Click here to read this article in pdf format: october-17-2011
We apologize for not having written sooner. We usually do if we find new, market moving information. Unfortunately we have not in the past three weeks, which is also evident in the range trading all asset classes have witnessed.
As we write, the G-20 is meeting and the EU will have its own discussions, later in the week. One of the main topics markets have been paying attention to is that of EU banks recapitalization. This is not news. We have been discussing the futility of this issue since 2010. It is nothing short of circular reasoning. On June 4th, 2010, we warned that:
â€œâ€¦there continues to be confusion in the analysis of the EUR problem. The latest one consists in criticizing the ECB for lack of clarity in its bond purchases (â€¦) While the Fed gave details about its unsterilized asset purchases, the ECB will not. But we explained why this is so:
â€œâ€¦The Fed was financing what we call in Economics a â€œstockâ€, i.e.( mortgages) â€œâ€¦a variable that is measured at one specific time, and represents a quantity existing at that point in time, which may have accumulated in the past…â€ (http://en.wikipedia.org/wiki/Stock_and_flow ). The ECB is financing â€œflowsâ€, deficits, or â€œâ€¦a variable that is measured over an interval of timeâ€¦â€ Therefore, by definition, we cannot know that variable until the interval of time endsâ€¦When will deficits end? Exactly!! Nobody knows! Thus, it is naÃ¯ve to ask more clarity on this issue from the ECB. The only thing that is clear here is that the Euro, i.e. the liabilities of the ECB will necessarily have to depreciate as long as that interval of time exists, until a clear reduction in the deficits is seenâ€¦â€
Again on June 29th, 2010, we added that: â€œâ€¦Finally, we want to discuss an idea suggested yesterday by Morgan Stanleyâ€™s Global Economics Team (ref.: â€œThe Lure of Liquidityâ€, The Global Monetary Analyst, Morgan Stanley, June 16th, 2010). The authors (i.e. J. Fels and E. Bartsch) propose that â€œâ€¦the Euro has been caught in a vicious circle, where the sovereign debt crisis and the bank funding crisis are mutually reinforcing each otherâ€¦â€. Essentially, monetary policy, which this report calls â€œPassive quantitative easingâ€ is to blame for this spiraling circle. It is also proposed that had the ECB activated â€œActive quantitative easingâ€, where the central banks buy public or private (i.e. mortgages) bonds in size, the result would have been differentâ€¦the crisis would have been contained.
We could not disagree more with this flawed and misleading notion. It is flawed because it doesnâ€™t acknowledge the structural difference in what the ECB is financing, vs. what the Fed was financing. We brought up this issue weeks ago, when we said the Fed had been financing â€œstocksâ€ (a magnitude in Economics), assets, which are finite and certain, like mortgages, while the ECB is financing â€œflowsâ€, which are only determined at the end of a period (i.e. Q4 2010) and are therefore uncertain. Thus, the ECB cannot commit to buy a certain size of debt and run the risk of failing to meet expectations. The ECB, as well, cannot have an exit strategy, as we discussed in our letters at the beginning of May.
This interpretation is also misleading, because it suggests that the solution to this problem would have been increasing the capitalization of the European financial system. This system is not active, but passive in this storyâ€¦.â€
The circular reasoning therefore resides in that the recapitalization of banks by their sovereigns increases the sovereign deficits, lowering the value of their liabilities, generating further losses to the same banks, which would again need more capital:
However, as we write, policymakers are considering the recapitalization of EU banks again. Not only does it not make sense, but also, should this exercise be coercive in nature to the private sector, forcing bondholders to become equity investors in a mandated conversion, unspeakable damage will have been done globally to any prospects of growth. This is the path that may be taken after all and we are accordingly ready to see higher correlations, volatility and the run for USD liquidity make a comeback. Gold could be seriously affected in the process.
What would be a solution for the EU? We have repeatedly said it: Either full fiscal union or monetization of the sovereign debts. Anything in between is an intellectual exercise of dubious utility. On January 28th, 2011, we described in detail what we think is still a viable alternative: The swap of EFSF bonds for sovereign bonds, in the secondary market.
We want to end our comments today with two observations, back on this side of the pond:
1.- Since the announcement of Operation Twist, unlike what was expected, the US yield curve has steepened, rather than flattened. Is this the result of a reallocation from US bonds to stocks, or a vote of non confidence on the Fed? For now, we are inclined to believe in the former, but only because we find stocks had been oversold too fast. Longer term, we have our doubts and we find that this steepening of the yield curve and gold stronger in USD terms rather than in Euros, is not a coincidence.
2.- Last week, the Fed created ex-nihilo approx. $1.3 billion to lend for 3 months US dollars to EU banking institutions. These are US dollars nobody in the US has saved for, and these are US dollars indirectly financing, many times via the credit multiplier, the fiscal deficits of the EU. A forced recapitalization of EU banks would eventually increase the size of these operations, because private investors would dump their holdings running for liquidity. We hope this will not occur because the only possible unwind in that case would be through global USD inflation. Again, gold stronger in USD rather than in Euros, we think, is not a coincidence.
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Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.
Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.