Irish Mortgage Brokers Blog

I hope you enjoyed the first round of economic history from 2008 to 2011, I think it is time for round 2.

Alan Greenspan was on CNBC last week and his interview is a very interesting take on Europe - which happens to be the first thing he looks at every day (European Bond Markets). Meanwhile Lloyds are reporting that the risk of a 2nd recession in the UK are higher at c. 25-30%.

Greece is the crisis that just keeps giving, The Telegraph has the usual Eurosceptic line but it isn’t about being smug any more. The Greek referendum call of recent days came out of left field and while it may never actually occur the political optics show that the Aegean issues are far from solved, along with the replacement of military officials (the interpretation being the fear of a coup).

And German joblessness is higher for the first time in 2 years, standing now at 7%. The rate of inflation in Germany is currently 2.6% (HICP at 2.86%), having remained over 2% since January 2011. The issue with that (and unemployment that wasn’t growing) is that it lead to a ‘Goldilocks delusion’ where not cutting rates and fiscally conservative policy was considered best. It seems now that Germany has not decoupled from the rest of Europe.

Growing resentment about profligate EU members along with some fear inducing inflation as well as rising unemployment make for a very grumpy Germany, it does not bide well for negotiations. Perhaps hindsight will equally not bide well for the Germany that handled the Great Recession so well (from an employment perspective) either?

Of course at home here in Ireland we are about to pay €700,000,000.00 to speculative/junk rated bond holders who in any normal circumstances would be jumping for joy at a 50% haircut. Politicians are walking out of the Dail due to the lack of discussion, and bingo halls being raided by cops [irrelevant but a sign of the times!].

The Central Bank of Italy (Banca d’Italia) €-Coin ‘one figure for all European GDP’ statistic is also showing a sharp down-trend at present, negative for the first time since September 2009. Italy, with the worlds 3rd largest debtor at €1.9 trillion Euro, and winner of ’scary chart of the day’ almost every day regarding their bond spreads v.s Germany.

I don’t know of any model that can capture and create metrics out of the information flying around at present. There are interesting twitter based investment tools that use crowd sourced information to imply the trajectory of the markets, but I’m not privy to being under the hood on those.

What I am trying to say is that all of this news doesn’t paint a pretty vista, and in this analysts opinion the October/November 2011 period will be another big turning point or cusp. I last made a call like this in January of 2008 (and while it seemed grim at the time it was understated in retrospect), and during that time I went entirely to cash and advised all of our private clients to do the same until late 08′ early 09′.

Today I am repeating that call - to stay out of the markets for a while and see what comes of this all. You might miss out on the Spring 09′ moment, but you won’t face the burn on the road that gets you there. The news flow is simply too negative at present for confidence to go any other way than down, capital preservation remains key.

Until Central Banks step up to the plate (and it our long held belief that they must and will -they are already our lifeline) with the multi-trillion multi-lateral approach there is no reason to do anything other than earn interest.

Our friends over at GoldCore made this video, we are really impressed, well done!

We are not issuing bonds, so the cost of servicing our debt has not magically risen to ‘7%’ because we are not borrowing at that rate, what is happening is all in the secondary market.

What that means: The primary market is when the bond is first issued at par (100) and with a coupon (for instance 3%). When a bond is issued the main concern of a bond buyer is getting your capital back (that par value of 100) and it trumps the yield in terms of importance, so you regularly see people buy debt at very low rates from those most likely to pay it back, Microsoft recently issued a bond at 0.8%!

That is where the Ireland story gets interesting, our bond yield is not 7% because we issued it at that yield or interest rate, it is 7% because people are sacrificing their capital to get out of the trade. That means they don’t believe they will get their money back at the end and because of it they will take a loss today rather than carry on and potentially take a greater loss later. You also have a timing issue in which the ‘dirty price’ means you can almost break even (as if you only earned 0% interest - not bad in a world of deflation).

When you buy a bond you pay the seller their accrued interest, so if a bond pays coupon once a year (we’ll assume at 4%) and you buy half way through the year then you pay the seller 2% plus the purchase price (100) giving you a total of €102, this is just for an example. If sellers are getting out of a trade because they fear Irish debt then the accrued interest is part of the deal, and that means they might be selling at 96 but being paid 4 as part of the accrued interest and therefore they are in effect getting out of the trade having made no interest - bust most importantly - having protected their overall capital.

Ireland is being punished on the secondary market, this is newsworthy, but not reflective of definite action because we are not currently issuing any debt. The secondary market is the proxy for the primary but until next year we don’t have set prices on how much it will cost at that point to raise money.

To yield 7% it would mean that a bond yielding 3% historically would be trading at around 96.26 [103/107], because the actual interest rate isn’t changing, rather it is the capital value which is changing. It’s like a see-saw, if yields go up on one side, the prices are going down on the other, if yields are falling the capital value is rising.

The final thing affecting Ireland is the flight to safety, peripheral countries are not in vogue and because of this investors are piling into the Bund, the true benchmark. Why is it the true benchmark? Well, they don’t look at the Irish/French spread do they!

Proof of this additional problem is in the German 30yr Bund, trading c. 131! That is a near unheard of 31% appreciation in the CAPITAL value of the bond! It issued with a coupon of 4.75% but now that has been compressed down to 2.9% this shows that investors are willing to spend €31 over and above the face value to get a yield of 2.9% because they believe fully they will get every coupon payment and their €100 back at the end of the term.

In a nutshell, Ireland is facing twin dilemmas, on one hand we have a credibility crisis causing capital values to plummet and yields to rise, but on the other there is an international flight to safety (in the US it is happening on the TNotes and TIP’s markets) making everybody who isn’t Germany look less attractive, inflation would perhaps give an appetite to investors to get into riskier assets, for bond investors this could mean a return to Irish debt (they don’t often substitute with equities), and gold prices along with the likes of the previously mentioned TIP’s make a compelling case for this, the mention of QE2 - which is only one policy option there are three or four more - will perhaps create this dynamic.

For now however, our yields will not change the cost of funding our debt, its all secondary market and therefore our costs are fixed in servicing it for now - it will be the auction next year that matters, all the noise at present is merely pointing out that we could be ‘headed’ for trouble at that auction, it doesn’t mean we are already there.

Caveat as always: the interpretation of the budget and a credible turn around plan are what will make or break our efforts to avoid going to the EFSF, so for now its a wait and watch story.

We have been talking about this for a while (28/01/09, 11/03/09, 23/04/09), it was a popular topic on this blog in 2009 but well covered and for that reason we have not revisited it much, but the alignment of the stars warrants a look at the symptoms of the disease because now they are ever more present than before. At this point we can see a clearer path; which is still leading to a bond bust destination.

It has also becoming a mainstream topic, recently it showed up in an article titled ‘Currency, the weapon of choice in a world of lower demand‘.

If something can’t happen it won’t, and what can’t happen is a world in which we see century bonds (bonds with 100yr terms) becoming commonplace, they will probably be (as is the benefit with all hindsight) the poster-boy of the time when the bond market was in full insanity. To give an Irish context we can all relate to: property prices mid 2006, that’s where bonds are now.

Investors are not stupid, it could also be the case that we see a world of deflation and they will be able to sell these centuries at a profit, but when you consider the counter trends it doesn’t scream ‘deflation’ to the same degree.

Take a look at some of the offerings (signs):

Goldman Sachs 50yr bond issuance-longest bond issued in their history.

Mexico issued at century and it cleared. Note: ‘cleared’, and this is from the same country that suffered two currency crises and one sovereign default in the last 30 years!

Norfolk Southern - “NEW YORK (Dow Jones)–Norfolk Southern Corp.’s (NSC) reopening of its 100-year bond, first issued in March 2005, has launched at 5.95%, inside price talk of 6%, according to a person familiar with the sale. The sale has also been upsized to $250 million from original guidance of around $100 million”. So they not only issued a century, but they more than doubled the debt issued and it was ALL bought!

Rabobank also issued a 100yr bond. It’s great that they have a triple-A rating (today) but in 100 years will that still be the case? This is a bank let us not forget, and anybody who can see 100yrs out in banking is either a liar or deluded.

They said on their company site that “Until now only a few rail roads and power stations have conducted a bond issue of this type. It’s a real confirmation of the strength of the credit, and obviously, it’s borrowing 100-year money at historically low levels,” I’d go a step in the other direction - it’s a sign that investors are yield hungry and making mistakes, the market doesn’t lie but it equally doesn’t create winners only - time will tell but when a bank issues and clears a 100yr bond it means something isn’t right.

TIPS trading negative 0.55% - this is a bond that has inflation protection built in, it is a proxy for inflation expectation in the same way that gold is (more on that later). People are literally willing to buy in at a loss in order to get that insurance. That is a sure fire sign that inflation is expected

History is interesting, in 1910 nobody was backing the Wright brothers, they were backing the makers of airships, yes, airships, the same craft which spawned such maxims as ‘lead balloon’ and ‘it’ll fly like a lead Zeppelin’, and some awful tragedies as well such as the Hindeburg Disaster, a lot can change in a year, never mind 100 years! The hunt for yield is relentless, but at the same time you have these inflation indicators screaming out (TIPs & Gold) so somebody somewhere is going to get badly burned.

Inflation? Yes, it will be artificial, because QE will bring it about, the latest approach seems to be a currency play-ground tactic along the lines of ‘if you print a trillion then I’LL print a trillion too!’ . Sad but true, and it is being done both as a competition and for competition.

Gold, yes, the boring metal of a decade ago that is now back in the halcyon vogue it enjoyed in the late 70’s. Will it last (this time)? Comfortably trading over $1,300 the difference now versus then is the structural movement of the metal. It isn’t to say this trend can’t die, but it is a slower build up, and broadly in line with the massive increase in money supply that has been a hallmark of the last thirty years.

When the bond market falls it will fall ugly, even on the municipal bond front, the stalwart of private investors, there is trouble brewing, recently Meredith Whitney authored a 600 page report titled “The Tragedy of the Commons” stating “Municipalities receive one-third of their revenue from the states. If the states hold back that money for their own stricken budgets, towns and cities won’t have the funds to make their interest payments. “It has to happen,” says Whitney. “The states will secure their own shortfalls, and leave the cities to fend for themselves.” It’s all about inter-dependency, she says, with the federal government aiding the states, and the states funding the last and most vulnerable link, the municipalities”.

Combine that forecast with the fact that the insurers who (apparently) back it up are no longer high investment grade material, The public finance market no longer has a triple-A rated bond insurer. Bond Buyer lead with this story yesterday - “Standard & Poor’s on ­Monday downgraded Assured Guaranty Ltd.’s two insurer platforms to AA-plus with a stable outlook from AAA with a ­negative ­outlook. Stock in the parent company fell 8.3% to $19.52, but response in the ­municipal market was muted”.

So if things go wrong, their assurance is about as good as the mono-liners who backed sub-prime mortgages! Everything is falling into place for a proper bond market blow out. It doesn’t have to happen, but when all of the dominoes are in place it would be stranger if it didn’t.

“Contradictions do not exist. Whenever you think that you are facing a contradiction, check your premises. You will find that one of them is wrong”, Francisco D’Anconia to Dagny Taggart in ‘Atlas Shrugged’.

I see it as one of two possibilities, either the dollar is in secular decline in value or gold is a bubble. Either opinion has valid arguments, what are your thoughts?

In this video Toby Birch of Guernsey Gold talks to CNBC about Islamic Finance, Toby is a worldwide respected expert and practitioner on the topic of Islamic Finance.

This is the video taken at the Radisson Golden Lane in which Kevin O’Rourke of TCD delivered a talk about ‘The Great Depression to the Great Credit Crisis, similarities, differences and lessons’. It is a great video, well worth watching if you weren’t able to attend the event.

Kevin O’Rourke talks to CFA Ireland 26th Nov 09′ from CFA Ireland on Vimeo.

While we are bullish on precious metals (in particular silver) it is important to remember that many commodities are dollar denominated assets and for that reason they will often appreciate if the dollar weakens, this happens with oil, and it is currently happening in gold (see chart below).

The recent gains in gold are at least in part due to dollar weakness, price gold in euro or loonie and it looks relatively flat for the last seven months in which historic nominal highs were tested. Low carry costs and future inflation risks are in that mix as well, however, in the respect of an inflation hedge gold is still the master metal and silver has good upside potential as well. That doesn’t mean caution can be thrown to the wind in expectation of gains, although physical demand is up a reverse in financial gold plays could happen swiftly and undo much of the current range in a few days trading and for that reason holding metals should be (as we always advise) part of a play or portfolio and not THE portfolio.

Gold prices broke the $1,000 mark again and have been hovering around that mark for some time (today’s spot price is $991.91), this is making headlines as people comment on ‘record highs’ that the metal has reached in nominal terms (no inflation factored in), if you adjust for inflation the current price would need to be c. $2,500 to match the $850 peak reached in January 1980.

The Dow/Gold ratio is currently 9.7 historically during a crash you would see gold prices surge, the peaks in the graph below are the low points of gold prices/high Dow, and you can see that in the past (c. 2000) it would have taken 40 oz of gold to buy the Dow, the historic average was around the 5 or 6 oz mark which would mean either the Dow is overpriced or gold is under priced, a ratio of c. 6 would put gold at a price of $1,605 (Dow at 9630) and at 5oz would price gold at $1,926. The hidden aspect of the whole equation is that of inflation, by viewing prices relative to gold prices it tends to strip out some of the market trend linked to inflation.

Given the historic issues mentioned thus far, it is (in my opinion) fair to say that gold is not excessively overpriced, or perhaps even overpriced at all.

But this was a blog meant to be about silver?! Yep, its about silver, but with the historical importance of putting gold in perspective in order to make the point which is this: Silver probably has higher upside than gold in 2010.

From the time of Alexander the Great, through the life of Jesus, and until the end of the Roman Empire gold was priced at c. 12 ounces of Silver. During the bi-metalism era the ratio was c. 15 and the average over time is around 16, so irrespective of prices at the time, historically if you have 1 ounce of gold you can buy 16 ounces of silver with it and vice-versa, it actually correlates to the amount of silver and gold occurring in nature that comes out of the ground at extraction. So hopefully you are seeing why the price of gold is so important now?

There are basically two situations at hand, either gold is wildly over priced or it is not, and if it isn’t then the gold silver ratio of 62 (silver trading at c. $16) means that there is a sizeable upside on the price of silver - using the more recently historical average of 50 (approx) would put gold at a price of $750 and there are few in the market (even amongst precious metal doomsday commentators) that would see gold trading at those levels any time soon after such continued resistance at levels over $900, and thus we have a compelling argument for the upside in silver, because, unless ‘this time it’s different’ then the ratio needs to revise to mean.

If hypothetically gold lost half of its value and went to $500 (dow/gold or gold/oil ratios aside), the traditional gold/silver ratio of 16 would assume a price of $31 which is about double the price today - but the return of that ratio is only likely if we re-enter a 70’s style stagflation economy (and in that event gold would likely push higher in any case).

Silver historically has a tight correlation with gold and while the long term historic trend was a SGR of 16 the reality is that for many years it has steadily been more in the 45-55 range which still implies a silver price of $18 which would still represent a 13% gain if the range is met at 55 (which is more the more conservative figure).

Interestingly, many mining companies use the 55/1 ratio in valuing their non-primary extraction: so a primarily gold mining company will value its silver finds at 55/1 and a primarily silver mining company will do the reverse for any gold they extract converting its by-product gold into the cash equivalent of silver ounces.

This still bides well for silver even if gold stays at the current level, however, if you are still bullish on gold and expect to see it at $1,200 within the next year then it would imply (at worst) a SGR pricing of silver at $21.80 which is a 36% upside on silver versus at c. 20% upside on gold. The other thing that happens when gold runs strong is that silver sometimes goes over value in tandem with it, in 1980 the SGR was 17 when gold hit a high, if that happened today silver would trade at $58! That is a bit too ‘pie in the sky’ for my personal liking, but silver trading somewhat regularly over the $20 in the next year isn’t.

The point is simple, silver may currently be the better metal of the two most well known nobles to get involved in. It also doesn’t hurt to consider some past performance (although we prefer to concentrate on future upside!).

Silver has actually outperformed (in Dollar or Euro) every other comparable in the graph above over a five year period in both $/€ and also in the 1yr range and it only loses out to oil in the YTD. (many thanks to Dublin based GoldCore for the figures!).

To actually buy silver you can do it one of several ways, you can buy certificates, bullion or coins, we’ll do another post sometime explaining the various processes, you do need to be careful of VAT liabilities depending on how you proceed, if you can’t wait for that post and want specific answers you can always call us of course.

The fact that so many Irish investors totally overlook precious metals is a shortcoming of our investment community, precious metals have a proven record of maintaining their value in the face of any contingency, and responsible portfolio design should include some level of exposure to precious metals, if yours doesn’t then you shouldn’t question your adviser, you should question your choice of where you obtain your advice, you don’t have to master every aspect of the investment world, but if you are paying for advice either directly or via management fees then there is somebody out there who is paid to do that and you should at the very least be given the option and argument for precious metals.

Here is a simple question: ‘how do you protect or even augment your portfolio returns when markets are crashing or where there is systemic risk?’ if you have an answer then you can be a little smug because the majority of fund managers, the best and brightest the world of finance has to offer, for the most part didn’t have an answer during the last two years and if they did they didn’t (by and large) act upon it.

The classic definition of a hedgefund is not the ponzi-schemes run by the likes of Bernie Madoff, rather it was a fund that strategically goes long and short to produce positive gains regardless of whether the market goes up or down, that was what Winslow Jones was doing when he started the first hedge fund in 1949, while managed fund managers are happy to post a 20% loss when the averaage is -30% (for instance), hedgefund managers are meant to be able to outperform bull markets but also post positive returns in bear markets, sadly, many hedgefunds in the last few years weren’t even hedged! They were basically long only equity funds that liked to charge high commissions based on returns which were largely posted due to excessive leverage!

How did that work? Well, a fund starts off with €100 and then they go and borrow €900 so now they have €1000. If the market goes up 3% they make €30 which looks like a 30% return on funds invested if they pay back the leverage (borrowings) but this is false economy because if prices don’t go up funds get margin calls and then they are often coupled with problems of not being able to ‘roll-over’ their borrowings, repo markets [to a degree] have the ability to stand over any fund once in a 24hr period but in many cases this mechanism failed as credit providers lost confidence in repo-borrowers.

It is worth taking a moment to understand the ‘repo’ market, it doesn’t mean ‘repossessed’ rather it means ‘repurchase’ because what happens is that collateral is given up overnight in order to obtain operating funds, if this doesn’t happen, for instance if your counter-party doesn’t trust your collateral or thinks you might not be able to repay tomorrow then you can literally be shut out in an instant and you close down rapidly, this is what happened to Lehman and Bear Stearns.

Back on topic, the way to ‘hedge’ is to include investments that have an inverse correlation to the broad stock market or to particular shares held in the fund. The Japanese Yen is an example of a currency that does this, when markets crash the Yen strengthens, since around August 2007 - where the first hit of the current crisis started to play into the market. Every time the market took a dive the Yen has risen.

Often when stocks crash institutional investors rush to cash out of their stocks and repay their Yen denominated loans (Yen was used due to its low interest rate), that is called the ‘unwinding of the carry trade’ which we have covered before - the ‘carry’ trade occurred where people borrowed in yen to leverage up because a ZIRP (zero interest rate policy) meant it was a good currency to borrow to the hilt with.

Gold is another hedging tool, the deeper the crisis got in the early days the faster gold rose, going over the $1,000 mark in 2008, since then it fell back to the low 700’s and is trading again in the 900’s, the part to remember is that gold has

There are beneficiaries of systemic risk and systemic collapse, the downside is that many investors are nowhere near a life raft when the ship is sinking. I like the analogy of the Titanic, you see, for all the history of tragedy associated with the Titanic, it must be remembered, there were also a lot of survivors, they were the ones who got onto the available life rafts.

Dollar hegemony or dollar supremacy is likely going to change significantly in the next decade, the transition will be difficult and will feed through to commodity prices and equities. So being ready for volatility is vital.

Publicly I said at the end of November that I saw real value showing in Irish banks, they were trading well below the €1 mark, they fell right down but came back with a vengeance, hence I followed up with a sell call in June 09′when the major bank shares in Ireland were trading closer to €2. It is important to have an exit plan whenever you get into anything (again, make sure you have access to that life raft!).

the thing to understand is that there is always a bull market somewhere, you just have to find it, sometimes that means using inverse ETF’s or shorting strategies (which can be done via options as well), or just going long in the right places, we hope you don’t lose sight of the desitination because of the current scenery on the journey! Wealth is built in small steps, one day at a time.