At the risk of further alienating readers, we’re going to push ahead with the idea that the world needs energy and will have to keep getting at least some of it from hydrocarbons like oil and natural gas. Every time we broach this subject it costs us readers. We get nasty emails and unsubscribe requests in droves. It’s bizarre.
But unless you want to wind back the clock on modern civilisation by about 600 years – and there ARE some people who, if they could, would make it so we all lived on farms and lived in cold, dark, huts and took orders from the king/parliament – you’re going to have to find energy. But wait!
Yesterday we put together, via StockCharts.com, a picture of what the oil price is doing now. We were looking for evidence that oil is not correlated to the broader market. This idea of having assets that are not correlated is the basic idea behind the “Permanent Portfolio“. In the absence of a worldwide credit bubble, different asset classes like stocks, bonds, cash, real estate, and commodities move in an unrelated fashion.
But the one-year chart of Brent Crude oil that you see below shows that the oil price made its 52-week high in early April and has made lower highs and lower lows ever since. We generally leave the technical analysis to Slipstream Trader Murray Dawes. But in this case, we drew what looked like a clear channel showing the price action and noted that the price is trading above the 50-day moving average but below the 200-day moving average.
Click here to enlarge
We’ll ask Murray what his take is later. Our take is that the oil price is down about 15% from its highs just like the All Ords are. By all appearances, oil has not “decoupled” from stocks. For our shale stock recommendations, then, the big catalyst for higher share prices is not going to be higher oil prices and a global recovery. It’s going to be something else. What?
Well, if it’s going to be anything, the big catalyst for the shale shares will be the establishment of a large resource and then the demonstration that it can be produced safely. Our strategy has been to select “bi-hydrocarbonic” companies that produce oil but are exploring for large unconventional gas resources.
We made that term up, of course. Although it’s borrowed from “polymetallic” miners who can generate cash flow from one metal (say, copper) in order to explore for a higher value metal like gold or silver. There are energy companies in Australia that are producing oil from the Cooper Basin and using the cash to finance exploration and drilling for gas. It’s a nice combination.
Incidentally, the ICE December Brent Crude oil contract traded up to $115.23 per barrel in after hours trading in London. That’s an eight-week high. It means the price closed outside the channel we created on the chart above. Is it a false break out? We’ll ask Murray and keep you posted.
Now, to correct an error from last week. Last Wednesday we mistakenly reported that 10-year Italian bond yields were trading at a 45 basis point spread to 10-year German bunds. The real spread was 450 basis points, or about 4.5%. The bad news is that it’s gotten worse.
Italy’s bonds have taken centre stage on financial markets. What’s at stake is whether Italy enters the feedback loop that ensnared Portugal, Ireland, and Greece. Once bond yields went past 6.4% in all those countries, they reached a kind of tipping point where investors lost confidence that those governments could ever repay their debts.
Ten-year Italian bond yields reached as high as 6.68% yesterday. That was 491 basis points higher than equivalent German debt. It’s not far below 7%, either. According to the Wall Street Journal it took Portugal’s yields 45 days to go from 6.5% to 7%. Irish yields did it in 34 days. Greek bonds did it in a day.
Bond traders call it “cliff risk“. A simple way to think about it is as a feedback loop, where rising bond yields lead to a collapse in confidence, which leads to more rising bond yields. The whole thing feeds on itself and accelerates. And in the government bond market, it appears to happen when 10-year yields go past 6.4%.
There are a few reasons for this. The simplest reason is that the interest paid on new government debt gets prohibitively higher beyond 6.4%. Government bonds are supposed to be “safe” because the government can always raise taxes to pay off bond holders. But a yield of 6.4% or beyond indicates the opposite: government bonds are not safe and may not pay off at all.
There is also a more complicated explanation related to a feedback loops. A feedback loop is a system in which the output of a system – in this case bond yields – is affected by the input to the system – in this case investor sentiment. A “positive feedback loop” takes place when the inputs reinforce the outputs, sort of like when you hold a microphone too close to an amplifier and get a horrible high-pitched wail.
The Financial Times reports that Italian bond yields over 6.4% could trigger one such positive feedback loop in the bond market. Please note that “positive” is not used in the qualitative sense here. It’s used in the sense that the inputs promote the same output at an accelerating rate. The FT writes that:
One such feedback loop involves margin requirements, or payments that must be made to counterparties when the price of bonds used as loan collateral falls. On Monday, there were growing fears that these margin payments could lead to a further downswing in the markets.
This is because banks often use their vast portfolios of government debt as a financing tool, lending the bonds out into the repo market to generate a return. These repos are run through central clearing houses, which will clip some of the bonds’ value, or “haircut” them, according to the riskiness of the debt being repoed.
The higher these so-called margin requirements, the less return a bank can make from lending the bonds. If haircuts become too high, banks may choose to sell off their bond holdings, sending yields and spreads over benchmark debt such as German Bunds even higher. That, in turn, could lead to another rise in margin requirements, and so on. It was just such a loop that helped push Ireland towards an international bail-out last year. If Italian yields stay at current levels, then it becomes vulnerable in the same way.
This gets us back to the inconvenient fact that much of European bank capital resides in government bonds. If government bonds fall in value, bank assets do too. And in this case, banks can no longer use bonds as collateral for further borrowing. This reminds us of China, where borrowers are using stockpiled copper as collateral for loans from the shadow banking system.
Is the world addicted to leverage or what?
The only prudent people left in Europe are the Germans. They knocked back the idea of using Germany’s gold to boost the borrowing power of the European Financial Stability Facility (EFSF). “German gold reserves must remain untouchable,” said German economic minister Phillip Roesler. This will disappoint the Chinese.
The Chinese might be interested in helping Europe bail out its banks. But we reckon they’d only do it if the collateral for the loans was something like, say, German gold. As it is, the communist Chinese seem to have a pretty good idea that socialist Europe is not only financially bankrupt, but perhaps morally so, in an economic way.
Listen to Jin Liqun speaking to Al Jazeera. He’s the supervising chairman of the China Investment Corporation, China’s sovereign wealth fund. He says Europe’s problem is that its incentives are making people lazy:
If you look at the troubles which happened in European countries, this is purely because of the accumulated troubles of the worn out welfare society. I think the labour laws are outdated. The labour laws induce sloth, indolence, rather than hardworking. The incentive system is totally out of whack.
Why should, for instance, within [the] eurozone some member’s people have to work to 65, even longer, whereas in some other countries they are happily retiring at 55, languishing on the beach?
This is unfair. The welfare system is good for any society to reduce the gap, to help those who happen to have disadvantages, to enjoy a good life, but a welfare society should not induce people not to work hard.
What do you reckon he’d say about Australia’s welfare society? Do punitive and redistributive taxes create an incentive for people not to work hard? Or for businesses to stop trying to create a profit?
Finally, a note in response to yesterday’s suggestion that Greece should leave the euro and default on its debts.
You were suggesting that Greece should quit EURO, go back to drachma and be then , after devaluation, in a better condition to reimburse its debt.
It would be useful that you do not write silly remarks.
If Greece quits EURO to Drachma then the weight of its debt would EXPLODE as it is reimbursable in EURO.
You’re right, of course, if Greece is forced to repay its debts in euros. The whole point of leaving the euro and returning to the drachma is for Greece to restructure its debts completely, which includes denominating them in a currency that Greece controls. That way, the Greeks can restructure and reschedule the debt in drachmas and then print money to pay it off.
Why would Greece’s creditors accept this? Well, 20 to 30% of something is better than 100% of nothing. Both Greece and Italy have highly unstable political situations. It will be difficult for a government to stay in power if it promises austerity, asset sales, and years of economic contraction.
In other words, the political winds are shifting in Europe. It makes more sense for Greece to leave the Euro than stay in it and accept servitude to the ECB and IMF. Greece can then focus on reducing its debts and becoming competitive. Will it do so?
Shucking the euro requires shucking the idea that you can get something for nothing. In the first 10 years of currency union everyone was happy. The poorer European countries got access to credit on easy terms. This fuelled housing booms and government spending booms, in which borrowed money was redirected to favoured industries and political constituencies (a lot like Australia). The richer European countries enjoyed a huge competitive advantage in manufacturing and exported their goods within Europe’s common market for huge profits.
The result was the accumulation of huge and unpayable debts in some European countries. And meanwhile, staying in the euro virtually guarantees that countries like Greece can’t compete with countries like Germany. It’s a recipe for continued impoverishment.
The Europeans seem hell bent on following this experiment through to its fully centralised conclusion: a Europe where all national finances are federalised in Brussels. They are either too arrogant or too stupid to see what a colossal impossibility this is. But it will be fun to watch them try.
And what could all this mean for gold? That’s what we’re going to talk about at next week’s Gold Symposium in Sydney. In the meantime, our friend Alan Kohler wrote a great article yesterday at Business Spectator on the subject. He’s kindly granted us permission to republish it below.
Revenge of the Golden Days
By Alan Kohler
Europe is heading inexorably towards the monetisation of Italy’s debt via the European Central Bank. This means the price of gold will spike again.
The failure of the G20 meeting in Cannes over the weekend to either boost the IMF or come up with a new global monetary system was hardly a surprise. It was merely another manifestation of the paralysis that has gripped international politics all year – in fact ever since the glorious days of crisis in 2009, when the G20 became a sort of asylum seekers’ boat to a new world of cooperation.
Of course no one is more paralysed than Italy’s buffoonish prime minister, Silvio Berlusconi, who is engaged in a kind of genial, cheerful inaction as he sits on a ticking nuclear device – debt at 120 per cent GDP and bond yields over 6 per cent.
But it would be wrong to personalise the Italian predicament too much around him: Italy has been governed by a different coalition almost every year since WW2. Does anyone really think it is more capable than Greece of imposing draconian austerity on its people?
Berlusconi will not last much longer than Greek prime minister George Papandreou, but that’s hardly the point. The collapse of his government will change nothing.
Economic growth sufficient for Italy to escape its debt trap is a pipedream. Its economy has expanded at an average of 1 per cent a year for the past decade and it would need to suddenly more than triple that merely to stabilise debt at 120 per cent of GDP.
Italy has the lowest birth rate in the world, behind Japan and Hong Kong, and is one of the few countries with a higher death rate than birth rate, so a solution based on growth is out of the question.
The IMF could theoretically lend Italy money but it doesn’t have enough at the moment and there was no enthusiasm in Cannes to give it more simply so it could replace French and German banks as Italy’s banker. That’s not what the IMF is for.
In any case, the only country with enough cash to do this is China, which would have to sell large quantities of US bonds to do it and thereby bankrupt its largest customer to prop up a country that buys from its main competitor – Germany. Unlikely.
The recent EU summit talked about leveraging the European Financial Stability Fund to buy Italian (and Greek, Spanish and Portuguese) bonds. The summit resolution said this would require money from “private and public financial institutions and investors”.
But none of them have enough. Europe’s banks are under-capitalised and are being forced to reduce their balance sheets to get their capital ratios up. Hedge funds are shorting Italian bonds, not going long. Germany is not interested, the United States can’t, and China won’t (see above).
That leaves the ECB. The new president, Mario Draghi, all but ruled out monetisation of Europe’s sovereign debt when the ECB cut interest rates last week, but this stance cannot last. The ECB is the only institution capable of standing in the bond market and buying unlimited quantities of Italian bonds.
With its memory of hyperinflation between 1921 and 1924, during the Weimar Republic, Germany will be the last to agree to this, and will continue to press for “internal devaluation” (deflation) in Italy as it has been in Greece.
It’s one thing to impose devastating austerity on Greece, but quite another to do it to Italy. As Ed Harrison of Credit Writedowns wrote last week, the eurozone is really just a giant vendor financing scheme for Germany: is it really going to send one of its largest customers into default, with catastrophic consequences for its own banks as well as its exports?
In fact, an Italian default would be catastrophic for the world’s financial system generally, and will be avoided at all costs.
It was probably always going to turn out like this. That is, with both the United States and Europe monetising their debt and sending the world’s owners of capital scurrying into gold – effectively producing a de facto return to the gold standard.
There was no way the debt-funded golden decades following the end of Bretton Woods in 1972 could be paid back via global deflation and depression. It was always going to be done through inflation.
Alan Kohler is the Editor in Chief for Business Spectator and founder of the investing focused membership publication, Eureka Report. As well as his nightly appearances on the ABC news as the finance presenter Alan frequently writes for the ABC. Alan is considered to be one of Australia’s pre-eminent business writers and most trusted business and investing focused columnists.