(republished from “A View from the Trenches“,Â September 30th, 2012)
Click here to read this article in pdf format:Â September 30 2012
This week, we want to follow upÂ on some thoughts from our last two letters, where we deduce the impact of the policies undertaken by both the Fed and the European Central Bank (ECB). As well, we provide a few comments on an ongoing debate: Will we ever experience hyperinflation?
Last week, we came up with three important conclusions:
-Conclusion No.1: The ECB backstop generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)
This is what we wrote onÂ Sept. 10th:Â â€œâ€¦Â Until now, selling distressed sovereign bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banksÂ will demandÂ that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rateâ€¦â€
Where do we stand?
Everyone expects Spainto request a bailout and accept the conditions that would allow the ECB to buy their bonds. In the meantime, someone took the time to measure the impact of the ECB backstops over the past year and came up with a number: EUR9BN in capital gains. On Sep. 20th, the European Banks research team from Barclays published a note titled â€œLiability management-understanding the rationaleâ€. Barclays estimates that in their liability management transactions on EUR200BN of unsecured debt, European Banks have gained EUR9BN, from lower interest expenses. This of course, came courtesy of the Fed first (remember the EURUSD swaps put in place at the end of 2011?) and the ECB later, with 3-year long-term refinancing operations. The chart below (source: Bloomberg) shows the iShares MSCI Europe Financial Sector Index Fund (ticker: EUFN). The rally that began at the end of July with the speculation on the future actions of the ECB has peaked, awaiting further news.
Â If we are correct with this conclusion, removing (i.e. buying) the assets backstopped by the ECB (i.e. sovereign debt) from the banks in the secondary market via the OMT (Outright Monetary Transactions), will be expensive to the banks. Why? Because these banks, which after so much misery, end up finding out that the assets they were holding are no longer in risk of default and provide a nice interest, will now have to hand these assets over to the ECB. It would be ok to do this every once in a while. However, the fiscal deficits of the EU countries do not happen every once in a while, but every minute and they keep on growing! Should the ECB seek to make the OMT sustainable as the fiscal deficits of the Euro zone periphery continue, the banks will have to be appropriately compensated. The risk remains then, that at a future, much later date, the ECB faces a net interest loss (between the interest it receives for their sovereign debt holdings and the one it pays to the banks). Under this scenario, the only alternative left will be to monetize that deficit all the way to hyperinflation. But in the meantime, letâ€™sÂ move toâ€¦
-Conclusion No.2: The ECB backstop will set a floor to yields
This is what we wrote:Â â€œâ€¦As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap â€“having been validated by the ECB- will become the floor for sovereign risk within the Euro zone.Â The key assumption here is that primary fiscal deficits persist across the Euro zoneâ€¦â€
Where do we stand?
It is too early to say anything, as the ECB has not purchased anything yet and the potential secession ofCataloniaand recent protests have delayed (if we are correct) the establishment of a floor.
-Conclusion No.3: The ECB backstop will first push rates within the Euro zone to a convergence (periphery will have lower rates, core will see higher rates). And secondly, will force US rates to converge to the Euro zone rate, if the Euro zone survives the first convergence.
This is what we wrote:Â â€œâ€¦within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield targetâ€¦.â€ and â€œâ€¦If the () trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield.Â For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the worldâ€™s risk-free rate! The big assumption here is of course, that the first trend, above, holds true.Â Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggeredâ€¦â€
Where do we stand?
Again, with the political struggle between the periphery and coreEuropeand (within the periphery) between the people and their appointed leaders, this convergence has been temporarily interrupted
The charts below (source: Bloomberg) show the convergence that started at the end of July, in 2-yr rates (but can also be observed in 10-yrs, not shown here). In the second chart, we show theUS30-yr yield, which suggests that a bearish trend is building (i.e. higher yields), consistent with our conclusion. Time will decideâ€¦.
All this would indicateÂ that the key to whatâ€™s coming next is simply political, which brings us back to one of the first letters of the year, titled â€œAn analytic framework for 2012â€, where we precisely showed the tragic (and spiraling) circularity of enhanced deficits, adjustments programs and coercion by the EU council, backstopped by the actions of the ECB. We reproduce a chart from that letter, below.
As the problem spirals, the actions of the ECB must strengthen: If at the beginning of the year, 3-yr lines of secured lending bought time, by September, â€œconditionalâ€ but unlimited bond purchases were now required. A few months from now, that conditionality will surely be merely a simple protocol. In every turn of this circularity, as unemployment, prices and fiscal deficits grow, so does social unrest.Â Social unrest therefore is the determinant in thisÂ overdetermined system.
To those familiar with Algebra, we suggestÂ that the Ponzi scheme we live in is actuallyÂ anÂ overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America.Â That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system!
Some final comments on hyperinflation
We have noticed of late that thereâ€™s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. We will not discuss the latter today. With the regards to the former, we think it is still early to talk about hyperinflation. We donâ€™t know when it will take place. All we can guarantee is that there are certain conditions necessary to see inflation spike up and morph into hyperinflation, and such conditions have not crystallized yet. However, there is a high risk at this stage in the game that they do, and we briefly examined that risk for the Euro zone, onÂ September 10th.
Money has two purposes: to store value and to transact. There is however another use of money, which is a derivative of the storage-of-value use. The use of money to repay debt.
Those who demand money to repay debts do not do so to store value or to transact. But as long as there are debts outstanding, there will be a demand for currency to repay that credit. This means that, in order to see such demand diminish, we need to see defaults first, which will along eliminate credit extended in fiat, debased currency. As this process unfolds, the banking system goes bankrupt, is nationalized, and credit is directed towards and centrally managed by the government. This may easily takes years, but it is taking place in the Euro zone right now. The repo market and futures markets die along and central banks end up becoming counterparties in cross currency and interest rate swaps. Once this stage is reached, the private sector is out of the system and fiat money is only demanded to transact. Hereâ€™s when the velocity of circulation of money starts to rise exponentially.
As these successive steps are passed, slowly, central banks suffer structural changes in their balance sheets. For instance, letâ€™s take the example of Argentina. At one point, after many devaluations of the peso, the central bank by 1982 had become the main USD swap counterparty for corporate credit. However, to avoid a wave of bankruptcies after the June 1982 devaluation (after the Falklands War), it refinanced USD denominated debt at a 23% lower exchange rate, and in the process sold FX insurance at a cost (for the corporations entering the transaction) of 5%/month, when the inflation rate was 7.9%/month. This was going to be a huge burden that accelerated the deficit of the central bank, which of course was monetized (referÂ here), unleashing the first high inflation of 1985.
The parallel with the situation in the Euro zone is self-evident: If the ECB starts buying sovereign bonds as fiscal deficits continue, the recent transitory appreciation of the Euro (to $1.3150 was mainly driven by short covering and the capital gains in financials, mentioned above) is not sustainable. In the long run, the intervention of the ECB would only devalue the Euro, creating a currency mismatch for those companies Â in the Euro zone that issued USD denominated debt. Thanks to the FX swaps by the Fed and the crowding out of the ECB in favour printing Euros for government debt, these companies are more numerous than they would have been. Therefore, the ingredient for an hyperinflationary process is already present, but weâ€™re not quite there yetâ€¦
In the end, by the time the use of fiat money is reduced to its transactional role, central banks run huge deficits, called quasi-fiscal. They have backstopped government debt, money markets, repo markets, future markets and derivatives markets. The interest they pay on their liabilities to sterilize their actions always ends being higher than the one they receive for their assets. And it makes perfect sense: Otherwise, nobody would have asked these central banks to be their backstop! An additional source of fuel for this fire is the so calledÂ Olivera effectÂ (after Julio H. Olivera). This is another ingredient to turn a mild inflationary process into hyperinflation. This effect refers to the fact that when inflation reaches a relevant number, it becomes profitable for taxpayers to delay their tax filings, which reduces the tax burden. Governments are thus forced print more money to cover the loss in real revenue they suffer.
The fact that we are still in the early chapters of the story just narrated does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 wonâ€™t lead to spiraling quasi-fiscal deficits.