(republished from “A View from the Trenches“)
Please, click here to read this article in pdf format:Â October 14 2012
Today, we were supposed to follow up on our last topic (how to shift to a commodity-based standard, with a 100% reserve requirement). However, we will have to leave that for quieter times. Right now, we have to address a few points that we have been making since 2009:
Thereâ€™s a truly â€œmust-readâ€ book, for anyone who is really interested in understanding how central banks have run the show since the 1920â€™s: â€œThe monetary sin of the Westâ€, byÂ Jacques Rueff. In his memoirs, M. Rueff makes it clear that the rally that ended in October 1929 was fueled by what we call today currency swaps. Indeed, in 1931 (Robert TriffinÂ was still a student) M. Rueff was writing:
â€œâ€¦There is one innovation which has materially contributed to the difficulties that are besetting the worldâ€¦(â€¦)â€¦ Under this system, central banks are authorized to include in their reserves not only gold and claims denominated in the national currency, but also foreign exchange.Â The latter, although entered as assets of the central bank which owns it, naturally remains deposited in the country of origin.Â The use of such a mechanism has the considerable drawback of damping the effects of international capital movements in the financial markets that they affect.Â For example, funds flowing out of the United States into a country that applies the gold-exchange standard increase by a corresponding amount the money supply in the receiving market,Â without reducing in any way the money supply in their market of origin.Â The bank of issue to which they accrue, and which enters them in its reserves, leaves them on deposit in the New York market. There they can, as previously, provide backing for the granting of credit.â€ Letter toÂ Pierre-Ã‰tienne Flandin, October 1st, 1931.
The innovation M. Rueff referred to 81 years ago was what Keynesian economists of the 21st century very mistakenly call â€œdecouplingâ€; a term that was used precisely to characterize the impact that the reduction in the price (to 50bps) of USD currency swaps had on the funding market, in December of last year. Today, this impact is best reflected in the cost of funding of the worldâ€™s carry currency, the US dollar, in terms of Euros. That price is called the Eurodollar swap basis. From the chart below (3-month basis, source: Bloomberg), we see how it has performed since 2008, as a result of interventions. Every time the costÂ spiraledÂ up (basis down), the Fed intervened with the swaps (i.e. US dollar liquidity lines).
On December 12th, 2011, we explained the mechanics of these swaps, and in January 2012, tired of reading the idiotic claim that policy makers had decoupled the US from the Euro zone, we wrote in a note titled â€œThere is no decouplingâ€ that :Â â€œâ€¦The big mistake is to call this a decoupling, because it is precisely the opposite: The problems of the Euro zone are now really coupled to the Fedâ€™s balance sheet! A decoupling would consist actually in letting the Euro zone banks collapse,Â together with the ECB, without any swaps â€¦â€
Why did we say (and still maintain) that â€œThe problems of the Euro zone are now really coupled to the Fedâ€™s balance sheetâ€?Â The same economists who view these swaps as decoupling the Euro zone from the USD zone also believe that the swaps effectively removed â€œtail riskâ€. As we warned onÂ March 4th, the FX swaps would allow credit Euro zone corporations to raise debt in US dollars, opening the door for the European Central Bank to monetize sovereign debt and crowd out,Â in Euros, the non-financial private sector. In US dollars, this crowding out was not going to happen (and it did not happen), courtesy of the Fed.
However, if the Euro zone was going to survive, we wrote that:Â â€œâ€¦eventually, we shall see a wave of EU corporations defaulting:Â Compared to US corporations, EU companies are exposed to higher taxes, an overvalued currency, institutional uncertainty and the benchmark rate ( i.e. sovereign spreads) is higher than that for US companies (i.e. US Treasuries)â€¦.Â but, if that wave of defaults occurredâ€¦who would be bailing out the US institutions that financed the EU corporations? Yes, you guessed right: The Fed! No, Bernanke did not mention QE3 last Wednesday, but we donâ€™t need him printing monetary base to create the next bubble. All we need is a good currency swap, cheap Euro rates, a zombie EU financial system and the commitment to keep USD real rates in negative territory until at least 2014.â€Â We offered the chart below:
Which brings us back to the core of todayâ€™s articleâ€¦What has happened since we wrote about these issues?
First, last week Dennis Gartman, in his homonymous letter said that he was concerned about the fact that the adjusted monetary base has been falling, rather than rising, taking away the bullish case for gold on the topic of â€œmoney printingâ€. One must therefore remind those with this concern thatÂ the credit expansion caused by the backstop of the Fed alone is enough to inflate asset prices. This is consistent with the case we made in our last letter, that a commodity based standard is not as relevant as having a 100% reserve requirement. By the same token,Â if the reserve requirement is below 100%, it is not that relevant to see the expansion of the monetary base!Â The â€œprinting of moneyâ€ will eventually come, when EU corporations begin to default and the Fed has to â€œensure there is enough US dollar liquidityâ€. It happened in 1931-33,Â in spite of the fact thatÂ the adjusted monetary base had been contracting since 1929: The US dollar was devalued from approx. $20.65/oz to approx. $34.70oz and gold was confiscated. If you donâ€™t believe this, hereâ€™s the video showing the bailout of Germany from USD debt, announced by PresidentÂ Hoover in 1931:
And hereâ€™s the announcement of the confiscation of gold:
It can happen in the future, because the same Ponzi scheme is being played out before our eyes.Â We are not alone with this concern. Congressman Ron Paul has publicly expressed this view, as this video shows:
We willÂ repeatÂ ourselves: 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.
But, how do we know this is a problem? Is it true that EU corporations have already embarked in US dollar borrowing which can have consequences in the future? On October 5th, BNP Paribasâ€™ US Credit team published a review of the state of the Yankee market. Compared to a decade ago, the Yankee market represents now 20% of the US dollar corporate bond market (from 10%), but the strongest growth occurred since 2011/12. The same publication notes that industrials (i.e. non-financial issuers) have grown in importance and now constitute 58% of all Yankees (bonds) (Curiously, the authors of the publication see this positively, because â€“apparently-, thanks to this growth in US dollar borrowing by non-US issuers, the market (both demand and supply) gains in diversification. I hope someone reminds these people to check what level the cross-asset correlation reaches, when the next liquidity crunch comes. Our bet is that it probably reaches 1!)
Can we see this â€œcouplingâ€ of the Fedâ€™s balance sheet with the rest of the world causing other distortions? The Credit Derivatives team of Morgan Stanley, in its Credit Derivatives Insights publication of October 9th, noticed that less than 5% of the bonds in USD non-financials (in theÂ iBoxx) are trading below par. And in the high-yield space, 70% of the non-financials are above par. Whatâ€™s even worse, 24% of high-yield non-financials is even above their call prices!
In this context, hedging with credit default swaps is not efficient, because under the respective contracts, protection on default is covered only up to 100% of the price of the bond, and these bonds are trading above 100%. This means that, in some cases, even if one bought a bond and hedged it with a credit default swap, at default, one would suffer a significant loss.Â In other words, this shows a probability of default that is under priced, underestimated. And guess whatâ€¦it makes sense!! Yes, with Bernanke at the helm of the Fed, you have to underestimate the probability of default, because he is telling in our faces that he will print dollars as long as US dollar liquidity is needed!Â But, butâ€¦.should we really fear defaults? Well, there is always the ongoing concern that the Euro zone may break, sending shock waves everywhere. But also, in corporations, leverage is once again building up, and this time, more because EBITDA is deteriorating than the debt increasing.
This brings us to our final point: Will interest rates increase? We have observed a discrepancy of views in US Treasury rates forecasts this week too. If you read ourÂ last letters, you will know by now that we expect,Â if the ECB engages in its Outright Monetary Transactions,Â a convergence of short-term sovereign yields within the Euro zone. And, in the end, we expect both the short-term Euro zone yield and the USD yield to converge too, courtesy of the Fedâ€™s coupling via the backstop entailed in the FX swaps. But the path towards that convergence is what has been taking our attention lately. We think that in the beginning, US yields should increase until a maximum tolerable level is achieved, after which, the Fed intervenes via purchases to keep yields within an implicit target. Until we get there, we will have to first see the bailout of Spain and some concrete steps towards an EU banking union. That will surely be the topic of future articles. But right now, obviously, weâ€™re not seeing the materialization of these steps.
Once that level in USD rates is reached, the Fed will have to regularly purchase US Treasuries, to keep yields within their acceptable range.Â The assumption is that both the US fiscal deficit and the Outright Monetary Transactions continue.Â This would devalue the USD, making Yankee issuance even more palatable! This will be the bailout of the Fed, to the EU corporate sector and it can only last as long as the appreciation of the Euro does not hurt the Euro zone periphery. But it willâ€¦