March 2010 - Posts
Please, click here to read this article in pdf format: march-31-2010
This Monday, we attended a conference of The Economic Club of Canada,
which had Mr. Paul Jenkins, Senior Deputy Governor of the Bank of
Canada, as speaker. From the brief presentation titled “Beyond Recovery:
Sustaining Economic Growth” we conclude the following:
-The Bank of Canada is most likely not going to explicitly intervene,
if the Canadian dollar reaches parity and beyond. The speech itself was
a message to Canada’s export sector to increase productivity to
confront this appreciation. The operative word here is “explicitly”
because as we have written many times here, the Bank of Canada does
actually intervene in the market via its repurchase agreement
transactions.
-During the question period, we asked Mr. Jenkins about the Bank’s
view on sovereign credit default swaps. We posed this question in a very
open way, to test the reaction. Our impression was that Mr. Jenkins was
not familiar with this asset class, as he referred us to upcoming G-20
meetings that will address regulatory matters related to the issue. We
cannot blame him, since Canada has so far never been quoted in the
sovereign credit default swaps market, given its relatively solid
financial position.
-We are concerned about the view the Bank of Canada has, relative to
the environment the country is in these days. We do not want to get too
theoretical here, but we think the Bank of Canada still holds the
nineteenth century view that value is based on the productivity of
production factors. The Bank is lately making comments on the
productivity of Canada, on the belief that if productivity increases to
match the appreciation of the Canadian dollar, the country will remain
“competitive” and avoid inflation.
Why are we concerned? Well, what is productivity anyway, and why do
you think the Canadian dollar has appreciated?
I am sure most will agree with the opinion that the latest
appreciation of the Canadian dollar, in light of the increasing
sovereign risk concerns coming both from Europe and the US, was driven
not only by the “commodity bid” that accompanied the recovery of 2009,
but also by the “safe-haven bid”, which has left this currency almost
neutral vs. gold. We first proposed this thesis back in June 2009 and
refreshed it on March 4th (refer: “Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 and “The stars
favor Canada”, in: www.sibileau.com/martin/2010/03/04 ).
If we are correct, Canada is not only competitive supplying the world
with commodities, but with financial, fiduciary services too. The main
fiduciary service is ironically supplied by the Bank of Canada (which
means its staff is grossly underpaid) that seems to be very competitive
providing a reserve asset to the world. In fact, perhaps this country is
way more productive exporting a reserve asset than oil or gas or mining
products or engineering services. But would this productivity be
included in the Bank of Canada’s calculations? Why not? Why should we
worry if we are not more competitive than Brazil destroying our forests
to win the forest products market? Why should we be concerned if we are
not effective contaminating our boreal landscape with oil sands projects
so that we may compete with the Saudis in the energy sector? What is
wrong with being competitive with fiduciary services? The Bank of Canada
of course doesn’t share our perspective and will never clarify that
they implicitly make a subjective judgment on productivity.
Lastly, for those interested in the formal aspect of this discussion,
we refer to the concept of a “Social welfare function”, under the
Theory of Public Choice. In our opinion, for the Bank of Canada, this
function is:
W = y1 + y2 + …+yn ,
where W is social welfare and Yi is the income of a sector i among n
in the Canadian society. To maximize the social welfare function we may
seek to maximize for instance the income of sector 1 at the expense of
sector 2, if we deem sector 1 is “more productive” than sector 2. Does
it make sense to you? In our view, the function (and by the way, we
don’t think there is such a thing as a social welfare function) should
be: W = y1 =y2 =…=yn. But this is a discussion for another time!
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-29-2010
The main factor driving last week’s action was the summit of the
European Union, and its declarations regarding Greece (We could also
include the US Healthcare bill as another factor, but its consequences
are still unclear). In particular, France agreed with Germany to allow
the IMF to be engaged in a potential aid package. The reaction from the
European Central Bank (ECB) on this resolution was mixed, with Mr.
Trichet first suggesting it was a “bad idea” and later supporting it….
The ECB has no alternative but to show support.
We bring Greece’s situation to your attention today for two reasons. The
first one is related to our comments back on February 10th (refer: www.sibileau.com/martin/2010/02/10 “An
Institutional perspective on the Euro”) when we had anticipated
this outcome. Back then we wrote:
“…If the IMF has to intervene, the European Union will definitely be
a Confederation. This is unfortunately the path of least
resistance. This is the easiest and less painful path. If the
IMF is engaged, the Euro will no longer be considered an alternative
global reserve currency and the bid that there was under such belief
will no longer be there. We shall be sellers of Euros under this
scenario. This is the worst-case scenario, for if the EU
citizens lose purchasing power, the global recovery will become a
long-term dream. Note that we don’t care about Debt/GDP ratios or other
metrics. The relevant issue here is that on the margin, the Euro would
no longer offer more safety than other strong, healthy currencies. In
fact, its complex institutional framework would be a burden, compared to
other ones, simpler to understand…”
The second reason is related to our comments back on January 7th and
22nd (refer: www.sibileau.com/martin/2010/01/07 “Don’t
forget Greece” and www.sibileau.com/martin/2010/01/22 “What are
they thinking?”). Last Thursday, the ECB decided to extend its
emergency collateral rules into 2011. The decision was naturally
welcome by Greece, with Prime Minister G. Papandreou explicitly saying
it will “greatly assist banks”. We had also anticipated this move, when
we wrote:
“…Whatever assistance Greece may get from Europe will not be
explicit. Nobody will face the scrutiny of public opinion or the moral
hazard of such a move. As I wrote earlier, I believe Greece still has a
lot of tricks at hand that can use to its benefit, to keep financing its
current deficit. One of them is with the private placement market. If
Greece continues to use it, selling its debt to local banks (which take
deposits in Euros), then Greece will have infected the Euro zone with
its disease, forcing the European Central Bank to provide
liquidity lines to its financial system. This would be a hidden way to
support the deficit and I would be surprised if it is not explored…”
We are not gurus. We do not have the crystal ball at “A View from
the Trenches”. If we were able to predict this, it is because we’ve
seen and lived through it before. Greece in 2010 is going through the
same dynamics Argentina went through in 2000. When we identified this
link between the ECB and Greece, we suggested to focus on the spread in
the credit default swaps market between the National Bank of Greece SA
(NBG) and Greece’s sovereign risk. We chose NBG only because its credit
default swap is the most liquid of the Greek banks’ financing the
government. As you can see in the chart below (source: Bloomberg), this
spread has widened since we first addressed it on January 7th.
It is clear that the “infection” of risk transferred from the
sovereign to the financial system is in full effect, with Greece’s
sovereign risk now tighter than that of its banks (We understand (but cannot confirm) that
Greek banks already have bought half of this year’s issuance by the
Greek government). If the ECB validates this transfer, something to
monitor as the collateralized BBB- liquidity lines are used, the spread
should narrow to lower absolute levels. What would have given in then?
What will have been the escape valve to address the imbalance? The value
of the Euro, which should fall (all other things equal), with this
quantitative easing measure. Therefore (as we warned on Dec.17th (www.sibileau.com/martin/2009/12/17 ), on occasion of
Greece’s initial EUR2BN private placement) , all those who invest their
savings into Euro-denominated assets will be subsidizing Greek
taxpayers. It is a hidden tax, and one that neither Merkel nor Sarkozy
need to explain to their constituents. For the rest of the world, in our
view, this loss in European purchasing power will be a drag on global
economic growth.
Another point we would like to make here is also related to the
summit of the European Union as well as to our comments on Canada, made
on March 4th (www.sibileau.com/2010/03/04 ). Essentially, we have
put forward the notion that Canada and the Canadian dollar are no longer
receiving just the “commodity bid” (i.e. “mercantilist bid”), but also
the “safe-haven bid”. We suggested that to visualize this, one could
follow the spread between the ETF “XIU.TO”, that tracks the S&P TSX
60 composite (orange) vs. the ETF “IGT.TO”, which tracks the price of
gold, in Canadian dollars. We updated the chart first shown on March
4th, below (source: Bloomberg):
This spread widened as the Greek situation worsened, as anticipated
back on March 4th, and it tightened last week (i.e. as gold increased in
Canadian dollar terms, the TSX fell), following the summit of the
European Union. We think this proves our point.
And lastly, a word on “method”, as followed at “A View from the
Trenches”. On Mach 22nd we said that “…What is about to happen
politically and in terms of monetary policy has never been seen before.
Therefore, any quantitative assessment done based on historical stats
will be pure misleading inference…”
Think about what we’ve done above: We proposed a theory (hypothesis),
suggested a proof (thesis, i.e. focus on the spreads described above),
and later tested the hypothesis (demonstration: sovereign vs. financials
spreads, and XIU vs. IGT). We like the deductive method because we
think that there is nothing more practical than a good theory. Other
analysts play a pure inference game. They take observations going back
to the ‘70s and give you, for instance, the inferred probability that a
certain event will trigger an expected result. We think this inductive
approach is misleading and totally clueless, although it always looks
more “scientific” because those suggesting such inferences are
statisticians providing trading ranges. However, we could provide
trading ranges in our deductive approach as well (We don’t provide
trading ideas in this letter for obvious compliance reasons though). The
trading range game and its cousin, the so-called “tail risk”, is what
gave birth to correlation books and to synthetic CDOs among other
things, and we all know how it all ended. They were the product of
inductive reasoning.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-25-2010
Where to start today? There is plenty to discuss, so we will try to
summarize, if possible. Unfortunately, we think it is possible. Indeed,
perhaps the most commented news yesterday, aside from the European
summit beginning in Brussels today, was the drop of the 10-yr US swap
into negative territory (chart below, source: Bloomberg).
Many explanations have been suggested. Let’s first describe what we
mean by negative US Swaps. The swap is the difference between the 10-yr
implied Libor and 10-yr Treasury. When this spread is below zero, it
implies (=the operative word here) that the market prefers private risk
over Treasury risk. It implies deterioration in Treasury risk. But it
does not mean there is one, not at least this time, in our view. More
likely, we think, the negativity of this spread is driven by a
technical, namely the rush to hedge fixed-rate positions. In this we
agree with some analysts, and believe the negativity is a result of the
recent increase in long term issuance.
How can we summarize this? This move in swaps would be consistent with
the following chain of events: Ongoing recovery –> Higher interest
rates –>refinancing wave (last chance) in corporate credit (long-term
for short-term)–> hedging needs driving long-term swaps negative
–> credit spreads underperforming swaps stocks pushing higher gold
lower
Consistent with this line also, we show stocks vs. gold (chart below,
source: Bloomberg), in Canadian terms (TSX 60, represented by the ETF
XIU.CN vs. IGT.CN, gold in Canadian dollars). This is a relationship we
suggested on March 4th and which is proving us right, for it makes
money.
Two last comments: We are not showing the corresponding chart today,
but we want to bring your attention to the upwards move in Libor. This
was widely expected, even before the Fed announced its intention to pay
interest on reserves. The other comment we want to make goes back to our
letter from March 4th (www.sibileau.com/martin/2010/03/04 ) and is also
in line with the chain of events above. It is about Canada and the
Canadian dollar. With Canada’s less problematic (on relative terms)
fiscal situation and public refusal to regulate as much as the rest of
the world, the Canadian dollar/market is increasingly getting the “safe
haven” bid. This is reflected in the EURCAD cross, in our view. The
bottom line here is that “mercantilist” explanations (=Canadian strength
explained by commodities strength, foreign trade) will be less relevant
going forward. Even with higher interest rates in the US, the Canadian
dollar should do well, ceteris paribus. Of course, nothing is ever
ceteris paribus. But if you ask, we think that the changes about to
come, affecting the European Union, are actually supportive of the CAD
too. What could derail Canada’s path? Canadians! Yes, the Canadian
government, and therefore we worry every time we read Mr. Carney’s
“mercantilist” concerns on Canadian productivity vs. a strong CAD. It
makes no sense to us.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-22-2010
To be fair, one could say that during last week, nothing really new,
really surprising, took place. Instead, we saw the revival of
“repressed” market themes and fears, that helped volatility rise last
Friday. Those themes or fears are:
-Inflation: Under this theme we have to include two
sub-themes: Aggregate price level and asset prices
Last week we learned about increasing pressure on the aggregate level
of prices (however this is measured by the monopolies that are the
Reserve Bank of India or the Bank of Canada) in India and Canada, adding
to the inflation fears in China. India saw a policy rate hike and the
market now discounts one in Canada, over the second quarter of 2010.
We are clearly at an advanced stage in the credit expansion process
(initiated on December 5th, 2008 at 2 pm, when the Fed bought its first
pack of Agency debt within its Agency debt purchase program, which ends
this month). We use the operative word “clearly” because, by now any
digression in the markets’ expectations vs. the “rate” of money supply
results in a clear hike in volatility and valuation correction. This is
now a structural problem and it will get worse before it gets better.
From an asset price perspective, the unintended consequences of
quantitative easing policies are unfolding, leaving us in awe. Last
week, two research teams (BofA and Barclays Capital) published separate
and interesting comments on how fertile the environment is today for a
renaissance in LBOs (leveraged buyouts). Yes, while the world is seeking
to deleverage, the unintended consequence is that credit spreads and
rates have tightened enough to grant LBOs. Of course, such LBOs would be
limited to a certain segment of credits and banks are more regulated
than before. Nevertheless, the mere fact that this is a possibility and
that speculative trades are recommended thereupon has caught our
attention. We took note.
-Political risk: Regulation and protectionism
Honestly, we dislike discussing political risk. Even more so when such
risk is in the developed world. But the risk is there, unfortunately and
may affect us through the FX market. We will make only this comment on
the US-China dynamics: We don’t think that China’s goal is to hold the
value of the Renmimbi steady. What China wants to hold steady is the
financing of US sovereign debt. Furthermore, we see such purchases as
one of the most flagrant injustices in the history of income
redistribution. Every time the People’s Bank of China buys US debt,
millions of Chinese workers are being denied the opportunity of a higher
standard of living, for the benefit of fellow exporters who, at the
same time, have no alternative but to deposit their profits offshore, in
safer harbors like Australia or Canada. This is a disgrace which
ultimately can only be resolved from within. But China is not a
democracy and any shift from the current status quo will be against
established interests. The more the US pushes the line here, the farther
we will be from reaching a solution. In the meantime, this is
unsupportive of the USD and supportive of the Canadian dollar.
-Europe’s institutional problems
Last week, Germany publicly invited Greece to explore the possibility of
a solution outside of the European Union. From the beginning, we have
dissented with the mainstream view (held for instance by Jeffrey
Rosenberg, from BofA) that Greece’s problems are only a short-term
liquidity issue (refer: “An institutional perspective on the Euro”
www.sibileau.com/martin/2010/02/10 ) We have said
that the Greece situation reflects an institutional problem that
endangers the very existence of the Euro. We think we were right on this
one. In fact, more than a month ago, we said:
“…As investors, what should we interpret as a catalyst, as a
defining moment? Here’s our view: If the IMF has to intervene, the
European Union will definitely be a Confederation. This is unfortunately
the path of least resistance. This is the easiest and less painful
path. If the IMF is engaged, the Euro will no longer be considered an
alternative global reserve currency and the bid that there was under
such belief will no longer be there. We shall be sellers of Euros under
this scenario. This is the worst-case scenario, for if the EU citizens
lose purchasing power, the global recovery will become a long-term
dream…”
And as soon Germany’s position was known on Thursday, the Euro
suffered materially. In summary, we think that this spring, the world
will enter into totally unchartered territory. What is about to happen
politically and in terms of monetary policy has never been seen before.
Therefore, any quantitative assessment done based on historical stats
will be pure misleading inference.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-18-2010
Since European leaders confirmed their support to Greece a few days
ago and the Fed repeated that “economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for an extended
period” in their last Federal Open Market Committee statement, the rally
in stocks and credit, driven by a lower USD has continued, reaching new
highs. What seemed to be the next and unavoidable hurdle for the
market, the oversupply of Agency debt once the Fed stops it purchase
program, is no longer a concern. This week a few market analysts have
revised their demand expectations for this product and it appears the
demand will be there (refer: “Against All Odds”, US Fixed
Income Situation, BofAML, March 12th and “Where next for the
Treasury Market?”, Fixed Income and FX Research, UBS, March 17th ).
Will the demand be there for mortgages because they are intrinsically a
good product? No, they will be there because alternative investments in
credit are already too tight and traditional mortgage investors are
underweight this product.
If this sounds counterintuitive, then let us add that although most
agree that credit is already too tight and can still become tighter,
default expectations have not necessarily decreased, particularly in
High Yield. Finally, fundamentals are signaling a stronger than expected
recovery in the US, Canada and Europe.
Is this all the lagged consequence of the earlier quantitative easing
policies? Certainly, but why should we care?
In our view, the latest action in the markets proves that they are
dependent on a given rate of money supply. This is a difficult concept
to grasp in the developed world, for it is the base upon which the
dynamic theory of inflation was developed. A rate of money supply is a
dynamic concept, and we are used to think in “comparative static” terms.
The dynamic approach to inflation evolved during the ‘60s, mostly under
the so-called “heterodox” line of economists. In Latin America, Dr.
J.H. Olivera’s contribution to the theory is widely acknowledged.
Basically, this line of analysis sustains that agents in the market “get
used” to a rate of money supply, which they incorporate in their
expectations. For instance, if you have the Fed buying, say, $10BN of
mortgages/week, the respective market incorporates this liquidity metric
and invests accordingly. It is a “sticky” expectation and the problem
with it is that policy makers begin to interpret that the problem is
with the markets, in that they expect “irrationally”. More so, when an
exit strategy like that of the Fed is being widely publicized. But this
interpretation is incorrect, because it ignores the non-neutrality of
the rate of money supply.
Regardless of expectations, the intervention of central banks in the
rates markets has a real impact that distorts relative prices. In our
present case, the intervention has been steady and consistent, and we
have become too comfortable with it.
Think about it for a moment. Think about the message the markets are
sending: “Don’t worry about the upcoming supply of public debt, because
there will be demand for it”…But, what is supporting that demand?
Low-yield investment alternatives and a sea of liquidity. Where does
that liquidity come from? From the Fed’s purchases of public debt, which
reminds me of chapter XII of “The Little Prince”, by A. de
Saint-Exupéry, reproduced below:
“What are you doing there?” he [The Little Prince] said to the
tippler, whom he found settled down in silence before a collection of
empty bottles and also a collection of full bottles.
I am drinking,” replied the tippler, with a lugubrious air.
“Why are you drinking?” demanded the little prince.
“So that I may forget,” replied the tippler.
“Forget what?” inquired the little prince, who already was sorry
for him.
“Forget that I am ashamed,” the tippler confessed, hanging his
head.
“Ashamed of what?” insisted the little prince, who wanted to help
him.
“Ashamed of drinking!” The tippler brought his speech to an end,
and shut himself up in an impregnable silence.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-16-2010
Since our last letter on Thursday, we’ve seen the S&P500 seeking
to reestablish the 1,150pts level to move forward. The macroeconomic
backdrop seems firm enough to grant it…, if one forgets the fiscal side
of the equation…. We were surprised to see a sharp intraday drop of the
EUR/JPY cross yesterday, without major consequences for Treasuries,
which remained flat. Yesterday, one had the impression that US assets
were sold and JPYs were repatriated, without any consequence on other
crosses (EUR/CAD) or markets.
In summary, if we could ignore the upcoming challenges for the Agency
debt market, the US municipal debt market, the sovereign market, the
Fed’s “engagement” of money market funds, China’s credit policies and US
and European regulatory initiatives, we could say that world is going
to get better… right? Indeed, it all now depends on the willingness of
politicians worldwide to lead us through the right path. In the 1920s,
about three years after the Bolshevik Revolution, someone wrote an
impressive article, originally titled “Die Wirtschaftsrechnung im
Sozialistischen Gemeinwesen”. The article later led to a chapter within
another impressive book, titled ”The impossibility of economic
calculation under socialism”. To the majority of economists today, the
author of this article remains unknown…Will we ever read something
similar about this crisis? Will somebody ever write “The impossibility
of economic growth under monetary stimulus”?
Consistent with the challenges mentioned above, in the next three
months we need to see the construction of a private/public demand/supply
framework for Agency debt, the sustainability of municipal/state
finances, the successful refinancing of Greece’s debt maturing within
this period (the majority of it), stability of credit policies in China
(no manipulation of the credit multiplier, to compensate for the
imbalances created by the pegged Yuan), and no major destabilizing
regulatory measures in the developed world on the financial system. If
all these criteria were met, the only next hurdle would be the central
banks’ exit strategies coming in the second half of the year.
All of these stepping stones will require an increase in the saving
rate of citizens worldwide. Sustainable fiscal deficits, if any, not
only require cost cutting firstly, but also higher taxes. Sovereign
access to liquidity under a scenario of rate tightening demands other
issuers to be crowded out. Not intervening the credit expansion in China
calls for a higher Yuan or lower demand of Treasuries. However, the
issue of higher regulation in Europe and the US, in our view, is rather
politically driven.
What sense can we make of Senate Banking Committee Chairman
Christopher Dodd’s plan to empower the Fed to break up institutions that
pose a “grave threat” to U.S. economic stability? If any, the Fed,
above all, should be the first large institution to pose such a threat.
Does it make any difference if you have 5 rather than 100 highly
leveraged banks? In the age of computing, why would it be more difficult
to consolidate 5 rather than 100 balance sheets? If Canadians had been
allowed to buy houses without equity at no extra cost, would it have
made any difference the fact that there are only 5 big banks?
As we follow the developments of these issues, we can only be certain
of this: With this global political uncertainty, no serious stock of
capital will be rebuilt. Without such capital, no productivity will be
gained. And without productivity gains, unemployment will be
omnipresent.
In the meantime, because the upcoming challenges represent an
increase in the saving rate, we will need to be very cautious and watch
for signs of imminent valuation corrections. For this reason, alpha
should outperform beta strategies and liquidity should demand a premium.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-11-2010
In the past days, the world seems to have embarked on to another leg of a
rally, with equities trying to set the stage for higher highs. Volume
is reduced though and you may ask yourselves why we are not as bullish
as we were last year, after all the evidence in favor of a nascent
recovery. Is it because the recovery is weak? Is it because unemployment
remains high? Is it because consumer spending looks low? No, no, no…We
wrote before anyone, back at the beginning of 2009, that we expected
unemployment to be high and that we did not expect any growth, but
agony.
The main reason we were bullish then was that the stimulus programs, the
quantitative easing was well underway. That is no longer the case. Is
that all? Should we no longer be bullish just because stimulus programs
are unwound? No, there is another element to it. The same countries that
claim to be unwinding these programs are running unsustainable fiscal
deficits and absolutely no serious and credible action is taken. That,
to us, is enough to worry. Are we short the markets? No, we were stopped
weeks ago, because we can no longer take the pain of even a 1.5% loss…
Consistent with this sentiment, some analysts deem the credit (not
yield) curve in investment grade space (CDX IG13 index) to currently be
to steep in the front end, suggesting that the implicit default rate is
too high. What is the analysis based on? Simple, descriptive statistics,
going back to 1970. We wonder what period in history, back to 1970, was
ever similar to the outlook we’re facing? When was there monetary
coordination? When did the world fall since 1970 into a liquidity crisis
with stimulus programs of the size and geographic reach seen today?
Furthermore, we ask ourselves how is it that so much research is
currently being done on the defaults outlook, without anyone taking a
closer look at the maturities concentration the world faces in high
yield, between 2013 and 2015? When did a scenario of so close a maturity
front together with increasing interest rates not demand a steep credit
curve? Hence our not so bullish stance here, as discussed above.
On another topic, we are finally seeing some long overdue concern of
politicians on sovereign credit default swaps. Particularly in Europe.
As we wrote on March 1st (refer: www.sibileau.com/martin/2010/03/01 ): “…politicians
focus on the greedy side of those who trade these swaps, which is
really idiotic, because these derivatives represent a huge boost to
systemic risk, even if they were traded for the most morally justifiable
reasons…”. Regulators are wrong in seeking to prohibit these
instruments, blaming them for their problems to issue debt. By the same
token, regulators are ignoring the true problem of these contracts,
which is the fact that any counterparty selling them does so on
leverage. If a sovereign in Europe or the US was to fall, the implicit
guarantees that these institutions selling sovereign credit default
swaps have would be worthless and they would be undercapitalized, at
exactly the same time everyone rushes to the liquidity door.
Finally, we refer to our previous letter, where we challenged the
notion of Canadian markets strength based on commodities performance or
even growth expectations. As you can see in the charts below (source:
Bloomberg), the exodus to Canada is a process that started long before
Parliament discussed the 2010 budget last week. It began in November,
and took off in earnest with the Dubai credit event. The Canadian
“thesis” worked against the Australian dollar, a commodity currency
which has increased policy rates (below left) and extremely steadily vs.
the Euro (below right). The foreign exchange market never lies.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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 Trenches” is temporarily no longer published on a daily
basis. Over the past year, we enjoyed writing every day. However, we
are very busy of late, undertaking another project that hopefully will
be finished by next Fall. We will write as often as possible, but not on
a daily basis. Thank you so much for your support and understanding)
Since our last letter, the markets have continued to rally, on the
assumption that Greece’s fiscal problems will not spill over to other
peripherals mainly, but on the more broad based belief that global
activity will continue to recover. Hence, as expected, gold is
underperforming, the USD is being sold together with Treasuries and oil
and equities rally. In our last letter too, we had explained why we
favored Canadian equities over gold. We disagree with the general
notion, the true vox populi that the not-so-crazy fiscal budget for 2010
plus rising commodity prices are lifting the CAD. In our view, the CAD
is being lifted by default, by Canada’s historical inertia, which in a
moment of global volatility, looks like a safe island in a brave ocean.
It is true, that inertia is the result of a relatively stronger fiscal
position, but it is also apparent to us that smart beats strong, and a
smart government that truly opened this country’s economy and financial
system to foreign investment could run a wider fiscal deficit (if it so
wished), with a still stronger CAD.
In Europe, on the other hand, we do not think fiscal problems will
just vanish, and we see the proposal by Germany’s Finance Minister
Schaeuble to create a fund similar to the International Monetary Fund,
but for the Euro region (as reported by Financial Times Deutschland) as
ridiculous. However, we respect one of Denis Gartman’s rules of trading
(rule no. 8) and think like fundamentalists, while we
trade like technicians. Therefore, we are enjoying the recent ride on
Canadian stocks.
What perhaps may have gone unnoticed yesterday was the New York Fed’s
announcement that will use money market funds as counterparties in its
reverse repurchase agreements, to add capacity to drain reserves. We had
initially alerted of this on Sept 30/09 (www.sibileau.com/martin/2009/09/30 ), which (for the
sake of intellectual honesty) we first learned about from Bank of
America’s Global Rate Focus report, on Sep 25/09. Later on Oct 21/09, we
wrote:
“…the Fed will eventually need to take liquidity off the market.
One of the tools to achieve this is the reverse repos, where the Fed
exchanges Treasuries in its balance sheet for cash (that leaves the
market). The problem with this is that the volume required is so huge,
that the current dealer infrastructure is not enough. Thus, money market
funds, for instance, would have to participate in the effort. But if
money market funds were to hold these Treasuries, the crowding out
effect on the commercial paper market would be significant, affecting
rates…” (refer: www.sibileau.com/martin/2009/10/21 )
On this news, Bloomberg reported yesterday too, that there is
currently a shift out of Municipal debt, and in favor of Treasuries
(i.e. Federal debt). The same has and continues to happen with European
peripherals’ debt in favor of German bunds. But given the institutional
differences of one currency zone and the other, in the US the currency
is not affected. It took the US a four-year civil war to define itself
as a Union, finally in 1864. We certainly hope Europeans figure that one
out faster and peacefully!
In the meantime, as the Fed starts engaging money market funds, we
fear that problems will pile up. Here’s a potentially challenging
scenario:
Some municipal issuers will have difficulty accessing the commercial
paper market and may draw from liquidity lines that banks extended to
back such commercial paper. Would banks in the US dare to show a strong
hand against governmental entities in financial trouble? I don’t think
so. Who’s going to end up footing the bill, then? Corporate issuers, as
liquidity dries. Simultaneously, if this crowding out process unfolds,
the credit quality of municipal issuers will be affected, increasing
capital requirements of financial institutions. Under this scenario, if
the US Federal government shows a sustainable fix to this problem, the
USD will strengthen and gold will continue to drop. Otherwise, if the
problem gets out of hand, we will get inflationary signals, with the
both interest rates increasing and the USD depreciating. Please, keep in
mind that this is a long term view, so typical of “A View from the
Trenches”. In the meantime, our view is that in the absence of further
volatility in sovereign risk (very unlikely), the other asset classes
will see slight pricing revisions, consistent with a more sustainable
fiscal path. Relative value and curve trades are in full fashion these
days…
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-4-2010
(A brief announcement before we start with our comments today: Going
forward, “A View from Trenches” will not be published on a daily basis.
Over the past year, we enjoyed writing every day. However, we are very
busy of late, undertaking another project that hopefully will end by
next Fall. We will write as often as possible, but not on a daily basis.
Thank you so much for your support and understanding)
Since our last comments on Tuesday, we have had a few updates on
policy. The most important indeed is Greece’s announcement of
revenue-raising and budget-cutting measures . Since last week, the 5-yr
unsecured sovereign credit default swap spread has dropped dramatically,
from 400bps to 294bps (at close). If this issue was, as Mr. Jeffrey
Rosenberg sustains, a short liquidity problem, things should be left
there, with us waiting for the results yielded by the budget plan. But
as we clearly made the case before, this problem goes beyond the sphere
of liquidity. It is an institutional problem, and as such, we will have
to follow Germany’s reaction vis a vis Greece’s initiatives. So far,
Prime Minister Merkel made it clear yesterday that the next meeting this
Friday will not be about aid commitments.
In our view, these budget announcements have no purpose but to set
the necessary conditions towards a more sustainable institutional
framework, where either or both Germany and France guarantee Greek
issuances. However, an impressive opposition is growing in Germany
against this move. On this issue, Mr. Otmar Issing (Economist, former
member of the board of the Deutsche Bundesbank (1990–1998) and of the
Executive Board of the European Central Bank (1998–2006) couldn’t have
been more explicit: “Garantien für die Käufer griechischer Anleihen
durch die bundeseigene Förderbankgruppe KfW kommen überhaupt nicht in
Frage”, reported the online edition of Frankfurter Allgemeine (Our
translation: Guarantees for the buyers of Greek liabilities through a
KfW Bank Group are out of the question).
On a separate but related note, we have not been bullish of gold
lately. In our opinion, gold in terms of Canadian dollars was a poor
investment decision. In hindsight, we believe this was a correct view.
And looking forward, we maintain such view. In Chart 1 below (source:
Bloomberg), we show the ETF “XIU.TO”, that tracks the S&P TSX 60
composite (white) vs. the ETF “IGT.TO”, which tracks the price of gold,
in Canadian dollars. As can be seen, since Feb. 8th, when sovereign risk
out of Europe escalated, gold has barely risen, vs. the S&P TSX 60.
Why take the risk of a single asset vs. the Canadian equity market?
Chart 1
Furthermore, February 8th would seem to be a relevant date. Thus we
take a look from a different market, the FX market (which never lies).
This time, we wanted to look at the EUR/CAD cross. Indeed, this cross
moved significantly in CAD’s favor since February 8th , as shown in
Chart 2 below (source: Bloomberg):
Chart 2
But Chart 3 below (source: Bloomberg) provides us with a more fertile
conclusion. It shows the EUR/CAD cross (orange) vs. the CAD/USD
(white). It is very apparent to us that the shift out of the Euro and
into the CAD started at the end of November, immediately after the Dubai
credit event, and as rumors on Greece’s fiscal weakness were starting.
This move out of the Euro and into the CAD has been slow but sure! The
CAD/USD has been visibly more volatile, almost breaking the trend
(remember the resistance at 1.075 CAD/USD?)
Chart 3
We have consistently held that the strength in the CAD did not spill
over to Canadian assets, suggesting that it was driven by central banks’
reserve purchases. We believe this is now clearer than ever. Yesterday
also, with bearish oil inventory data, the Canadian dollar kept its
strength intact, touching 1.0275 CAD/USD intraday.
What to make of this?
Canada is receiving an important flow of capital. Going forward,
those mainstream economists (which we could also fairly brand as
“mercantilists”) that focus on commodities performance based on the
global recovery path to understand the Canadian story will be
disappointed. In our view, Canada is no longer just a commodity
exporter. Canada is now starting to export “peace of mind”, which the
world seems unable to find elsewhere. We made this prediction long ago,
when on June 2nd , 2009 wrote:
“… The Canadian dollar should remain within a free and flexible
exchange regime (including no further regulation on Canadian banks)”.
The stronger the intervention is, the weaker the Canadian dollar ends.
(…) Canadian stocks will not rise (as in the US), if the Bank of Canada
relaxes its monetary policy…Canadian stocks are rising because foreign
money is flowing in! And for foreign money to keep flowing in, Canada
must show it can provide a stable currency. The world is starving for
stability! All Canada needs to do is to remain quiet, while the rest of
the world misbehaves and voices its anti capitalistic rhetoric. In the
world of the blind, the one-eyed country gets the big bucks!…”
(“Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 )
We think this process in favor of Canada is in full force, unless
Parliament Hill derails it, which is always, always possible. Two days
ago, the Bank of Canada made clear (at least to us) that at the end of
its conditional commitment period, in June 2010, an upward revision of
policy rates will follow. This does nothing else but reinforce the
appreciation of things Canadian.
With these winds, we fail to see weakness in Canada’s real estate sector
and we want to be long Canadian equities, as they are driven by mining
in precious metals, basic resources and boring banks. Our propensity to
fear that slack in global growth will indirectly punish Canadian
valuations via lower commodities prices, is lower and lower, as the
world comes to Canada to deposit their savings in a safe place.
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.
Please, click here to read this article in pdf format: march-2-2010
We will be brief today, for nothing of macroeconomic consequence has
taken place in the past 24hrs. The action that caught our attention
yesterday was in the foreign exchange market (the market that never
lies). In particular, we refer to the action in the Canadian dollar.
The cross with the Euro gained (i.e. the CAD rose against the Euro) 2.3
cents intraday, and although (or because) the TSX composite closed
+0.85% higher, we can only deduct that the demand for Canadian dollars
did not reflect a pari-passu demand for Canadian assets. Therefore, our
intuition is that with yesterday’s calm, the demand for Canadian
dollars that did not end in assets was a demand for reserve purposes,
at a central bank. We are open to alternative suggestions to explain
this phenomenon but any of these explanations would also have to
address how the Canadian dollar did so perform on a day where neither
oil nor gold rallied.
Was the CAD rally based on the news that the Canadian economy
expanded at a 5% annualized rate in the fourth quarter (faster than
forecasted by the Bank of Canada)? We doubt it because a) the CAD’s
sensitivity to interest rate gap (i.e. with the higher than expected
growth rate the market revises its forecast on policy rates) has been
low, and b) the strength was not uniform but clearly against the Euro.
On another note, in an interesting report, Bank of America estimated
yesterday that approximately $160BN will flow to private investors by
the end of 2010, as a result of the buyout of delinquent mortgage loans
by Fannie Mae and Freddie Mac (refer: “The long and short of
delinquency buyouts”, in Situation Room, Bank of America Merrill Lynch Credit Strategy, March 1, 2010). At “A View from the Trenches” we had anticipated the consequences of this operation back on January 4th, when we wrote:
“ …Since (our) last letter of 2009, the US Treasury announced it
would lift the cap on the Preferred Stock Purchase Program (refer
Michael Cloherty’s “Removing the PSPP ceiling: Treasury’s unlimited
support”, Bank of America’ “US Agencies” report of Dec 29/09). This
explicit show of support for agency debt (which I assumed it was going
to smoothly disappear in 2010) tells (us) that the USD strength will be
only a relative notion in 2010. (We) say relative because the strength
should show vs. those countries that explicitly decide to import USD
inflation (i.e. Brazil) or face serious fiscal problems (i.e. Euro
zone), while the weakness should show vs. those countries that will
profit from the credit-inflated recovery (Emerging markets or commodity
currencies, like the CAD)… “
We stand by these comments and the market is proving us right. What
we did not grasp back then was the magnitude of this operation ($160BN
of private liquidity) under certain loan delinquency level assumptions
that can further deteriorate, if the recovery process disappoints. We
invite readers to closely monitor activity in the GSE market for this
is serious enough to keep the dream of asset inflation alive.
(Note: Mainstream economists use the term “asset inflation” to refer
to bubbles, because their theory of inflation is wrongfully based on
the non-neutrality of money, as implied by the exchange equation: M*V =
P*Q. Therefore, they treat bubbles as an aberration that can only be
addressed with regulation)
Martin Sibileau
The comments expressed in this
website and daily letters are my own personal opinions only and do not
necessarily reflect the positions or opinions of my employer or its
affiliates. All comments are based upon my current knowledge and my own
personal experiences. You should conduct independent research to verify
the validity of any statements made in this website before basing any
decisions upon those statements. In addition, any views or opinions
expressed by visitors to this website are theirs and do not necessarily
reflect mine. My comments 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 (e.g., options, futures, warrants, and
contracts for differences). My comments 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.