s purchases schedule), that probability will sharply decrease.