Anatomy of the End Game

by Martin Sibileau

About a month ago, in the third-quarter report of a Canadian global macro fund, its strategist made the interesting observation that “…Four ideas in particular have caught the fancy of economic policy makers and have been successfully sold to the public…” One of these ideas “…that has taken root, at least among the political and intellectual classes, is that one need not fear fiscal deficits and debt provided one has monetary sovereignty…”. This idea is currently growing, particularly after Obama’s re-election. But it was only after writing our last letter, on the revival of the Chicago Plan (as proposed in an IMF’ working paper), that we realized that the idea is morphing into another one among Keynesians: That because there cannot be a gold-to-US dollar arbitrage like in 1933, governments do indeed have the monetary sovereignty.
Is this true? Today’s letter will seek to show why it is not, and in the process, it will also describe the endgame for the current crisis. Without further ado…
After the fall of the KreditAnstalt in 1931, with the world living under the gold-exchange standard, depositors first in central Europe, and later in France and England, began to withdraw their deposits and buy gold, challenging the reserves of their respective central banks. The leverage that linked the balance sheet of each central bank had been provided by currency swaps, a novelty at the time, which had openly been denounced by Jacques Rueff. One by one, central banks were forced to leave the gold standard (i.e. devalue) until in 1933, it was the Fed’s turn. The story is well known and the reason this process was called an “arbitrage” is simply that there can never be one asset with two prices. In this case, gold had an “official”, government guaranteed price and a market price, in terms of fiat money (i.e. schillings, pounds, francs, US dollars). The consolidated balance sheets of the central bank, financial institutions and non-financial sector looked like this before the run:




And like this after the run:

Indeed, those who claim that today is different and make the dangerous case that “…one need not fear fiscal deficits and debt provided one has monetary sovereignty…” refer to this crucial difference in the balance sheet of the central banks then (i.e. in the ‘30s) and now:

And they are right: There cannot be any arbitrage, because there is no real asset to exchange fiat currency against. Only fiat vs. fiat (i.e. currency vs. government debt). But does this mean that the governments have monetary sovereignty? Does this mean there will not be an end game? I don’t think so. We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis. The key to understand how this will occur lies in focusing in the shadow banking system, rather than the banking system. In the universe of shadow banking we do not back fiat currency with real assets, but we provide sovereign debt as collateral to obtain the fiat currency necessary to establish positions in the commodities markets.

Some preliminary details

Our first assumption is therefore that the debt of the sovereign that issues the world’s reserve currency is repudiated. We can think of many events that would trigger that reaction: A monetary policy of the Fed that continues to enable fiscal deficits (something that already Jacques Rueff explained in the ‘30s) or the coming burst of the European Yankee market bubble (i.e. US dollar denominated debt issued by European corporations). Whatever the reason, the repudiation will have an impact in the repo market, which finances positions in the commodities markets.
Consider a trader in the commodities futures market. To finance his trading activity, he pledges collateral in the repo market, and receives cash. The collateral is often US sovereign debt and those supplying the cash in exchange for it are money market funds, under repurchase agreements. This secured financing entails the actual exchange of ownership, title on the collateral, which is “warehoused” in the balance sheet of the “lender”.
With the funds, the trader enters into a futures contract in the commodities market, but facing a central counterparty (clearinghouse). The trader has to post an initial and a maintenance margin. While the futures contract is in place, the trader (and his counterparty, the clearinghouse) will have an unrealized gain or a loss. As long as the contract is on, the trader will have to adjust the margin according to the gains or losses. At maturity of the contract, the trader can settle in cash or by delivery. At a consolidated level, however, there has to be a delivery of the commodity, at an auction, for the market (usually not higher than 1% of contract settlements). In the end, the trader must repurchase the collateral it had given to the money market funds, at a price equivalent to the principal plus accrued interest (i.e. repo rate). Below we show these steps in a chart, with real samples of how a hedge fund would show these transactions in its financial statements:

The End Game

Now that we are familiar with the steps above, think what would happen, if the US sovereign debt began to be repudiated, just like the debt of Italy or Spain. At the beginning, the repo rate (i.e. the interest rate charged by the money market funds) to lend to the commodity markets players would increase, making trading in commodities futures more onerous. Immediately after, however, liquidity would disappear as those investing in money market funds seek only short-term exposure with minimum risk. As well, given that most central banks hold US sovereign debt as reserves, one would expect an increase in global concern and a flight to safety in real assets.
With the rise in the cost of funding (i.e. repo rate) and the rise in commodity prices, it is to be expected that one trader short of a futures contract may suffer substantial losses. The increase in counterparty risk or the increase of a failure by a central counterparty (i.e. clearinghouse) would jump. And I think the jump would be so significant that even the delivery of physical commodities at auctions would be at risk.
The failure of a central counterparty is not new. In 1974, the Caisse de Liquidation failed on margin calls defaults associated with sugar futures contracts. In 1983, the Kuala Lumpur Commodities Clearinghouse crashed on palm oil futures and in 1987, the Hong Kong Futures Exchange clearinghouse failed also due to futures contracts, in equities.
Should a scenario like the above unfold, the Fed would likely be forced to intervene, inter-mediating between the money market funds and the commodities futures market. It could do so by issuing its own debt to money market funds (or any lender in the repo market) and using the proceeds to enter into repurchase agreements with traders in the commodities markets. The chart below illustrates this scenario:

Let’s take a close look at the balance sheet of the Fed, once it enters the repo market. A few observations are relevant:
a)      The Fed would now fund positions in the commodities markets
b)      Operationally, the Fed would probably mark the repoed Treasuries to model, not to market. Like the European Central Bank does today with Greek or Spanish bonds.
c)      The Fed would not “print” money. They would simply raise funds from the shadow banking system by issuing its own debt. Therefore, they would have to pay an interest rate high enough to entice money market funds to buy it.
d)      The Fed would not be able to “refuse” US Treasuries repoed. It would have to buy all the US Treasuries offered in repurchase agreements at their “marked-to-model” rate. But the money market funds could refuse to lend to the Fed, if a market rate is not offered.
And here is the catch, because in order to raise US dollars from the shadow banking system, the Fed would have to pay a higher rate than it would charge for its repurchase agreements. Otherwise, there would be no need to intervene the broken repo market, to start with!

And what would traders in the commodities markets do with the “cheap” financing provided by the Fed? Why, buy gold among other real assets!
 

This would constitute a much worse scenario, than the laughed at arbitrage that Keynesians so proudly say today is not possible, from fiat currency to gold.
Under this scenario, the rest of the world would get their hands on the reserves of central banks (i.e. US Treasuries) to dump them in the Fed’s balance sheet via the repo market and recycle the US dollars it obtains with money market funds, to receive Fed debt! (See chart below). In the process, the rate the Fed would have to pay to raise US dollars from the shadow banking system would have to spiral, sending a wave of bankruptcies across the US dollar zone, including the Yankee market. The Fed would be forced to increase its currency swaps and at the same time continue doing unlimited quantitative easing. The currency swaps would be extended to delay the inevitable defaults in global US dollar denominated bonds and the quantitative easing would be necessary because, given the high interest rates and defaults, even with austerirty, the fiscal deficits would continue, as tax revenues fall driven by the collapse of activity.
And now, the cherry on the top: How would the Fed cover its net interest losses, between its debt and the US Treasuries it would repo? By issuing currency!! This quasi fiscal deficit would lead us to double-digit inflation and if left unaddressed, would end in hyperinflation. The process would end when the US dollar loses its status as a global reserve currency, a status that the Fed would seek to defend at all costs, repoing Treasuries in the commodities futures markets.
 

Final comments

For the sake of intellectual honesty, I want to end this exercise laying out the main assumptions:
The first and foremost critical assumption is that there will be a repudiation of US sovereign debt. The second assumption is that this repudiation will break the repo market enhancing counterparty risk in those markets where the funding is sourced from the repo market. I think these two assumptions are reasonable and the spike in the price of gold to $1,900/oz was in my view triggered first by the speculation and later by the confirmation of the downgrade to AA+ of the US credit rating by Standard & Poor’s. It has also seemed very curious to me that since that moment, and in a very strange way, the gold market became more volatile, with violent triggered sales, on no relevant news (But this is pure speculation, only proper to myself, of course).
The third assumption is that the Fed would intervene in the way I suggest. And this, indeed, is more debatable. It is certainly not the only way the Fed could act. There are other “versions”, but this is the more likely in my opinion and others have led to the same results, in other countries at other times (refer for instance, the “Cuenta de Regulación Monetaria” implemented by Argentina in 1978, where the central bank paid a subsidy on interest-bearing deposits and cashed a penalty on chequing accounts). Also, bear in mind that if this scenario unfolded, nobody would want to take the other leg of the long futures contracts on commodities (for instance, by 1981, the central bank of Argentina had to absorb and finance a loss $5.1BN in foreign exchange swaps from failed counterparties, refer Communication “A” 31 (May 6^th, 1981).  At the end of 1982, this loss was estimated at $10BN), converting the markets into a one-way ticket to high inflation: The link between forward rates, commodity prices and inflation expectations would be lethal!
Finally, the fact that US policymakers have been busy lately trying to regulate money market funds is to me an indication that I am not alone with these concerns. After a failed attempt by SEC Chairman Mary Schapiro to regulate money funds, on November 13^th, the Financial Stability Oversight Council put forth new recommendations to regulate the industry. Of course, some of these recommendations (see “minimum balance at risk”, on page 6 of the document) do not apply to Treasury money market funds, because US sovereign debt is not risky, right?
Martin Sibileau

Martin Sibileau graduated from the Universidad de Buenos Aires in 1997, with a BA in Economics. He holds a Masters in Finance from the Centro de Estudios Macroeconomicos (Buenos Aires, Argentina) and a Masters in Business Administration from the Richard Ivey School of Business (Univ. of Western Ontario, London, ON, Canada).

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.