Dylan Grice: „The Gold Market Is Healthier Now“

"Gold has become much more affordable in recent days as the price has collapsed. Such a collapse is unpleasant, but not cause for concern," advises Dylan Grice. "Gold remains durable," as a source of protection from loss of confidence in the system, and, he adds "a correction was overdue. Now, the gold market has become healthier." Critically, Grice warns during this interview with Finanz und Wirtschaft, "gold will not protect against a crash in the financial markets, it showed 2008," since if many investors simultaneously urgently need cash, they sell everything they have, including gold. However, Europe is a time-bomb, China's credit bubble is ow where the US was before the financial crisis, and while inflation may not be an imminent threat (and likely shuffled more gold holders out leaving "a more stable investor base,") Grice concludes, "Gold endures. If confidence in the currency is lost, or in the bond market; Gold is a safe haven." There are good reasons to own gold. And to buy gold, there is now a reason more than a week ago: It's 30% cheaper.

Via Finans und Wirtschaft

Why the gold price has suddenly dropped so quickly?
There are many opinions, ranging from conspiracy to cyclical or chart-based technical reasons. I have no idea. And I know no one who really knows. Although many people believe, to know the reason, but that's not the same.

Do you have at least a guess?
We still do not know what caused the stock market crash in 1987, and we'll probably never find out. The same applies to the slump in the gold market in recent days. To know the cause, would be nice, but is not so important.

What does the falling gold price?
Each boom has  large corrections, and these are often violent. In the gold market, there was a break in the mid-seventies, the price fell more than 40%. This was painful, and many people wrote back then: for gold - it felt like the end of the bull market; not true. This was a healthy correction. 1987 shares fell 25% in one day, that did not mean the end of the bull market. 1994 broke the bond market. In 1997, the Asian markets, but in both cases continued to rise.

Can the translate that directly to the gold market?
The collapse does not necessarily mean that the gold bull market is over. They could indeed be over, but I think not. And in view of the great whole, such a collapse is not important, even if it is violent and unpleasant course. There are good reasons to own gold. And to buy gold, there is now a reason more than a week ago: It's 30% cheaper.

So is this a buying opportunity, or should we come to doubt the bull market?
I have no idea if the gold price rises or falls in the coming months. But gold endures. The market strategist Marc Faber argues, the share price of Apple had fallen much more than gold. But what will happen with Apple in ten or a hundred years? That nobody knows, and this applies to all companies and for most currencies. All we know is: A gold bullion a hundred years ago is the same as a gold bullion now. In Roman times, they said "let himself pay one ounce of gold a decent toga and a meal," that is still true today.

The price of gold fluctuates but violently.
Yeah, we just saw a spectacular fluctuation. But owning gold brings with it durability. This makes gold as an investment is very attractive.

Discontinuity does not fit into a durable investment.
Gold is up for twelve years in a straight line, which is extremely unusual. Since it takes a downsizing, a certain liquidation. This is not unnatural. While this largest price drop in the past thirty years is unusual, on the other hand, these unusual incidents occur quite often in financial markets. A correction was overdue. Now, the gold market has become healthier.

Gold will now be seen as less?
The mood in the financial markets has changed. Investors have become more confident that the worst is over and everything will be all right: Europe has solved its problems in principle, that the U.S. is on track, and China beat well. I had predicted that China will have a difficult year 2012, but it has not materialized. All this ensures optimism. Those who had bought gold for fear of imminent higher inflation, perhaps now sees no more danger of inflation and thus an end to the gold price increases - why should he keep gold?

Is inflation coming?
I was never bullish for gold, because I assumed higher inflation is imminent. Inflation is slow and is a long-term problem. You will not see it suddenly - such fears I've never understood. But those who acquired gold for the wrong reasons, it may now be sold. Those who maintain it now belongs to a more stable investor base.

The market sentiment has not brightened rightly
Look around: States and financial systems are deeply in debt, interest rates can not fall further, real interest rates are negative, we live in a world of financial repression. The best possible outcome would be a gentle rise in interest rates in the coming years. This would be accompanied by negative real interest rates, because that is the only way for governments to gradually reduce their debt burden. In this scenario, long-term interest rates remain extremely low and therefore overvalued stocks and bonds. That's not a bad environment for gold.

What are worse scenarios?
The danger is that the central banks lose control of inflation and interest rates. This is a deadly combination for the bond market, and also for stocks that showed up in the seventies. There are also other dangers: Europe is a time bomb. The euro was supposed to bring peace and prosperity and has instead caused a split. China deregulated the financial system, and the debts have grown significantly. The country is now where were the U.S. was before the financial crisis. This is a dangerous game. On credit expansion sooner or later followed by a reduction in debt. The consequences of this are evident in the U.S., Spain, Ireland, in the euro zone - also politically and socially. That will not be any different in China.

Gold rose in parallel with the expansion of central bank balance sheets. This is no longer?
I am very careful of such correlations. As I learned as a student with extensive econometrics, you can in fact establish a correlation between rainfall in Scotland and the money supply in the UK. Correlations do not mean much, even if the relationship between central bank balance sheet, fear of inflation and the gold price is reasonable. The fear may subside, then breaks up the correlation.

Should central banks in emerging markets buy more gold?
I do not know. If I were central banker, I would certainly do that.

Gold is not a safe haven anymore?
Gold will not protect against a crash in the financial markets, it showed that in 2008. If many investors simultaneously urgently need cash, they sell everything they have, including gold.  If confidence in the currency is lost, or in the bond market, then gold is a safe haven. This happened to some extent in the seventies. Holding gold before the last crash was the right choice and it is now more than ever. I suppose I do not know how to evaluate permanence, but it is worth a lot to me.

Putting His Mouth Where His Money Is: Meet Dylan Grice’s New Home

It is no secret that one of Zero Hedge's favorite mainstream strategists over the years was SocGen's Dylan Grice, which perhaps in itself was a logical warning sign that his career in the mainstream was doomed to a premature end. Sure enough, several months ago, Grice, whose guiding motto has been sound money uber alles as he dutifully exposed - as much as he could  - crack after crack in the facade of the status quo, announced he was leaving SocGen, and was headed for greener pastures, literally, in this case Zurich-based fund Edelweiss, run by Anthony Deden. And while lateral moves in the financial industry are nothing new, we were quite impressed to learn that unlike most other "capital preservation" managers, Dylan Grice's new home has a rather stunning allocation of AUM to precious metals. How stunning? Decide for yourselves.

That's right: 60% of Edelweiss' capital is allocated to PMs, as over the past 7 years, more and more cash was allocated to gold, silver and the like. This is orders of magnitude more invested in real assets than most other "wealth preservation" funds will allocate to the sector.

Naturally, the performance of the fund has tracked that of the precious metal sector, and has as expected, outperformed the vast majority of its competitors in the past decade.

Here is how Grice's new employer describes itself:

Founded in 2001, Edelweiss Holdings is an open-end investment company focusing on the preservation of wealth against the erosion of the purchasing power of money.


As stewards of capital, we seek to provide durable refuge in an uncertain world. We reject the hollow output of an unprincipled financial system, preferring instead the timeless substance of honest entrepreneurship.


As responsible owners, we value independence, scarcity and permanence both as to our thinking and also as to the aggregate nature of our investment collection.


Our practice is intellectually honest, conservative, disciplined, respectful of capital and entirely free from conflicts of interest. Edelweiss Holdings employs its own investment team reporting to a board of independent directors.

And the refreshing introduction letter from its founder:

Understanding what we do at Edelweiss Holdings requires an understanding of why we do it—and the ideas behind why we do it. Above all else, it requires an appreciation of what we call the sanctity of savings. This idea imparts a deep respect for honest capital and for the knowledge and wisdom embedded in that capital.


Saving involves sacrifice. Sacrifice requires fortitude. Fortitude should be rewarded over time by an accumulation of capital, granting the saver more options and freedom than he or she otherwise would have had. There is unlikely to be a second chance to re-accumulate a lifetime’s savings. When it’s gone, it’s gone. That capital is precious to the saver.


But that capital is precious to the wider community, too. In a free society, the most profitable activity is likely to be that which satisfies the greatest desire. Since savers provide the capital which makes that activity possible, they make the satisfaction of society’s desires possible too. And capital grows cumulatively, today’s capital stock laying the foundations upon which tomorrow’s prosperity is built. The better the allocation of scarce capital to its most productive use today, the more solid those foundations. Whether people realize it or not, the decisions we make with the capital and savings of today’s generation are our bequeathment to tomorrow’s. We are consequently motivated by a conviction that the wise stewardship of honest capital is a fundamentally noble endeavor and view the responsibility of managing savings as much a burden as it is a privilege.


Capital is scarce. It is valuable. And so it is vulnerable. It is vulnerable to confiscation explicit and implicit, to competitive erosion and to bad ideas. The protection of honest capital thus requires honest thought: about the world, its dangers and opportunities, about our investments, about the nature of risk. Above all it requires honest thinking about ourselves, our capabilities and our limitations.


Some might liken our approach to “value investing.” But we’re not sure what “value investing” is. The cheapest stocks are often some combination of bad businesses and poor management. Others might see us as “contrarian.” But we don’t know what “contrarian” means either. It is contrarian to cross the road with one’s eyes closed, yet we prefer to cross with our eyes open. So we are quite consensus sometimes. We currently own a relatively large holding of gold in our vaults. In the past we have had similarly large concentrations in government bonds, or in oil royalties and other types of assets. So, some might think we practice “macro investing.” But we don’t know what “macro investing” is either. Do macro investors try to predict the future and make their bets accordingly? We don’t. Our crystal ball is as foggy as the next man’s.


We are none of these things. We are independent. We see ourselves as honest entrepreneurs in search of honest entrepreneurs, patient in action and careful in thought. We are not traders. We are owners. And the ownership of productive resources run by honorable and able people is the best way we know of protecting the scarce savings of our shareholders.

It looks like Dylan has found a perfect place to call home. We look forward to presenting his periodic musings to an audience that certainly shares his employer's views regarding resource allocation and certainly capital formation.

Three Scenarios For Gold

Even though we have presented comparable scenarios looking at the coverage of the US money base in gold terms previously, aka "gold coverage" ratio, including once from Dylan Grice, and once from David Rosenberg, now that we have drifted into a new, previously unchartered and very much open-ended liquidity tsunami, it is time to revisit the topic. Luckily, Guggenheim's Scott Minerd has done just that. Not only that, but he presents three distinct gold pricing scenario, attempting to forecast a low, medium and high price range for the yellow metal.

To wit: "The U.S. gold coverage ratio, which measures the amount of gold on deposit at the Federal Reserve against the total money supply, is currently at an all-time low of 17%. This ratio tends to move dramatically and falls during periods of disinflation or relative price stability. The historical average for the gold coverage ratio is roughly 40%, meaning that the current price of gold would have to more than double to reach the average. The gold coverage ratio has risen above 100% twice during the twentieth century. Were this to happen today, the value of an ounce of gold would exceed $12,000.” 

Keep in mind, the $12,000 price is based on the current monetary base. When this number rises by $2 trillion (at least) through the end of 2014, the upside case of gold will be orders of magnitude higher.

And now you know why bickering over a few hundred dollars here and there is largely irrelevant, and in fact one should be delighted if gold can be purchased at as low a price as possible. Why? Because one thing is absolutely certain: in order to keep the ponzi going, with every other sector at peak leverage, including household, corporate and financial, and real assets already massively encumbered by debt, the only real indirect buyer of gold will be the world's central banks, by means of diluting the existing paper supply. And whether or not the New York Fed, or some gold cartel, are actively pushing the price of gold lower, this is very much irrelevant, and in fact continues to be a welcome diversion, one which allows for the artificially low entry prices into gold. Because one day, gold will revert to its fair value, and so often happen, that is when its will go back to 100% "coverage" as faith in fiat evaporates. At that point whether one bought gold at $1000, $1500 or even $2200 will be absolutely irrelevant.

Charting The Exponential Function Of Financial Complexity

There is a perverse macro-level outcome from over-zealous central-planning. We have talked in the past about the greater risk of huge tail events in a controlled/normalized/planned/smoothed world, but as SocGen's Dylan Grice in an analogy to driving: "traffic lights and road signs are well intentioned, but by subtly encouraging us to lower our guard they subtly alter the fundamental algorithm dictating micro-level driving behavior." In other words, we drop our guard. With the plethora of financial market traffic light and road signs (Basel III, Solvency II, Bernanke Put) the fear is that this illusion of capital or safety has made markets more lethal (think AAA-rated bonds for a simple example). "We should be able to understand that the world isn’t risk free, can never be made risk free and that regulations which trick people into thinking it is risk free serve only to make it more dangerous." But instead, following the rule-of-Iksil (baffling with bullshit), regulators have gone the traditional route - but this time to an exponential place of craziness with Dodd-Frank - layering complexity upon complexity to give an out to those who abuse it most. Perhaps, as Grice notes, instead of focusing on 'fixing' the "crisis of capitalism", it would be more pragmatic to focus on the "crisis of dumb counterproductive intervention"?



Source: SocGen

On The Keynesian Lunacy Of Targeting Outcomes

The pages of the financial press overflow with opinions on what targets would make the world safer: what ratio of risk-weighted-assets banks should target, what RoE targets they would be safe at, what inflation target the central bank should aim for, or what growth target is appropriate for China. When SocGen's Dylan Grice was asked if he was a fan of the idea of nominal GDP targets! He snapped he is not and thought it "a terrible idea". As he opines, today’s various issues – the euro, China’s economy, over-indebtedness – are the cumulative unintended consequences of such past targets, and the naïve presumption that complexity can be commanded. Even mildly complex systems, any outcome is the wrong thing to target, with the process being where the focus should be. Expressing how little time he has for macroeconomics, reasoning that it’s obsessed with the targeting of interest rates, GDP, inflation, unemployment, exchange rates, et cetera, as though such a thing was possible without unintended consequences; Grice notes that Austrian economists understood this too. Ludwig von Mises distilled social phenomena to the simple observation that "man acts purposefully".

Dylan Grice - The tyranny of targets: process, outcome and the complexity of it all

The pages of the financial press overflow with opinions on what targets would make the world safer: what ratio of risk-weighted-assets banks should target, what RoE targets they would be safe at, what inflation target the central bank should aim for, or what growth target is appropriate for China. Someone even asked me if I was a fan of the idea of nominal GDP targets! I’m not. It’s a terrible idea. Today’s various issues – the euro, China’s economy, over-indebtedness – are the cumulative unintended consequences of such past targets, and the naïve presumption that complexity can be commanded.


All outcomes are caused by an underlying process.


But I’d argue that for even mildly complex systems, any outcome is the wrong thing to target. As we just saw, targeting one outcome of such a process changes that process, and changing the process subsequently changes all the other outcomes. In any kind of complex system where the underlying outcome generating processes aren’t well understood – whether a company, or a society – the effects of changing the process won’t be well understood either. Unintended consequences must ensue.


Yet even a cursory glance at the news shows ‘outcome targeting’ to be endemic: in response to the damage caused by Basle II, we’re given the ‘new and improved’ targets of Basle III (now already being traduced); the insurance industry now faces Solvency II targets; investors fret that banks won’t be able to hit their RoE targets; investors wonder if China will be able to hit its 8% GDP growth target; most major central banks target some sort of CPI inflation rate.


This is lunacy. How much damage has already been caused by banks that overreached themselves in trying to meet their RoE targets? How lopsided and capital destructive has China’s insistence on hitting its breakneck GDP growth targets at all costs been? How much of today’s painful credit deflation was caused by the credit inflation central banks pumped up while aiming for their CPI inflation target? In targeting these outcomes, underlying processes were distorted. Unforeseen outcomes resulted. But regulators continue to prescribe capital targets, banks continue to target RoE, China continues to target a growth rate, and central banks continue with ever more experimental methods in defence of their inflation targets. Indeed, today in Europe we’re seeing the unintended consequences of imposing outcomes (i.e. an exchange rate) on the eurozone economies.


Regular readers know how little time I have for macroeconomics. One reason is that it’s obsessed with the targeting of interest rates, GDP, inflation, unemployment, exchange rates, et cetera, as though such a thing was possible without unintended consequences. Since such variables are actually outcomes of a complex process, most macroeconomics seems to me to be an embarrassingly naïve study of outcomes which completely neglects process.


I’m not sure when this started. Adam Smith’s observation on the ‘invisible hand’ of selfinterested but mutually advantageous behaviour might have been our species’ first articulation of a complex adaptive process. Austrian economists understood this too. Ludwig von Mises distilled social phenomena to the simple observation that ‚man acts purposefully,? while Hayek coined the phrase ‚spontaneous order? to describe the market. And all this before complexity had been given its name by mathematicians.

The thing is, Adam Smith and the Austrians didn’t fall into the trap of focusing on outcomes. And we’re trying to avoid that trap too.

"The Truth Gets Out Eventually"

Some look at today's FaceBook IPO flop, the ongoing market rout, and the situation in Europe with disenchantment and disappointment. We, on the other hand, view it with hope: because more than anything, the events of the past few days show that the truth is getting out - the truth that capital markets simply can not exist under the authoritarian rule of central planners, the truth that the stock market is a casino in which the best one can hope for a quick flip, and finally the truth that our entire socio-economic regime, whose existence has been predicated by borrowing from the uncreated wealth of the future, and where accumulated debt could be wiped out at the flip of a switch if things go wrong in the process obliterating the welfare of billions (of less than 1%ers), is one big lie.

We believe that hope is what SocGen's Dylan Grice is what he has in mind when he penned the following conclusion to his most recent piece: La Grande Illusion.

Since the crisis broke in 2008, the Fed and BoE have printed enough money to buy over 60% of the issuance of their respective government securities since. It makes you wonder. What would bond yields in the US and the UK look like without these purchases? Probably like those in the eurozone periphery. Indeed, maybe the euro debacle could have been completely avoided if the ECB had been headed up by a Ben von Bernanke, or a Mervyn Le Roi. Maybe that’s why so many of my friends agree with Atlantic magazine, which praised Ben Bernanke for ‘masterfully navigating’ the financial crisis and avoiding another depression.


Maybe all the Anglo-Saxon central banks have done is create the illusion that our sovereigns are more solvent than they are, and that our budget constraints are really a safe distance away.


But I don’t think they are. And I think the truth gets out eventually. The Enrons, the Allied Capitals, the Bernie Madoffs … they all get their comeuppance. Indeed, it’s what’s happening today in the eurozone. The accounting shenanigans eurozone governments resorted to in order to meet the entry criteria have been found out. Or at least, current CDS prices correlate well with countries’ cumulative deficit manipulations in the run-up to monetary union, as estimated by Paul van den Noord and Vincent Koen at the OECD. You can’t escape your budget constraint with financial gimmickry. You can just make it look like you have for a while.


Because if there is at least one thing the central planners of the status quo do not have control over, it is just that: hope.

Tim Price And Don Coxe: "We Have Entered The Most Favourable Era For Gold Prices In Our Lifetime”

Submitted by Tim Price, Director of Investment at PFP Wealth Managmenet, courtesy of Sovereign Man

We Have Entered The Most Favourable Era For Gold Prices In Our Lifetime

Acclaimed screenwriter William Goldman (The Princess Bride, among many others) famously began his autobiography with three telling words: "Nobody Knows Anything."

The same logic would seem to apply to much conventional reporting of the financial markets. Any investor looking for informed analysis of market developments can therefore save themselves a few minutes every day by choosing not to read any of the 'Companies and Markets' section of the FT, which typically constitutes a fantastic piece of fiction.

(If there is a more thankless task in finance than trying to explain why certain markets did what they did yesterday, we don't know what it is... unless it's working in the PR department at Goldman Sachs.)

But as Soc Gen's Dylan Grice has frequently pointed out, human beings are suckers for stories. We seek meaning from just about everything, and financial markets are no exception. Why else would otherwise rational people shell out ~£2.50 every weekday just to read a selection of vapid and contradictory speculations about recent market price action?

At the risk of going out on a limb, here is our own inherently subjective "take" on the current market environment: Investors seem to believe that the euro zone debt metastasis has gone into remission. There is an uneasy calm to both equity and bond markets -- it feels like the calm before the storm.

Both Goldman and Barclays have issued research notes recommending equities over bonds. It is certainly difficult to get excited about G7 government bond markets except from the perspective of shorting them. As Stratton Street recently observed, there are over $10 trillion in marketable US government securities, yet their average yield amounts to less than 1%.

But it might yet be dangerous to adopt Goldman's binary response which is to advocate blanket support for stocks. This is not a black vs. white issue; just because most government bond markets are uglier than sin does not automatically justify going 'all in' on the stock market, even as deposit rates remain painfully thin.

We nurse an ongoing fear that equity markets are being largely supported by the inflationist antics of central banks. This may have led to many investors becoming addicted to the effects of cheap credit, and they may not like it when cheap credit is ultimately withdrawn.

But whatever is driving equity sentiment, there are undoubtedly pockets of value for those with the stamina and patience to embrace them. In Don Coxe's latest and typically excellent letter, "All Clear?", he highlights the opportunity in precious metals mining companies:

"If there were one over-arching theme at the BMO Global Metals & Mining Conference, it was that the gold miners are upset and even embarrassed that their shares have so dramatically underperformed bullion...

"On the one hand, they were delighted in 2011 when it was reported that since Nixon closed the gold window, a bar of bullion had delivered higher investment returns than the S&P 500 for forty years-- with dividends reinvested. But some gold mining CEOs find it an insult that what they mine is more respected than their companies' shares...

"In our view, we have entered the most favourable era for gold prices in our lifetime, and the share prices of the great mining companies will eventually outperform bullion prices."

Gold remains one of the most widely misunderstood assets in the investible world. Indeed, it may be better to refer to it as a means of saving that does not expose the saver to counterparty or credit risk or to the depredations of the monetary authorities.

As Don Coxe makes clear, governments are running deficits "beyond the forecasts of all but the hardiest goldbugs five years ago; central banks are printing money and creating liquidity beyond the forecasts of all but the most paranoid goldbugs a year ago."

The choice for the saver is essentially binary: hold money in ever-depreciating paper, or in a tangible vehicle that has the potential to rise dramatically as expressed in paper money terms.

Gold prices have now softened, offering investors yet another chance to get back on board what is perhaps the most compelling form of money- and portfolio insurance available.

Why large cap gold miners are being so undervalued by equity investors relative to gold is an open question that takes us back to the realms of stories. That the discount exists is undeniable; all that is required to crystallise that value, we believe, is patience.

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Central Bankers as The Chosen People

A couple of weeks ago, Dylan Grice at SocGen came out with a piece about how politicians use the time-tested strategy of "marginalize-then-brutalize" to turn blame for society's ills towards a small minority, thereby deflecting any responsibility.Viewing the remainder of this article requires a Subscription

Wall Street’s weekend LTRO conversation: Stealth sovereign bailouts

Analysts are questioning the "double-down effect" the ECB's LTRO exercises are creating in eurozone sovereign spreads. Citi notes a spike in the purchase of government securities since the initial take-up in December:

Perhaps more striking is this chart, which shows rising proportions of sovereign securities to total assets in the banks of peripheral countries that have been most prone to interest rate shocks over the last few years:

Sure, it might seem counterintuitive to gobble up the very sovereign debt representing such an existential threat to one's own capital base, but when one examines the effects that the LTROs have had on eurozone sovereign yields, it seems reasonable to assume that is the ECB's plan and we will just have to live with it. As Citi puts it:

As the EBA announced in February, that the next stress test will be in 2013, periphery country banks have the blessing of European regulators (and probably the active encouragement of their national regulators and other national authorities) to expand their holdings of domestic securities, and specifically domestic sovereign debt.

Jefferies chimes in Sunday evening with a brief history of modern financial repression, following on the same threads that Dylan Grice and Credit Suisse strategists explored last week. Did you know, for example, that between 1945 and 1980, there was only a single year when Argentina saw anything other than negative real interest rates? Jefferies summarizes a piece of academic research put out by the Bank for International Settlements in November 2011:

It appears that individuals forget that financial repression has been used far more frequently in the past, particularly in liquidating the vast debt accumulated by developed countries post the Second World War. Indeed, in the past, the US and UK have seen their debt ‘liquidated’ using negative real interest rates by 2% to 3% of GDP on average per annum. The US and UK did not use high levels of inflation to do so in comparison to other countries. Argentina holds the record with negative real interest rates recorded every single year but one between 1945 and 1980.

Secondly, the inflation rate may not necessarily need to neither be that high relative to history nor take markets by surprise. According to the authors, between 1945 and 1980, the average US and UK negative real interest rate was 3.5%. However, the average for Argentina between 1942 and 1980 was 21.4%.

What should be recognized here is that, irrespective of one's opinion on inflation prospects, one ought to consider the possibility that, if a central banker believes it can be done, a central banker will probably try to do it -- in fact, the decision might even be credibly backed by a study done by none other than the central bank of central banks, the BIS.

Here is what the process has typically looked like the past:

So, with the negative real-rate outlook as a backdrop, Jefferies finds the proper words to elucidate its views on last week's LTRO:

The ECB’s LTRO can be thought of as ‘a shadow QE’, in which the domestic banks support the ‘financial repression’ of their respective government debt. In effect, they have doubled down on their own government debt to rescue the country and at the same time themselves. Low nominal yields keep the governments solvent while the banks can earn a healthy spread between borrowing at 1% and owning government debt at more than triple that over a three year period. The scheme can work as long as the government does not default.

Morgan Stanley is running with the same theme on Sunday with a brief remark on LTRO, echoing the comments above:

With banks incentivised by the cheap loans and encouraged by their regulators and governments to load up on the bonds of their sovereigns again, they are actually becoming more vulnerable to the next sovereign crisis. Recall that the ECB’s version of QE, which we call indirect QE, differs from other central banks’ QE in an important way: there is no transfer of sovereign risk from the private sector to the central bank. Rather, the risk remains on banks’ balance sheets.

As noted earlier, the elevated dispersion in LIBOR rates could be indicative of data that doesn't jibe with the official story on post-LTRO sentiment in the European financial system. Soc Gen, however, thinks LTRO has provided more than enough liquidity to address funding stress:

The result from this exercise, which is more important than the actual number, is the fact that banks have taken up as much funds they believe they need. And that should ease any concerns about funding (banks face ?€320bn of redemptions in senior unsecured and government guaranteed bonds this year) or liquidity issues. Furthermore, it is likely that banks will look to use the funds for carry trades and the front-end financials look likely to benefit as was the case in December/January.

Indeed, there is a lot of buzz over the potential for carry profit the ECB has introduced with their LTRO programs. Here's a great example of a winning carry trade, courtesy of Citi:

Individual bank reports suggest that non-euro banking groups too used their euro area branches to tap the 3Y LTRO in February more than they did in December. If there was a large demand by foreign banking groups, and if the liquidity obtained in the LTROs by their euro area subsidiaries was channeled outside the euro area (and possibly swapped into other currencies), this would clearly undermine the stimulus of the 3Y LTRO for euro area companies and households.

However, the LTRO does not address any solvency issues or how much credit will flow into the economy as banks are still likely to reduce their balance sheets given the mediocre economic outlook.

Clearly -- but clearly, this isn't about "companies and households," unless by companies one means banks. Jefferies provides a perfect visual representation of the bottom-line effect an extra €1 trillion's worth of liquidity is having on markets. Not that it isn't already abundantly clear what happens as of late when a) central banks decide to open the pipes and b) try to stem the flow coming out of the fire hydrant, but this should drive it home:

LTRO has also been driving an impressive rally in euro credit markets, especially in new supply, which is booming. Soc Gen:

€35bn of non-financials issuance and almost ?€45bn in senior unsecured have made the opening salvo in the primary market quite fantastic. Almost every issue printed this year is trading tighter versus reoffer as the initial LTRO-fuelled rally works its magic and has the desired impact of boosting credit markets. Tighter spreads, lower new issue premiums and great demand have combined to keep interest at a high. Issuers are seeing lower funding costs and investors have their performance.

The going right now is so good, issuers should be striking while the iron is hot. High beta core premiums are now in single digit territory and we could expect peripheral corporate premiums to follow suit in due course.

Looks like the only losers here are the vulture types, who according to Goldman are concerned about "LTRO 2 potentially slowing distressed asset sales in Europe." Major bummer, but who knows -- they may find another buying opportunity coming their way at some point.

For those who especially appreciate well-placed double entendre in their sell-side research, Citi now believes it prescient -- based on more deductive reasoning on LTRO -- to divide the non-periphery eurozone countries into a "soft core" group and a "hard core" group (really):

Data from the Netherlands, where banks have increased their take-up from the ECB by more than 4 times between June and December 2011, confirms our view that the country has moved to the group of soft-core countries. In our view the only hard core countries are Germany, Luxembourg and Finland.

A final word from the Jefferies note on the shell game the ECB has been able to pull off with regard to collateral standards:

Investors should keep an eye on shifts in collateral since the injection of liquidity has been done against very lenient collateral standards. Although the ECB could easily engage in further LTRO tenders, in our opinion it would not be in the ECB’s interest to continue to adopt a laissez- faire policy towards the collateral it accepts. One way for the central bank to keep the LTRO in place but reduce its systematic risk would be to tighten collateral standards. This would be a modest ‘risk off’ bet for markets but might not get noticed initially.

Filling your head with euro dreams... @dailycollateral

No, Dylan Grice Did Not Say Germany’s Unwillingness To Print May Lead To The Rise Of Another Hitler

A few weeks ago, SocGen's Dylan Grice released a piece which quickly became a scathing focal point in the inflation-deflation debate, in that he speculated that it was not the Weimar-unleashed hyperinflation (which incidentally is the primary reason why most Germany now dread what the outcome of a profligate ECB would look like) that led to the surge of the Nazi party, but in fact the opposite: the stinginess of German monetary authorities in the 1930s that further exacerbated the situation and helped unleash the Hitler juggernaut. Many promptly took sides in the argument, the bulk of which were shocked that Grice - traditionally a defender of prudent monetary and fiscal policy, would go so far as suggest that it is the ECB's duty to print or else it may justify another "Hitler"-type advent. Well it seems there was more than meets the eye, and in a follow up piece the strategist says: "The purpose of the historical analysis, therefore, was not to reach conclusions about how adherence to hard money principles will linearly lead to resurgent fascism, or war on a par with that seen in the 1930s. Neither was it in any way a defence of Keynesian fiscal activism. It was to illustrate that adherence to even the best principles must come at a price, making a judgment on whether or not that price is prohibitive or not is unavoidable, and today Germany and the ECB have to make that judgment." And his conclusion: "From the beginning of this crisis I've believed the only way politicians will get ahead of it is to bring in the ECB. Since I believe politicians do want to get ahead of it, I expect the ECB to print, and print copiously. I've repeatedly emphasized that printing will solve nothing, beyond buying market confidence for a while... All ECB printing will do is buy the politicians time and space to reset government and private sector balance sheets, to reform how their economies function and be honest with their own citizens. Whether they use that time or not is a separate question (frankly, I'm not hopeful)." But instead of us putting words in Grice's mouth, here is the explanation straight from the horse's mouth. Incidentally we agree 100% with Grice on the issue that eventual printing is inevitable. Which for the TLDR crowd means the entire Grice missive can be summarized as follows: 'buy gold.'

From Dylan Grice:

My point was that there is always a price. Today, the price of Germany and the ECB holding on to their hard money principles is a possible break-up of the single currency. But both have signalled that they won't pay that price ("if the euro fails, Europe fails"). So my conclusion was that since Germany's stance is logically inconsistent (it wants to hold onto its principles but it doesn't want to pay the price), it will ultimately be forced to choose. My prediction was that it   will sacrifice its principles. The three broad criticisms I got from readers were:

  • My history was factually wrong
  • My analysis was simplistic
  • In suddenly urging the ECB to print, I was a hypocrite

Let's go through each one in turn.

Complaint #1: Grice’s history is disgraceful and wrong

One common response to my thesis was that "fear of inflation" had nothing to do with Germany's decision not to devalue. In fact, the key factor was the  foreign debt Germany owed to the Allies. A number of you replied with this criticism, but the following was my favourite.

“Just read Dylan Grice's case that Reichsbank's hard currency policy helped the Nazis to power in 1933. I am amazed that SG would allow such Germanophobic historical crap to be published under its name. Unbeknownst to your strategist, the Allies set Germany's monetary policy back then. His paper is a disgrace.”


Irate Reader 1

Fanmail, eh?! To be fair to Irate Reader 1, foreign debt was an issue. According to Adam Tooze [See "Wages of Destruction: the Making and Breaking of the Nazi Economy" by Adam Tooze], then American President Herbert Hoover was leaning very heavily on Germany not to devalue because he was concerned about the value of American loans to Germany. But to say the Allies were setting German policy is quite an exaggeration. According to Tooze, the UK was very keen on Germany following its policy of devalution, while the French were offering them cheap refinancing credit. Keeping America onside was deemed by Germany - rightly or wrongly - to be in Germany's best interests.

Of course, the logic that said Germany couldn't devalue because devaluation would merely lead to an increase in the real debt burden is flawed, because the alternative policy of deflation also leads to an increase in the real debt burden (because the debt was denominated in gold). What Germany needed then, as various countries in the eurozone need today, was to default, plain and simple. So if Irate Reader 1 and those who made the same point are correct, the parallel with today is ironically even more acute. Then it was the US forcing an overindebted country into depression rather than allowing it to default; today

Germany is doing the same thing.

But as it happens, it's just not correct to claim that fear of inflation had nothing to do with Germany's decision to deflate rather than devalue. According to a speech given by then Reichbank president Hans Luther in September 1931:

“People point to the fact that inflationist countries receive a premium on exports as their costs have not adapted themselves to the depreciation of their currency. All that is true in itself: we have, indeed, experienced it ourselves. But have we not also experienced what follows? Have we quite forgotten that this advantage is only present in the first stage of inflation, and that as soon as costs and prices catch up the premium on exports vanishes … Then there would certainly be a demand to create a new “first stage” and so on. For this reason there is no question for us of a carefully controlled dose of inflation.”

At the same event, then-Chancellor Bruning said:

“Conditions in Germany, however, are very different from those in Britain. No people that has had to endure, as Germany has, the ghastly experience of such inflation, can tolerate a fresh blow, in times of the greatest uncertainty and fear, to confidence in the future of their savings.” [The Economist, Oct 3rd 1931, page 613 for both speeches]

If that's not fear of inflation driving a deflationary policy, I'm not sure what is. As for the charge that my observations were Germanophobic ? I think that implies that I'm blaming Germany for their depression, or even for what followed. But I wasn't (and I don't as it happens). I'm not interested in blaming anyone for what happened. Sometimes things just happen. I am just trying to understand why and how.

Complaint #2: Grice’s history is simplistic

Another common complaint was that I wasn't doing justice to an historical event with complex causes. One client wrote:

“Although a nice story it is more a fairy tale. Society/human nature/markets/economies are too complex to go back and say what would have happened. It’s futile anyway; you can’t do anything about the past but learn from it. And Dylan doesn’t.”


Dismissive reader

But I thought it was best summarized by a reader's comment on the write-up of my original piece on the FT's excellent Alphaville site:

“This is hideous historicism and statistical manipulation leading to grand and sweeping conclusions. This is the worst sort of shamanism!”

Shamanism?! I actually looked up shamanism in the dictionary and found it had something to do with the American-Indian religion. I think he meant charlatanism. Anyway, these readers were frustrated that my treatment did not do justice to a highly complex phenomenon. Why was I so sure unemployment was the decisive factor behind the Nazi rise, as suggested in the chart below?

If professional historians who have devoted their entire careers to the study of Hitler's rise to power cannot agree, how can a four-page investment strategy report? And anyway I wasn't attempting to provide the definitive answer. The fact is we don't know and we probably won't ever know, because we can't ever know what the single major cause was, or even if there was a single major cause. That's why I wrote.

“… how different might history have been if the Germans had inflated their economy when the crisis broke? It’s impossible to say.”

But what seems obvious to me is that the misery caused by yet another German economic crisis combined with uniquely German circumstances (e.g. the humiliation at Versailles, a 15 year decline in living standards, a calling into question of the liberal economic doctrine of boundless growth) drove demand for  a new belief system capable of explaining the world around them.

So I find it highly implausible to say that the depression - which I proxied with the unemployment rate - had nothing to do with that demand, and that it was merely coincidental to political radicalism. If we accept that the depression was one factor, it follows that anything weakening the intensity of that depression would have lowered the probability of the Nazis gaining power. And if we accept that an inflationary policy would have mitigated the intensity of the depression, the thought experiment and any logical conclusions derived from it seem perfectly valid to me.

Complaint #3: Grice is a hypocrite calling on the ECB to print

This was actually a slightly puzzling one for me, as I thought I'd made my position clear. But I couldn't have been because quite a few of you raised the same objection. As (another) irate client wrote:

“Your hypocrisy is astounding. After preaching about the evils of money printing, you now join in with the chorus, squealing for the ECB to ride to your rescue by bailing out your bankrupt employer!”


Irate Reader 2

Or another good one from the Alphaville readers' comments

“I find it quite entertaining how so many people who have been blustering and soap-boxing about the importance of hard money and criticizing money printing, quickly ‘go soft’ when their policies are actually in danger of being enacted. Grice being a case in point.”

This is not what I said. I argued only that Germany's principled stance exacerbated its depression and served the Hitlerite cause. If we all agree that serving the Hitlerite cause was a bad thing, then we presumably also agree that a willingness to compromise its principles would have been a better thing.

I found this not only interesting, but challenging too, because the corollary is that there is no such thing as an unbendable principle. This might be an uncomfortable observation, but that doesn't make it false. If a principle is unbendable it ceases to be a principle. It instead becomes a rule. And I agree with Doug Bader, the British WW2 fighter pilot, who said “rules are for the obedience of fools and the guidance of wise men.”

The purpose of the historical analysis, therefore, was not to reach conclusions about how adherence to hard money principles will linearly lead to resurgent fascism, or war on a par with that seen in the 1930s. Neither was it in any way a defence of Keynesian fiscal activism. It was to illustrate that adherence to even the best principles must come at a price, making a judgment on whether or not that price is prohibitive or not is unavoidable, and today Germany and the ECB have to make that judgment.

I categorically did not recommend that the ECB or Germany go down the printing path. What I actually wrote on page 4 was this.

“ … whether or not Germany wants to do that is its decision. To be clear, I’m not recommending any particular course of action and offer no comment on what I think they should do. I’m only trying to understand what I think will happen … it is entirely rational for them not to sanction an ECB funding of a bail-out … if they’re so fearful of the dangers of playing fast and loose with the credit system. I don’t blame them for that at all. Central banks’ over-willingness to play such games in recent decades has been instrumental in creating the overleveraged world we live in today.”

As a general principle, I don't make policy prescriptions. I don't believe my view on what should be done is particularly relevant to investors. The world is full of opinions about how the world should work, and how it should be run. Does it really need another one? I don't think it does, but to bend a principle (!) for the sake of clarity, here's what I think should happen. I think the ECB shouldn't get involved. I think it shouldn't sanction any ECB funding of the ESFS either. I think it should tell governments who made this mess that they can fix it. It should say, "If you want a central bank that prints money when things get tough go and launch your own currency using your own central bank and print until your hearts are content."

But then, I'm not emotionally attached to the euro, or Germany's popularity in Europe. And I think the ECB and Germany's politicians are. Nor is this a new idea on these pages. It is a position we've taken since the crisis broke. On 27 May 2010, after the very attempt to ring-fence the peripheral eurozone economies, I wrote a piece called "Print baby print" in which I said the following:

“Today, the ECB is buying insolvent eurozone government debt which it is promising to sterilise. Yet they face the same stark calculus faced by their Anglo-Saxon cousins in 2008. You can only worry about the economy's ‘price stability’ if the economy hasn't already melted down! So here's my prediction: they won't sterilize, and the [QE] program will expand.” [See "Print baby print -? emerging value and the quest to buy inflation" Popular Delusions, 27/05/2010]

From the beginning of this crisis I've believed the only way politicians will get ahead of it is to bring in the ECB. Since I believe politicians do want to get ahead of it, I expect the ECB to print, and print copiously.

I've repeatedly emphasized that printing will solve nothing, beyond buying market confidence for a while. Ultimately, I believe the eurozone's structural problem is its government-heavy, over-regulated, anti-entrepreneurial welfare model which I believe is broken. In client discussions I've drawn the parallel between today's uncompetitive eurozone, with the unrealistic social promises it has made to future generations, and Detroit. All ECB printing will do is buy the politicians time and space to reset government and private sector balance sheets, to reform how their economies function and be honest with their own citizens. Whether they use that time or not is a separate question (frankly, I'm not hopeful).

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