A View from the Trenches, November 11th , 2010: "Confusion reigns"
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Since our last letter, commodities (excluding oil) have sold off. The developments out of Ireland have impacted the Euro, as we discussed earlier and, in addition on Tuesday, the CME announced at close that deposits and margins on silver contracts and hedge positions would be raised. These two factors have temporarily affected liquidity on risky assets.
The first one, Ireland, has obviously an important spillover potential, as the banking system is technically insolvent and, if bailed out, will require either Irish taxpayers or EU taxpayers to foot the bill. If it isn’t bailed out, it will then affect the capital of other financial institutions within the EU mostly, with Irish exposure. On that note, sovereign credit spreads of Peripheral EU jumped yesterday and the situation is understandably affecting the Euro. The chart below (source: Bloomberg) is very telling. Since it peaked on November 4th, the Euro has embarked on a very well defined downward trend.
This trend is draining liquidity from the market, although not to worrying levels, for the Euribor-OIS spread is still low, at 26.4bps. Some may argue that it is due to the intervention of the European Central Bank…which is true and may continue, producing an “orderly” fall of the Euro, in spite of wider sovereign spreads. Of great help is the fact that the Irish government does not require to access the capital markets before 2011. All this is what, in our view, is preventing gold from resuming its upward trend, to prove once more that it is on its way to become the world’s de facto reserve asset.
Having said this, we want to return to a point we made on Tuesday, when we wrote that:
“…we watch with interest the developments in the long-term part of the US yield curve (i.e. 30-yr Treasuries). Although most would argue this is simply a correction to match the Fed’s 5-7yr average duration purchases through QE2, we think something else is in the works here. Such a correction should, in our opinion, have been completed last week. Yesterday’s increase in the 30-yr yield and simultaneous rise in commodity prices represents the very early stage of the upcoming US sovereign crisis…”
Yes, the yield curve steepened since Nov 3rd, but the chart below (source: Bloomberg) should also be visual enough to raise concern over the wisdom of the Fed’s recent decision. As long as the money being “printed” by the Fed causes a shift from Treasuries (long-end mostly) to cash, without lifting commodities or stocks, we will be in the proverbial liquidity trap and the USD will be far from a crisis. But as soon as the massive unwind of pre-QE2 positions and short USD/long EUR positions (which we think are causing the confusion) is over, we will see the weakness in the long-end of Treasuries as the seed of a materially higher price of gold and the beginning of the US currency crisis.
Martin Sibileau
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