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Toronto, Sunday, May 5th, 2013With equity valuations no longer levitating but in a different, 4th dimension altogether, and credit spreads compressing Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out. It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick wont work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool: Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But Ive just given you the conclusion. I nee d to back it now
Martin Sibileau
martin@sibileau.com
(647) 999-2055
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
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Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs. It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a perpetual level. This expec tation provided the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention. This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPMled pool of liquidity injected to the call loan market.
Martin Sibileau martin@sibileau.com (647) 999-2055
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
PRE WORLD WAR II Federal Reserve Assets Liabilities Gold US dollars Fr Francs Currency swap Banque de France Assets Liabilities Gold Fr Francs US dollars
With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefitting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
Martin Sibileau
martin@sibileau.com
(647) 999-2055
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. We live in a fiat currency world, and banks simply let their loans amortize; theres no mark to market. With these purchases, capital reenters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. As long as this process is left to the market to work itself out smoothly, b orrowers dont suffer, because ownership of t he loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns dont improve their risk profile, lending capacity will be constrained. In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.
Martin Sibileau
martin@sibileau.com
(647) 999-2055
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
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Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.
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1971 - To date Federal Reserve Assets Liabilities US Treasuries US dollars Euros 2 European Central Bank Assets Liabilities US dollars Euros
European Central Bank Assets Liabilities US dollars Euros US Dollar loans US dollars
EU Banks Assets Liabilities US dollars US Dollar loans EU loans Debt Loan Loss Reserves Equity
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Final words
Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation.
Martin Sibileau martin@sibileau.com (647) 999-2055
Disclaimer: The comments expressed in this publication are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer. I prepared and distributed this publication as an independent activity, outside my regular salaried work. No part of the compensation I receive from my current employer was, is or will be directly or indirectly related to any comments or personal views expressed in this publication. All comments are based upon my current knowledge. You should conduct independent research to verify the validity of any statements made in this publication before basing any decisions upon those statements. The information contained herein is not necessarily complete and its accuracy is not guaranteed. If you are receiving this communication in error, please notify me immediately by electronic mail or telephone. The comments expressed in this publication 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. The comments expressed in this publication 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. All rights reserved.