A View from the Trenches, March 9th, 2010: "US Fed vs. municipal debt"
(”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
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