Click here to read this article in pdf format: september-27-2011
Since our last letter, we have witnessed (and perhaps are still witnessing) once more, the typical run for liquidity, when all asset classes tell us that diversification is a myth and that there is no place to hide but in the US dollar. Those who were long of gold (including ourselves) got a good lesson (in our case, a reminder) in asset management under central banking and hopefully too, got to appreciate the value of stop losses, like we did, which saved our day.
Let’s first begin by saying that from the perspective of the “real” economy, absolutely nothing has changed since September 12th. This sell off was indeed a déjà vu and we had, in previous letters, described a scenario like it. For instance, on February 2nd 2010, we proposed three phases in this downward cycle, shown in the chart below. Everything would seem to indicate that we are in what we called phase 2:
When are we going to enter phase 3? Before we address the question, let’s briefly comment on the announcement that triggered the recent sell off: the Fed’s so-called Operation Twist. By now, everybody knows that the Fed announced it will shift the composition of its assets, basically selling short-term Treasuries and using the proceeds to buy longer term Treasuries (this is a very, very basic description). In doing so, three things will occur.
Firstly, the yield curve should flatten, affecting negatively the profitability of credit investors (banks, insurance companies) that fund cheap in the short term market to lend long term, at higher spreads. If providing credit will be less profitable, credit supply will contract, affecting borrowers.
Secondly, by shifting the tenor of its assets to a longer term, the Fed will suffer huge losses, when interest rates finally rise forced upon this central bank by a massive repudiation of the US dollar (its liabilities). By then, how will the Fed be recapitalized? This point however will take a lot to materialize. But we nevertheless mention it here for the record. Peter Schiff in his blog described these first two (watch: http://youtu.be/BCYGVKBOcCo ) issues.
Thirdly, and to us this is perhaps the most important, Operation Twist contributes to confirm the stagflationary trend. For mainstream economists, this is difficult to see, because they ignore the role of the price system in the market process. Every mainstream analyst has told us in the past days that because the Fed is not expanding its liabilities, this move should not be inflationary. Let us tell you why, although this fact (i.e. no expansion of Fed’s liabilities) is correct, the conclusion is not.
Since the beginning of QE1, central banks and regulators have incrementally exercised financial repression on global markets. In doing so, they have deprived markets of the benefit of the price discovery mechanism through which they can efficiently allocate resources.
With the purchase of government bonds, whose yield are a benchmark rate, the benchmark rate has been manipulated to the point where, with rates practically at zero levels, markets no longer have a benchmark.
With the intervention in the banking system, markets no longer can easily price the solvency of banks and their capital needs.
With the intervention, during the waves of defaults, in the legal proceedings between creditors and borrowers, markets can no longer have a clear view on recovery values at default, or even seniority of credits. Will pension plans have priority over lenders? Will private investors in sovereign debt end up deeply subordinated?
Until last week, therefore, we had slowly lost our benchmark rates, the capacity to calculate losses/defaults, and understand the legal consequences of extending credit. Since last week, thanks to Operation Twist and a flatter yield curve, we will also lose a benchmark for the inter-temporal rate of exchange: The relative value of time will almost disappear. How can anyone make an educated investment decision in this context? He/she can’t, which brings us sad memories of our life during the hyperinflation years in Argentina. During those extreme years, we remember having seen stores closed because “they lacked prices”. Many stores would simply shut and leave a sign by the door that read: “Cerrado por falta de precios”. Indeed, given the acute movement in prices, store owners could not decide whether their sales would leave them with a profit or a loss, and would not open to the public!
There and then, this happened with consumption goods. Here and now, it is starting to occur first with investment goods. All parameters relevant to an investment decision are absent: the value of a risk-free asset, probabilities of default and cost of capital, institutional certainty and soon, the value of time. In this context, investments, and subsequently productivity and employment can only collapse.
Going back to our point on the inflationary impact of Operation Twist, if we understand now that this measure contributes to destroying investment, if the produce of the USA drops, even if the size of the Fed’s liabilities doesn’t increase, the amount of money stock vs. output will have still grown and the value of the US dollar will have to drop! This is why people call it stagflation! (Money stock = monetary base + fiduciary media, refer Figure 2 in “The causes of price inflation and Deflation: Fundamental Economic principles the deflationists have ignored”, by Laura F. Davidson at: http://libertarianpapers.org/articles/2011/lp-3-13.pdf )
Returning now to our previous question of “when are we going to enter phase 3?”, the answer is: We are not sure. In summary, if the Euro crisis finds a fiscal way out in which the European Central Bank (ECB) does not have to capitulate (and this includes the ECB lending to a bigger European Financial Stability Facility (EFSF)) we will not have phase 3, and gold will continue to sell off, in our opinion, at the expense of equities. If the ECB is made to capitulate because no fiscal solution is reached and the only way out is a weaker Euro, we will enter phase 3, with gold and equities rallying.
Lost in the mess of these negotiations, there remains the issue of what will happen in China with its current imbalances. We are starting to lose sleep on this one…
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: september-12-2011
Today’s comments will be brief. In fact, we will not seek to provide answers but to leave the reader with questions.
By now, everyone is surely aware of the decision by the Swiss National Bank to peg the Swiss Franc to the Euro, at 1.20. Effectively, the SNB would buy as many Euros as sold to them, at 1.20EUR/CHF.
On this news, Dennis Gartman, last week wrote that from now on, the policy of the SNB will be driven by that of the European Central Bank. We think that is not correct. Because the European Central Bank has no policy of its own. The ECB has its hands tied. As we wrote back in May 10th, 2010 , when we foresaw this:
“…We think that (…), the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, (…), the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy (…)? In the long run, the only way out for the ECB (…) is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy …”
Indeed, we think that with the peg, the supply of Swiss Francs will also be determined by “…the growth rate of the EU’s consolidated fiscal deficit…”.
Back then, on our next letter dated May 13th, 2010, we further discussed this point and added this graph, that now looks ominous:
The letter, titled “ECB Plan = The End of Paper Money?” already mentioned the importance of currency swaps extended by the Fed (seen in the chart above). We finished that letter noting that gold looked like a bargain at $1,240/oz. And just like we wrote about these swaps 16 months ago, last Monday we went on record stating that: “… AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER…”
With this in mind, we invite readers to think about this: If, in the face of upcoming US dollar funding problems for Eurozone banks, the Fed will commit to lend unlimited US dollars to the European Central Bank, to further sell them to Eurozone banks….WILL THE FED NOT BE EFFECTIVELY PEGGING THE US DOLLAR TO THE EURO? WILL THERE NOT BE AN UNOFFICIAL EQUILIBRIUM EXCHANGE RATE AT WHICH THE FUNDING MARKET IS CLEARED?
And if that is the case…What will differentiate the Fed from the Swiss National Bank? We think nothing!
After the German’s High Court ruling, where any institutional fix to the Eurozone problem, including Eurobonds will be legal but operationally unfeasible, the European Central Bank is the only savior and will have to monetize the consolidated fiscal deficit of the Eurozone. If the Fed, just like the Swiss National Bank, pegs its currency to the Euro, then the supply of US dollars will also be driven by “…the growth rate of the EU’s consolidated fiscal deficit…”.
We saw it coming . This scenario will eventually make the case for gold clearer and clearer. In the process, the banking system of the world will go bankrupt, nationalized and more concentrated, and financial repression will grow exponentially.
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: september-5-2011
In our last letter, we showed that our view from May 2010 is fully developing (We had stated that eventually money supply in the Eurozone would be determined by the growth in the zone’s fiscal deficits). Also, the contagion from the Eurozone to the USD zone is also growing, thanks to the EUR/USD currency swaps extended by the Fed to the European Central Bank. This contagion, we wrote, is nothing new, but had been highly criticized already in the early 1930’s by Jacques Rueff. We insist therefore that readers get a copy of Mr. Rueff ‘s “The Monetary Sin of the West”, published in 1972. An online version can be found at: www.mises.org/books/monetarysin.pdf . Too old? Perhaps, but remember: There is nothing more practical than a good theory!
If you have been following us vs. other analysis, you will notice that only recently, other analysts are beginning to pay attention to these FX swaps. Mainstream analysts refer to it as the “Fed’s USD backstop”, which is also appropriate. Why is this for us so relevant? Because thanks to this backstop, the world ends up being impacted similarly (“similarly” being the operative word here) to what we would see, if the Fed bailed out Eurozone banks. Is the Fed bailing out foreign banks providing this backstop? We see it that way, although the Fed will always deny it. But think of this simple question: What would happen to the weakest Eurozone banks that need to roll over USD funding, if that backstop wasn’t there? They would certainly be insolvent by now. However, the Fed doesn’t see it that way. What the Fed sees is the underlying counterparty risk. The Fed turns around the question to tell us that if the backstop was not there, the US banks would have funding problems, competing with Eurozone banks for funding.
To his credit, Dr. Ron Paul, was the only politician to see this far in advance, last year, when he questioned Mr. Daniel Tarullo, member of the Board of Governors of the Fed, on this point on May 20th, at a joint hearing of the Subcommittee on International Monetary Policy and Trade (watch minutes 6:22 and 7:36 of this video: http://www.youtube.com/watch?v=hMo-V8HoNdc ).
Had we been in that session with Mr. Tarullo, we would have asked him what would the Fed do, if the dollars lent to the European Central Bank, forwarded to Eurozone banks, cannot be paid back because the assets these dollars funded are in default or generating substantial losses to the originating banks?
This is important because that is exactly what occurs during stagflation: Businesses go bankrupt. We know the answer: The Fed would do nothing, allowing these dollars, printed money, to remain overseas. This is why we say that the FX swap is effectively quantitative easing from the Fed on the Eurozone. We will go on record stating this: AS LONG AS THESE FX SWAPS (USD BACKSTOP) REMAIN IN PLACE, WE WILL BE LONG GOLD. THE TOP FOR THE GOLD MARKET WILL BE REACHED THE DAY THIS BACKSTOP IS ELIMINATED EITHER VOLUNTARILY OR FORCED UPON THE FED BY THE MARKET AND NOT ONE MINUTE EARLIER.
Turning now to the Eurozone, it is completely clear now what we have been predicating time and time again, since February 8th, 2010: The zone faces an institutional crisis. Back then, it was only an institutional problem. The disastrous handling of the crisis by Euro politicians have made it now a real economic one and we think there is no way out here but dissolution in chaos. This again, shall be very bullish of gold and bearish of risk (unlike mainstream view, we distinguish gold from “risk” because to us, gold is money). Enough said. We could go on but we think that over the past letters we have been very clear and unfortunately, times will now accelerate and we will witness this problem evolve exponentially.
In China, it seems the People’s Bank has not been sterilizing its FX reserves purchases. However, to mitigate the corresponding inflationary impact, it has been relentlessly increasing the reserves requirement ratio of financial institutions, using the “credit multiplier” channel. According to Bank of America’s Rates and FX Research team (“Global Rates and FX Weekly”, August 26th, 2011), by September 2010 the level of USD reserves had reached $3.4 trillion (CNY21.8 trillion) , while the People’s Bank’s debt had decreased from CNY4.4 trillion to CNY2.7 trillion. The gap between the FX reserves (i.e. assets) and the debt (liabilities) was covered by the increase in reserve requirements (i.e. liabilities too: Remember that the banks’ reserves in a central bank are an asset to the banks and a liability to the central bank).
Why did China’s central bank choose to hike reserves rather than issue debt to mitigate the impact of its USD purchases? It was simply cheaper, apparently, which means that if the trend continues two things will become evident: 1) the profitability of China’s banking system will be hurt, and 2) the US Treasury will find it harder to place its debt.
On the first point, the central bank may be forced to increase the interest rate on the reserves, dragging banks to depend on it, increasing the cost of eventually appreciating the Yuan (i.e. exit strategy). On the second point, the Fed will be forced to step in, should China merely stop accumulating reserves. We may add that as the first point becomes more relevant, the cost of eventual defaults will be way higher. Both issues are very bullish of gold and bearish of risk, too.
After all these considerations, we are really surprised to hear mainstream analysts say that another recession (as if the last one had ended) would be a so-called Black Swan event (i.e. a rare event). How so? We would argue that the opposite is true: In this context, avoiding a double dip is actually the Black Swan event!
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: august-19-2011
In light of the events yesterday, which in our view were mainly driven by fears of US dollar funding problems in the Eurozone banks, we thought it would be appropriate to reproduce our comments from June 4th, 2010, which anticipated a scenario like yesterday’s. From the comments, it should be clear that the ongoing environment is and probably will continue to be highly supportive of gold and bearish of stocks. The only thing that could change things here is a strong, determined will to fiscally integrate ALL members of the Eurozone and the simultaneous announcement of Euro bonds (to understand how they would work, please refer our letter from January 28th, 2011). Below, our comments from June 4th, 2010:
“…At “A View from the Trenches” we were ahead of the curve, anticipating this “content problem” (refer: www.sibileau.com/martin/2010/05/10, “What to expect when you are expecting”), associated with secondary market purchases even before the announcement of the ECB’s plan. Back then we wrote:
“…the ECB would tend to behave like a convertibility board, where sovereign debt is converted to Euros. Therefore, under scenario B, the supply of money would be determined by the growth rate of the EU’s consolidated fiscal deficit! The ECB is not under control but is always “chasing the rabbit”…Governments puke debt and ECB comes after and cleans up buying in the secondary! Thus, what would be the exit strategy under scenario B? In the long run, the only way out for the ECB under scenario B is a consolidated fiscal surplus, which is totally out of ECB’s hands. De facto, the ECB is denied an exit strategy…”
There is also another criticism that we think is unwarranted, namely, the short term nature of the existing currency swap contracts between the ECB and the Fed. It is maintained that because these contracts are renewed on a weekly basis, instead of a longer-term (i.e. 84 days), USD funding conditions remain “uncertain”, which does not contribute to calm the markets. We believe the opposite is true. If the Fed validated the capital investments in the Euro-zone via currency swaps, which are nothing else but a hidden bailout of financial institutions, the Fed would be feeding the bullish trend in gold, at the expense of future higher USD inflation and of US taxpayers, and delaying an adjustment that would affect the ECB’s balance sheet more violently.
The term mismatch in the currency swaps (1-week) and the 3-mo Libor-OIS benchmark, as well as the uncertainty over its renewal sends a clear signal to those yet surviving that they need to unwind and take losses. In 1965, M. Jacques Rueff (http://en.wikipedia.org/wiki/Jacques_Rueff ) described a very similar situation occurring in the ‘20s with “currency swaps” between Britain and France, in this way:
“There is a very interesting document from this period, 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.” (J. Rueff, “The Monetary Sin of the West”, 1972)
Back in those days, as the Sterling and French Franc were backed by gold, the currency swap consisted in having Paris “lend” gold reserves to London, to address funding problems. The 2010 version of the same problem could read like this:
“There is a very interesting document from this period, a letter from M. Trichet, who was then the European Central Bank’s President, to Mr. Bernanke, who was the Chairman of the U.S. Federal Reserve; it must be of 2011. M. Trichet said, “We know that you are entitled to ask dollars for your dollars, but in the frame of the close friendship between the European Union and the United States we ask you, so as to avoid trouble for the European Union, not to do that, and receive Euros instead.” And we were, I must say, weak enough to comply with this request and not ask for dollars. The fact that I had such important U.S. dollar deposits in Frankfurt shows that we did not use this right to ask for U.S. dollars. 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 2009 and 2010. This explains the depth of the collapse and of the depression, because the adjustment was so long delayed.”…”
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: august-9-2011
Where do we start after two weeks of absence? Let’s start by first acknowledging how utterly wrong we were to leave gold before the debt ceiling debate. Our analysis was binomial and reality proved that most times, grays are the norm, and in many shades, while “black and white” are a mental construction.
For the record, we wrote: “…What is the reason for our position? If prior to August 2nd we have a deal regarding the debt ceiling in the US, gold in our opinion would have to correct, given the reduction in jump to default risk. If we do not have a deal and we face a downgrade or default on US sovereign debt, we think that the world will face a serious run for US dollar liquidity. This, as counterintuitive as it sounds, would appreciate the US dollar, for as long as it takes the Fed to intervene, launching a forced QE3 (debt monetization), whereby downgraded/defaulted debt is purchased.”
What went wrong? Right after the last-minute agreement to lift the ceiling, weakness came from Europe and it was a weakness that was addressed by the monetary authority (European Central Bank, ECB) through its Securities Markets Program. We will have more to say more about this program in a moment. Had we not seen it coming? Yes, but not so fast! On the other hand, the downgrade was only partial (one in three ratings agencies), and has not yet triggered the reaction it deserves, let alone the one we had expected, had the downgrade forced the selling of Treasuries/Agency debt by money market funds and financial institutions. In hindsight, would we make the same “mistake? Of course, we would! We were managing risk and the first duty we have in this game is to survive.
To finish our thoughts on gold, we must say that after S&P downgraded the sovereign debt of the US, when yesterday morning we saw gold trading only $10/oz above the previous top last week (i.e. $1,684/oz), we had no alternative but to buy it. We could not believe what a bargain it was. Was gold expensive last week at $1,684/oz, after having reached an agreement over the debt ceiling? Yes, we think. Was gold cheap at only $1,694/oz on Monday morning after the downgrade of US sov debt, the ECB’s announcement that it would buy core Europe’s sovereign debt, the belief that France will be downgraded, the repricing of the whole credit spectrum and a Fed that may have no alternative but to monetize government debt? Absolutely! The new set of information changes the whole story! We will mince no words here: The dam is broken and there is really no way to hold the fury back. The forces that will be unleashed here will surpass what anyone of us can imagine and the end game is a world’s reserve currency backed by gold. Within a fractionary reserve system? Unfortunately we think so, but backed by gold!
Now, in terms of the political situation in the US, which is what appears to be the main driver behind S&P’s downgrade, we think the US has a structural/institutional problem, which goes beyond political parties. Effectively, Mr. Obama last week faced what under a parliamentary system is known as a “vote of non-confidence”. Under such system, proper to the Commonwealth, when a Prime Minister cannot have his/her budget approved, elections are called and citizens actually vote for or against it, reelecting or not the official party. That is quite an advantage, which the Presidential system lacks. The President of the United States has received a vote of non-confidence and yet, he will hold power until the end of 2012.
Meanwhile, in Europe, on Monday we learned that Germany voiced its opposition to fiscal integration of the Eurozone, leaving all the weight on the shoulders of the ECB. The ECB can not do much and what is doing is simply futile, but truly supportive of gold. Let’s see (what we are about to discuss is radically different from the EFSF purchase of sovereign debt that back in January, we thought was a good move):
In the figure below, we can see that under the Securities Market Program, the ECB in step 1, creates money ex-nihilo and buys sovereign debt held by Eurozone banks. Immediately after, in step 2, the ECB sterilizes that increase in the supply of money by issuing short-term debt, which takes out of circulation the Euros that were previously printed.
In the end, in step 3, we see that the Eurozone banks hold short-term debt of the ECB, while the liabilities of the ECB are backed by Euro sovereign debt.
What is important here? What we don’t see!!! Let’s go in detail:
1. Yes, the supply of money has not been increased, but at the same time, the credit multiplier has not been touched. Eurozone banks, which were previously defacto insolvent, count with the same firepower to continue the expansion or maintenance of credit within the Eurozone. The bigger they are, the harder they will fall!
2.- The liabilities of the Eurozone banks may and actually are denominated in USD. If the sovereign debt the ECB holds further deteriorates (a capital loss to the ECB), so should the credit of the ECB, its short-term debt, which is backed by the sovereign bonds. But if that is the case, there will be a mismatch between the assets the Eurozone banks have and the liabilities they have assumed.
3.-If the mismatch just described widens, the ECB will be helpless. In as much as the same involves US dollar liabilites, the Fed would be forced to extend a currency swap to the ECB to support the Euro financial system. When and if this occurs, the cancer will have spread, metastasising into the two main reserve currencies of the world.
In light of this, yes, we think gold was cheap on Monday. Has gold gone up too fast too much? Yes. It will not be an easy ride.
We have not had the time to further deal with the consequences of the US debt downgrade or to examine how the creditor countries (Asia, Latin America) can react to this chaos. But we think the Eurozone is currently the main driver of the current crisis, ahead of the US fiscal situation.
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: july-25-2011
Two weeks ago, we wrote that we had bought gold during its sell-off on June 30th /July 1st . We did so reluctantly. and sold it at the close of Friday 15th, consciously against that basic trading rule that says that one has to let profits ride. In perspective, during last week, our proceeds now invested in Canadian dollars made more sense than the oscillation of gold between $1585-$1,605/oz. As we write, we do so on the contrarian side, telling ourselves that it is always better to be out wishing to be in, than to be in, wishing to be out.
We are contrarian because it is hard for us to see gold making higher highs…and yet it does. What is the reason for our position? If prior to August 2nd we have a deal regarding the debt ceiling in the US, gold in our opinion would have to correct, given the reduction in jump to default risk. If we do not have a deal and we face a downgrade or default on US sovereign debt, we think that the world will face a serious run for US dollar liquidity. This, as counterintuitive as it sounds, would appreciate the US dollar, for as long as it takes the Fed to intervene, launching a forced QE3 (debt monetization), whereby downgraded/defaulted debt is purchased. Nobody can honestly quantify this scenario, but from the moment it is triggered to the moment the Fed steps in, we would see assets, among which gold stands as one, selling off. Therefore, we remain on the sidelines, nervous and fighting our greed.
On another note, today we want to write about an issue that is in our opinion the main root of the problems the world faces today: Dogma. We will take here Wikipedia’s heretic definition of “Dogma”:“…Dogma is the established belief or doctrine held by a religion, or by extension by some other group or organization. It is authoritative and not to be disputed, doubted, or diverged from, by the practitioner or believers…”
We think that the world is in trouble today because leaders believe in the following dogmas:
-The existence of an “output gap”
This dogma is nothing else but the complete dismissal of the price system as the most effective tool man has to allocate resources. An output gap is the difference between what is called potential output and real output. What do mainstream economists think a potential output is? Do they think that resource allocation is whimsical? Have they ever stopped to think why is it that entrepreneurs/firms decide to produce less? Obviously not. The answer is simple: To remain profitable. Central bankers lowering interest rates to address this gap is no different than Robert Mugabe’s decision to confiscate farms from farmers who whimsically choose not to increase their output. It leads nowhere and only further complicates things. There is no gap because there is no “potential” output. This is a mechanistic view that if taken to the extreme, should lead us to conclude we should be working all the hours that we do not use to sleep or eat.
-Inflation can be targeted
This dogma is based on another one: The belief that the expansion of money and credit is neutral, which means that it has no effects on relative prices or the structure of production within an economy. If this was correct, it would make sense to keep creating money and credit until the output gap is “closed”. But such creation involves a process where relative prices are seriously changed, affecting production and the relative allocation of resources.
-Well capitalized financial institutions can resist a run for liquidity
This dogma is currently very much in fashion, with Basel I, II and III and why not IV? It is based on the denial that fractional reserve constitutes a fraud. If it is not, we should not believe that financial institutions will face a run. If it is not, all we have to care about is that the expected losses resulting from the investment decisions of these institutions are consistent with their capital. Of course, these investment losses are considered to be random, not the generalized result of a misallocation process, triggered by the expansion of credit and money.
And the last one…”Gold is not money”, as sustained by Ben Bernanke, when asked by Congressman Ron Paul. We leave it to the reader. Here is the Youtube link to it: http://youtu.be/2Dj9v9s9buk
There are more dogmatic beliefs, but we think they are all simply extrapolations of the ones described above. One of these extrapolations, for instance, is the belief that under a system with a central bank and fractional reserve, one should pay a premium (i.e. lower return) to diversify his/her portfolio (i.e. lower risk). This belief is the natural outcome of the dogma of the existence of a risk-free asset (US treasuries).
Unlike the times of Aristarchus of Samos or Nicolaus Copernicus, ours has the fortune of already counting with a diversity of economists/journalists/politicians (mostly from the Austrian school), who can champion the scientific challenge of the dogmas above and communicate it through the Internet. We should therefore be optimistic.
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.
Through our past letters we have turned more and more negative, we acknowledge. We’ll go through a quick summary of our thoughts since the beginning of the year:
We had been optimistic until March, hoping that the European Financial Stability Facility would be used to buy sovereign debt from EU peripherals in the secondary market. That alternative was dismissed and since then, the Euro zone has been following the path of typical currency crisis under convertibility.
In the meantime, emerging markets (creditor nations) have been fighting the inflation they consciously imported from the developed world, attacking the symptoms, rather than the root. The root was and is their monetary policies, which seek to prevent their respective currencies from appreciating (by buying FX reserves): The symptoms are higher balances in their respective banks, ready to fuel more consumption. They will continue the attack by limiting capital inflows in volume and in price (with taxes), increasing the banks reserve requirement ratios, capital or cost of funding.
In the US, we have and continue to witness a deterioration in the employment and activity indicators. Mainstream economists will point that this is in spite of the billions of fiscal debt being monetized, with QE1 and QE2. We, however, will say that this is occurring because of the billions of fiscal debt being monetized, with QE1 and QE2. Along this line of reasoning too, we wrote in our last letter: “…we see the relationship between cause and effect differently: We don’t see future higher oil prices driving energy stocks higher in the long term. On the contrary, because interventionism is destroying wealth, lowering asset valuations (i.e. stocks), production will be affected and the lower supply will push prices higher…”. We stand by this concept and today we show a chart (source: Bloomberg), which we fear may be signaling a nascent trend:
In the chart above, we compare the price of oil (orange) vs. the S&P TSX Energy index (white), for the period starting June 24th, 2011, the day after the International Energy Agency surprised the world with the announcement that 60MM barrels of oil would be released. The price of oil has outperformed the rise in value of energy stocks, 5.7% to 4.7%. We fear this trend, which is characteristic of stagflation, may further develop, where it is better to buy the product than the means of production. Usually, the equity of the companies that produce commodities constitutes a leveraged way to bet on the price of such commodities: If we think the price oil will increase, we may buy energy stocks to earn a meaningful profit from that increase. If we think the price will decrease, we may short those energy stocks for the same reason. But under stagflation, that is no longer the case, particularly when the inflationary process spirals. We will be paying attention to this relationship.
Lastly, two weeks ago, we had warned that the price of gold would be challenged and that we preferred liquidity. We still believe gold will have a tough time going forward, but with the threat of Moody’s to downgrade Italian banks, the fear of risk contagion throughout the Eurozone began to spread (and was later confirmed with Portugal’s downgrade). Accordingly, during the sell-off on June 30th /July 1st, we had no choice but to get long of gold again. We will sit tight now.
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.
Read this article in pdf format: june-27-2011
Thursday, June 23rd, 2011 was a day of infamy: The International Energy Agency surprised the world by announcing that 60MM barrels of oil would be released over 30 days, as an answer to the disruption of oil supplies from Libya.
Personally, we were slow to react to the announcement. Naturally, we first viewed it as unnecessary: If a market suffers from a supply shortage, the best way to encourage supply is to allow prices to increase, to boost production of the good in question. As the day progressed, we read, watched and listened to commentators throw the idea that because the price of oil was going to come down, as it did, the markets in general were going to welcome the decrease: Long stocks was the way to go!
But what totally caught our attention was the performance of gold. A day earlier, on Wednesday June 22nd, gold had moved from the $1,540-5/oz range to $1,550, with the expectation that at the press conference held by Ben Bernanke (after the release of the FOMC notes) a hint of further monetary policy easing would be given. That was not the case. Mr. Bernanke was as neutral as he could in his conference and that brought gold back to the $1,540/oz range, at the close of the session. That was the range gold should have held on Thursday, but events on Thursday changed the game dramatically. As a consequence, since then, gold backed all the way down to $1,499 on Friday, only to close barely above $1,500/oz. What triggered the sell-off? Was it “technically” dragged by the correlation with oil? We are not so sure, and here’s why:
We first note that the decision to release oil reserves on Thursday was of a global nature. Some analysts have made the point that the decision was tailor-made for those affected by the widening in the spread between Brent and West Texas Intermediate crude, and we tend to sympathize with that view. The next conclusion obviously was: “If politicians were able to pull this one of a global nature, ruining in the process a lot of market participants, what would deter them from selling the gold reserves of the US Treasury if, say tomorrow the debt ceiling for the US is not expanded? “
Selling reserves of any good that is in short supply is only a very short-sighted solution, for by temporarily lowering the price of that good, its production is further discouraged, causing higher prices longer term, which will have to be paid, to restore the same reserves. In the process, as the reserve bid is unleashed in the future, final prices end higher than previously expected.
Now, if the collapse of the current fiat currency system finally arrives, the easiest way out will be a system that still allows fractional reserves (i.e. reserve ratio below 100%), but without a lender of last resort, with the central bank of the world’s reserve currency (presumably still the US) backing its notes with gold. It’s an imperfect solution that would only delay the final deleveraging this crisis demands, but it would work. Would it not make sense to see, before this occurs, that gold reserves are sold by necessity at fire sale prices, ending in the hands of friends, who later sell them back to the government, at higher prices? It would. After the intervention on Thursday, it does. Anything goes.
Those who last week recommended taking advantage of the low prices in shares of oil producers, speculating with future higher prices of oil, do not capture the essence of the problem we are facing. We have entered the stage where the world will need goods, but government intervention will discourage their provision: The world will need more oil, but nobody will find it profitable to supply it, given the risks involved. The world will need a safe reserve currency to park savings, but governments will deny it even in the form of gold. The world will need a stable financial system, but banks will be prohibited from providing it. This will bring misery to the point where basic needs, such as food, will be precious, but given price controls, will not be profitable to produce. Furthermore, these interventions of global reach generate the resentment of those nations affected, with one event leading to the other, including military interventions that eventually get out of hands.
In summary, we see the relationship between cause and effect differently: We don’t see future higher oil prices driving energy stocks higher in the long term. On the contrary, because interventionism is destroying wealth, lowering asset valuations (i.e. stocks), production will be affected and the lower supply will push prices higher. If central banks validate the higher prices by printing money, the process will spiral. Until Thursday, we wanted to own physical gold. Thursday was the game changer and cash is now supreme. Financial repression has arrived sooner than most expected and is now the order of the day.
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.
Hi everyone,
I've been kind of busy lately, to write my letter. However, I did not want to miss the chance to explicitly note that what happened yesterday, with the GLOBAL nature of the intervention in the oil market (to help someone really affected by the Brent/WTI spread) the game has totally changed. TOTALLY!
Personally, I am now entirely out of gold in my own portfolio. I am inclined to add to the short-stocks trade, but I have a hunch that tactically today would not be the time to do so.
I am scared to see how easily a global intervention in the oil market was pulled out of nowhere and wonder what would deter governments to intervene the gold market. As the situation deteriorates and the run for liquidity spikes, I imagine the possibility of an arbitrary sale of gold.
In my mind, the macro level post FOMC press conference was $1,540. The sell off after that was totally unwarranted and the lack of information tells me somebody bigger than me knows something I obviously don't.
Any thoughts?
MS.
Please, click here to read this article in pdf format: june-13-2011
This past week may well have been the game changer. To be fair, the game change began the week before, with the lower than expected jobs growth print. Since then, we have seen the Fed reiterate their exceptionally accommodative policy, the ECB delay rate hikes (an expected event, we must add) stating that no restructured sovereign debt will be taken as collateral, and the advance towards a more regulated and less profitable banking sector in the US.
What to make of all this? Gold, in USD terms ended the week lower, a reflection of the ongoing deleveraging. It is noteworthy that gold and the Euro did not correct on the more dovish outlook presented by Trichet in the press conference of Thursday. In that conference, Trichet obviously did not pre-commit to a rates path, but made it clear that the European Central Bank would not participate in a restructuring of Greek debt (or support anything that would trigger a credit event in sovereign debt for that matter). The Euro (and gold) did not react here, just as it did not react earlier in the week, when Moody’s signaled the possibility for the US of losing its AAA rating.
Last Friday, the Euro and gold reacted to European Central Bank Executive Board member Juergen Stark’s comments with regards to the participation of private investors in sovereign debt. The comments simply reminded investors that there is no united front but friction between the ECB and Eurozone governments, vis-à-vis a viable solution, if any, for the periphery. Also relevant was the fact that these comments were made concurrently with a report from the Wall Street Journal of a Spanish bank which sold only about half its offering of covered bonds backed by loans to Spanish regional and local governments.
In the meantime, we paid close attention to Mr. Geithner’s remarks on Monday, who said that : “…Just as we have global minimum standards for bank capital , we need global minimum standards for margins on uncleared derivatives trades…”
Think of this for a moment…What does the US Treasury Secretary have to do with derivatives trades? Would it not make more sense to hear such remarks from the Fed? Don’t derivatives trades affect monetary policy, rather than fiscal policy? Indeed. The only reason the US Treasury is behind this crusade for regulation on derivatives is to coerce global banks to buy US Treasuries and hold them as collateral. If they succeed, they will have taken the risk contagion to a much higher level. Given the size of the derivatives market, they are playing with fire.
Back on January 28th , we suggested and explained how the Eurozone could still hope for an orderly solution of its institutional crisis, if funds from the European Financial Stability Facility were to be used to buy peripheral debt in the secondary market. That window of opportunity is now gone and we are absolutely convinced that Greece ends with a run against its banks, which will surely propagate to other Eurozone countries. It is only a matter of time. In the past however, we were comfortable with the notion of hedging this risk with gold ETFs. Now, with the harassment of the US government, the proven futility of the ECB’s existence (which we forecasted in detail on May 13th, 2010, when we explained the scenario where the ECB purchased peripheral debt and concluded that: “…There cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system…”) , the developments in Canada surrounding the Toronto Stock Exchange’s merger, the world’s indifference towards the massacres of dictatorships in the Middle East, we are left with the general feeling that savings are no longer safe anywhere else but in the form of physical, real, assets (ie. gold). All other asset classes will be highly correlated in a scenario where the present situation spirals. The global financial establishment is facing a slow death at the hands of a political establishment which desperately seeks to sustain their status quo.
We realize that to some readers, this long term view is catastrophic and that in the world of trading, long term views are irrelevant. Usually, we would agree with them. This time however, we fear they will be wrong and that our thesis will prove more tangible as the weeks pass by.
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: june-06-2011
Almost two months ago, we went on record stating that stagflation was here to stay. On April 11th, we wrote:
“…If we had to define in one sentence the action last week and that which is to develop in the future, we would say it in actually one word, not even a sentence. That word is “stagflation”. We truly believed stagflation would present itself to us later this year or even next year. However, we think it is here now. This leaves us on the contrarian side, because almost everyone we read, hear or watch is telling us that “growth” (a misnomer used by mainstream economists, including those at the helm of the Fed, to refer to a higher GDP) will be high in 2011 and that the Fed will be forced to raise rates in 2012…”
The latest activity data seem to be supporting our call but we now fear a worldwide desperate reaction by all governments in general. Possibly, you may have heard a recently popular definition of such reaction: “Financial repression”. What does it mean? We will offer our explanation…
Since 2009, with the start of quantitative easing by the Fed, the expansion in the money stock has produced excess reserves in the financial system in the US. In the Euro zone, something technically similar has occurred with the monetization of the sovereign debt of peripherals: The ECB has issued short-term debt to sterilize the purchases. This is a liability to the central bank, just like excess reserves. But we are now reaching a point where the stagflation we identified in April is becoming self evident, challenging the wisdom of monetizing fiscal deficits. What can governments do about it? The usual: Deny the problem and blame speculators. However, the monetization of fiscal deficits must go on, to keep the circus playing. The way to achieve this is by forcing financial institutions and pension funds to buy sovereign debt while at the same time, the credit multiplier of the fractional reserve system is pressed down.
This is not new at all (Prof. Huerta de Soto in his great work “Money, Bank Credit and Economic Cycles”, 2009, tells us there was financial repression as far back as under the Ptolemaic rule in Alexandria, citing Michael Rostovtzeff’s “The Social and Economic History of the Hellenistic World”, 1957). But for what matters to us today, the first country to start with financial repression since the start of this last recession was China. We called collective attention to it when it picked up, back on January 21st, 2010. Back then, we warned that the People’s Bank, by making it harder to bring US dollars to China, was going to segment the funding market into a mainland China and a Hong Kong funding platform. The restriction of capital inflows is a “classic” form of financial repression within those countries that don’t face trade deficits and which seek to delay or even prevent the appreciation of their currencies. Sadly, we fear that Canada will be the latest to join this club. During last week, it was reported that the Office of the Superintendent of Financial Institutions was researching into how big a factor foreign investment in Canada’s housing market is. To blame capital inflows is ridiculous. If foreign demand generates a bubble it is because the Bank of Canada is not allowing the Canadian dollar to appreciate enough to restrict foreigners’ purchasing power in a “natural” way. And we think this answer is obvious, for the Bank of Canada has postponed raising rates in the face of clearly bullish activity data. In summary, as this crisis reaches its next stage, in trade surplus nations, citizens will see credit restrictions either because capital inflows are taxed or regulated or because reserve requirement ratios increase.
In trade deficit nations, financial repression will be more perverse. The increase in money stock in these nations does not stem from capital inflows or trade surpluses, but from governments whose deficits are monetized. That monetization needs to find a place. When it was not so obvious, it could end in the hand of retail or institutional investors. But as it gets more obvious the propensity of these investors to buy fiscal deficits disappears. Therefore, governments will have to force institutional investors and banks to acquire the debt. In other words, the asset side of pension funds and banks’ balance sheets will deteriorate, making them more dependent of their respective central banks. At the same time, once the monetized debt reaches the system, governments will blame speculators for the resulting increase in asset prices, forcing also the increase in reserve ratios.
In conclusion, in trade deficit nations, financial repression consists of two acts: In the first one, governments force the deterioration in the quality of assets carried by pension funds and banks. In the second one, governments increase the reserve requirements of banks. This last act has a negative impact on the profitability of banks. Right now, defaults are at record lows, but as the proverbial wall of maturities is hit in say, two years, and interest rates can not be lowered further, the impact will be really felt. The realization of this scenario, down the road, will call for demanding physical gold, rather than gold ETFs.
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: may-16-2011
A week later, the sell off in commodities has continued, due to the global deleveraging that is taking place. It has been so serious that the media everywhere is almost calling the commodity rally dead. All sorts of explanations, most of superstitious nature, are given. We have even read an analyst suggest that in general, all rallies last about 115 to 130 months…therefore, the rally in gold is finished!
Last week we noted that: “…In this context, it may no longer be wise to trade long risk (i.e. commodities, stocks), but on a hedged basis (i.e. short Euro), to address the many deleveraging bouts that we will experience…” Below, we show the long gold/short euro trade, expressed in US dollars, via two ETFs (DGP: 2x long gold and EUO: 2x short Euro), which yielded a 1.83% return for the week (= [3.35% + 0.31%] / 2) , way better (more profitable and less volatile) than to be long gold in US dollars.
Should this performance of commodities, in currencies other than the US dollar, signal that the rally is not dead? Does it indeed have legs? Whenever we ask this ourselves, we answer with another question: “What makes you think interest rates will rise?”
On this point, we like Peter Schiff’s view (watch: http://youtu.be/4bZglexQk4o ). Peter says that the Fed will not raise rates because it will make it very expensive for the US Treasury to service its debt. He also thinks that QE2 was not to “support” growth, but to finance the US Treasury. Although this makes sense to us, we fear that it may not necessarily hold true.
We think the Fed could find ways to raise the policy rate, without impacting the US Treasury debt servicing capability. At least in the short term, and we at least, live in the short term. This perspective is consistent with what the European Central Bank has done, under the so called “separation principle”. The ECB has raised rates and at the same time, it has considerably deteriorated the quality of its assets, extending liquidity lines to weak financial institutions and indirectly, to peripheral governments. This has of course weighted on the Euro, but it has so far worked. Can it work forever? No, it cannot. But it serves as an example.
On this line, we learned from a note by the Bank of America, that proposed margining rules under the derivatives reform provisions of the Dodd-Frank act may be passed requiring financial institutions in the US to raise collateral on their derivatives positions in the form of US Treasuries (refer: “Dodd-Frank Collateral Rules Implements QE3”, Credit Derivatives Strategist, May 11th, 2011) . If passed, Bank of America estimates this could coerce the purchase of sums comparable to those of QE2, effectively establishing another wave of government debt monetization. The important thing here is that this could take place in 2012 simultaneously with an increase in interest rates, without impairing the US Treasury. The overall effect would be a formidable crowding out of the private sector from the debt market. Gold bugs be warned!
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: may-9-2011
About two months ago, at the Austrian Scholars Conference of the Ludwig Von Mises Institute, a few asked us what it was like to live under hyperinflation, when they learned of our Argentine background. We responded that it was not so bad, because hyperinflation is really the last stage of a currency crisis. At that point, the depreciation of the currency, the repudiation of the currency goes parabolic and “money dies”. It can last only a few weeks, months, until looting, social unrest takes over, the government collapses and you have a new government and a new currency, backed by something different than government liabilities. We really prefer that scenario to decades of light inflation.
However, given our age, we were only able to witness the inflationary processes of the ‘80s. We missed all the “preparation”, all the mise-en-scène of the ‘70s in Argentina. What do we mean? Hyperinflations can only take place after credit collapses. Not before. That is what happened in Argentina during the ‘70s, which allowed the acceleration of the ‘80s.
Why must credit first collapse? Because to reach hyperinflation, which is the ultimate repudiation of a currency, deleveraging must have run its course. Not by debt repayment, but by the massive devaluation of debts, taking all credit “supply” (not demand) off the table. When that process is done, it is only natural (in the absence of a banking system in local currency) to get to the next stage, whereby the currency is destroyed. Having said this, we can now turn to our point today.
The world certainly does not face hyperinflation yet which implies that if our view is correct, the pain will continue. Pain takes the form of deleveraging, like the one we witnessed last week in the commodities space. This deleveraging is counterintuitive, because as systemic risk increases as it did last week (first with the transmission of the sell off in silver to all the commodities space and second with the dovish stand by the European Central Bank), risk trades are unwound and capital must find its way back to its funding currencies: the US dollar and the Yen. Yet, it is these two currencies which clearly stand out as the most likely candidates to face hyperinflation in the future…How close is that future?
The answer to this question depends again on how much longer credit can remain alive. Unfortunately for our taste, we think credit could remain in ample supply for a lot longer than most think. The real catalyst to start its shrinkage will be a wave of defaults.
In the US, these defaults would have to come from the private sector, because the Fed will continue buying government debt. However, the maturity wall of the private sector is at least two years ahead of us. In Japan, this is a non-starter, given the ample level of domestic savings. In China, where markets are totally controlled by the government, this defaults also unlikely to be triggered and if they were, the People’s Bank of China, in our view, would be in a position to deal with them, particularly given the current high level of reserve requirements. In other emerging markets, deleveraging in their local currencies would not begin until deleveraging in US dollars begins. Therefore, where else can we see a threat of defaults?
The obvious answer is in the European Union. Perhaps, this is what was behind the second sell-off of the Euro that took place on Friday, when Der Spiegel first published a note online, suggesting that Greece’s exit from the Union would be discussed at a secret meeting during this weekend. The Euro fell to the high 1.43s from 1.45 on this, dragging all the commodities complex along. Defaults within the European Union are most likely than elsewhere, because they can either be triggered by sovereigns or by the private sector which is being asphyxiated by both the European Central Bank and the sovereigns.
In this context, it may no longer be wise to trade long risk (i.e. commodities, stocks), but on a hedged basis (i.e. short Euro), to address the many deleveraging bouts that we will experience, until credit is off the table and the doors are open to hyperinflation. From this, it should be clear that we do not share the view that last week’s sell-off in commodities was of a technical nature, namely that the USD had been oversold, but of a more fundamental one.
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: may-2-2011
Today we could discuss the most important developments that have unfolded since we last wrote on April 18th. We could discuss the rationale of Greece’s debt restructuring, the monetary policy of the ECB going forward, the slow acknowledgement that Spain will not be spared, the weakness of the USD or its counterparty, the unstoppable rise of gold. Our readers know that we warned about some of these issues (Spain, gold, stagflation) with fortunate timing and our thoughts on why the Euro has risen or why we are facing stagflation (i.e. jobless claims have suddenly began to stabilize and rise, GDP change has not met expectations) are on record for anyone to see. This morning however, we want to dig deeper. We don’t want to discuss things you may already know, but want to suggest why mainstream economists, like Ben Bernanke, continue to believe (unlike us) that this crisis can be fixed. We think (unlike them) this crisis ends in a currency crisis of a magnitude never seen before, with a transfer wealth of unthinkable proportions.
When Ben Bernanke gave his press conference last Wednesday, he labeled the increase in commodity prices of a temporary nature and dismissed his responsibility in the depreciation of the USD. The Chairman of the Fed reiterated the Fed’s mandate, as a natural way to shield himself from unwelcome questions. This mandate is dual, seeking to maximize employment, providing price stability. There is a popular perspective of this dual mandate, which is expressed in what is known as Taylor rule. The rule seeks to find an approximation to the changes in policy rate, driven by the rate of inflation and the level of activity (i.e. the other side of the unemployment coin) in a currency zone. The equation is written:
Or: Target short term nominal interest rate = Rate of inflation + equilibrium real interest rate + coeff a * (gap between current rate of inflation and target rate of inflation) + coeff. b* (gap between current GDP and potential GDP).
As you can see, mainstream economists (including Mr. Bernanke) believe that there exists: (1) a “target” rate of inflation, (2) an equilibrium real interest rate, and (3) a potential GDP.
However, none of these three concepts exists. They are only the mental tools of economic planning. When you think that there is a “target” rate of inflation, you assume that you can control the inflationary process and furthermore, it shows that you don’t understand what inflation is. Why? Because inflation is nothing else than the non-neutrality of money expansion at work. Not all prices rise or fall at the same time. It is relative prices that changed, with QE1 or QE2. To believe that one can target a rate of inflation is to believe that one can manipulate this non-neutrality of money. This is false and absurd. Ignoring this point explains why Bernanke believes that the price in commodities is of a temporary nature. In his mind, inflation can be targeted.
The next misleading concept is that of the existence of an equilibrium rate of interest. We believe this is self-explanatory, for there isn’t a single rate of interest, let alone equilibrium. If there was one, there would be no need for money as a medium of indirect exchange. This point was thoroughly addressed by Don Patinkin (ref. “The Indeterminacy of Absolute Prices in Classical Economic Theory”, 1949, Econometrica)
The last error lies in believing that there is a known potential GDP. This is a mechanic, Marxist, view of human action. It ignores the role of relative prices. Does anyone believe that a firm will hold inventory or work below capacity at a loss, just out of stubbornness? When a firm decides to lower output, or the use of resources, that decision is rationally driven, to remain profitable. The relative prices between inputs (and only one of which is capital) and output tells the entrepreneur that the apparently under-potential output is the profitable choice at hand. A potential higher output represents a potential loss.
In summary, the dual mandate of the Fed assumes the correctness of the price level doctrine. But in fact the whole mode of reasoning behind the Taylor rule is a typical case of arguing in circle. Its equation already involves the assumption which it tries to prove. It is essentially nothing but a mathematical expression of the untenable belief that there is proportionality in the movements of prices, unemployment and interest rates.
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: april-18-2011
Two weeks ago, we called our readers’ collective attention towards gold, noting that: “… we think higher highs are soon to come…”. A week ago, we expressed our concern that stagflation seemed to be manifesting itself before its time. We defined stagflation and went on to describe what made us believe that we were facing it. Over the past two weeks, markets have told us that our call was correct. They told us so by making our positions in our personal accounts profitable. Simply, their verdict is always the only one we pay attention to. But perhaps we were actually wrong and even then, we got lucky! Wise people are people full of doubts. We want to “wise up”, so we will devote today’s comments to raise doubts on our call…
If our stagflation call was right, shorting stocks and going long gold was the right thing to do. We think it was but what could tell us this is sustainable in the future?
Let’s leave gold aside for a moment. Its long-term trend is naturally from the lower left to the upper right, if only because of the steady increase in money supply coupled with the credit multiplier.
What could then make stocks return to a bull trend, proving us wrong? We think we would need to see certainty on a few fronts. Let’s see…
In the US, we don’t need to necessarily see sustainability on its fiscal deficit (to push stocks higher over the next weeks, that is…). All we need to see is that politicians of both sides tend to agree on a deficit cutting program, in a reliable way. On Friday, the US House passed a Republican budget in favour of cutting spending by more than $6 trillion over a decade. But no Democrats voted it and because Republicans oppose higher taxes and the cutting program involves the privatization of Medicare, both sides in Congress are worlds apart. Nothing tells us that this situation may change sooner than later.
It is not easy, we must say, to see how this affects markets. To begin with, it poses the question of how markets will react once QE2 ends in June, assuming no agreement on the fiscal issue. Opinions are divided here with those analysts on the street telling us that the Fed will just end QE policies, stop reinvesting mortgage backed securities proceeds and slowly raise rates. We cannot agree with them because the main assumption they have is that QE2 was to support the recovery in the private sector, and it succeeded. We disagree on both points. To us, QE2 was not to boost private growth but to finance the fiscal deficit and even that was not a success, as yields are higher. In this scenario, how can the Fed afford to leave the fiscal deficit problem unresolved and trigger a currency crisis? Perhaps the Fed governors are “lucky” and the surprising increase in jobless claims we saw last Thursday repeats itself next Thursday, showing that a trend in the making is at hand, and giving the Fed the perfect excuse to continue printing money. For brevity, we will leave this point here, only adding that there is a lot of confusion around this, with plenty of curve trades being recommended in Treasuries and misunderstanding of what backwardation is telling us, in terms of inflationary expectations (we will elaborate further on this, if it becomes more relevant).
Another source of global uncertainty remains that of sovereign risk within the European Union. During the last week, EU officials let it be known that a restructuring of Greece’s debt would not be catastrophic and immediately after, speculation began on whether such restructuring would trigger a credit event under the outstanding credit default swap contracts. We are not in a position (nor are we allowed to) to opine here. All we can say is that, on the margin, this doesn’t bring certainty. In addition, Moody’s downgraded Ireland by two notches to Baa3 from Baa1 (still investment grade) and this always leads us back to questioning the strength of the country’s financial system first, and that of all the EU at last.
Finally, no matter where one captures inflation statistics from, the story is unanimously the same and of higher inflation. A friend made the point that the latest release in the US, showing 50bps increase in CPI month over month implies a 6% annualized rate. We wrote here last week about this issue in relation to Emerging Markets. On that note also last week, China showed that the pace of increase in prices remains unabated and has announced another increase in the reserve requirement ratio over this weekend. It shall do nothing to the trend, only making things worse on the way.
In conclusion, we frankly see nothing new on the horizon that may derail us from heading towards a worsening “stagflationary” process. We will continue to trade accordingly.
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.
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