Wednesday, December 31, 2008

Time to Short the Government?

If you have been dumbfounded by the size of the ever-expanding federal deficits and crony bailouts, you are not alone. May be you are even more surprised at the low yields of the government paper: the on-the-run 30-year note dropped under 3% recently. In other words, there is someone out there willing to give Pelosi & Co. a 30-year loan for 3% a year.

Truth is stranger than fiction sometimes.

I passed on the deal when I got the call from the syndicate, haha. Remember the government does not have the money (by a long shot) that it actually spends on the budget, the wars, the bailouts and the stimulus. It simply enslaves the producers of future generations via higher taxation and/or a lower standard of living.

There are a couple of other (very basic) issues to consider with sovereign debt, and debt in general.

(1) One is that as a creditor, you do not want to lend to someone in their own currency. They can simply print it out and "pay" you nominally. This is the reason most of the second- and third world debt is dollar-denominated. The US used to have predictable policies but now it seems that the presses are running out of control. As a creditor holding dollar-denominated debt, I would be very worried.

(2) The second issue, quite basic (but as a nation we seem to have forgotten the basics in so many areas), is the 5-C's of credit: character, capacity to repay, collateral, capital and conditions (of the loan).
Do a quick mental rundown on these: character (the borrower cheats by printing own money, top politicians and administrators have questionable- at best- behaviors and IQ), capacity to repay (nominal, yes; real, not so much, deficits to grow structurally for the next 80+ years), collateral (none pledges thus far: think land, drilling rights, highways), capital (balance sheet of an extra large sieve, lots of liabilities off-balance sheet) and conditions (is the money used for something productive? absolutely not: government spending is inefficient by default, and most spending goes to "entitlement" programs; who entitled someone else to the fruits of the taxpayer labor is beyond the scope of this post).


Is the low-interest environment going to last? Probably not. How can an individual investor play this? There are two high-volume reverse ETFs for government bonds: TBT and PST. TBT 2x shorts the 20+ year instruments, and I like it better. The PST shorts 2x 7-10 year bonds. Both are listed under the "ProShareUltraShort" label of products.

If rates are going to rise (there is no doubt in my mind they will), the longer bonds are more sensitive to interest rate changes. Remember that they have longer "duration". A 10-year bond, with a 3% coupon and a 3% yield has a (m) duration of 8.6 yrs, and is priced at 100, of course. If rates go to 6% (not unthinkable), the price will drop to 77.7, if my calcs are correct, and the bond duration goes down to 8.2 yrs. I would guess that the index PST shorts has bonds of slightly lower duration.

If you have the same 3% yield/3% coupon payments on a 30-year bond, the (m) duration is 19.7 years, and the price is, again, 100. If the yield goes up to 6%, the price would then drop to 58.5 and the (m)duration would go down to 16.1 yrs. The price change in the index that TLT shorts 2x would not be as high as it does 20+ years, not just the 30-year.

If you have MS Excel, you can check those out yourself: =price(settlement, maturity, etc.) and =mduration(settlement, maturity, first coupon date, etc.). The quickest way is to do price( press shift+F3, and select the cells or fill-in.

What can go wrong? A lot, of course. A substantial market sell-off can really drive the yields down even further. This drives bond prices higher, and you get hit. Don't also forget that the SEC may decide to ban shorting bonds. I would not be surprised after the friends-and-family do not short list. Also if the Fed is a buyer, the real price discovery will be delayed. Just like with the price discovery on a lot of other assets. Then there are the issues with the 2x funds that are well-documented around the investment blogosphere. And, right now you've got deflation which means that the low rates might be around for a longer than most people think. And then there is the theory that as there are less inflows from Asia, the US consumer will start saving more and this will replace the demand. I doubt the last part: most will probably go towards paying down credit card debt. You can also have a move across the curve that is not parallel, meaning that the price change on the long bond can be smaller than that of the 10-year.

Tuesday, December 30, 2008

Opening Post: Thoughts on Inflation

You know it is coming. May be not next year but it will be here soon enough. So what is wrong with inflation? Many things. I am posting a video of a lecture below called "21 Evils of Inflation". It is a bit on the long side but does a good job explaining the many ways it harms everyone, including you.

What is inflation? In its basic definition, too much money chasing too few goods. There are a couple of components there, one is the amount of money (right now in the US, skyrocketing) and the second one it the velocity (basically, how much turnover there is; this has dropped). Eventually all the money that our government has been printing will find its way into the system. This is when you have to watch out.

Most Americans have not experienced rapid inflation firsthand. One needs to talk to Argentinians, Yugoslavs or Russians to get a first-hand account of what life is like once the rabbit is out of the bag, and the printing presses are in overdrive. Let me tell you, it is not fun. Check out the Argentina link below to get a sense of the complete societal breakdown that a hyperinflation brings. There is also the opinion that the Hungarian hyperinflation right after WWII was induced by the Soviets to destroy the middle class. And, for the history buffs, there is the story of SS General Bernhard Krueger (no, not the Kruegerrand gold coin guy) who was in charge of the Nazi's printing of massive amounts of British currency (and trying to put it into circulation) in order to destabilize Britain's economy: the work was done by people pulled from concentration camps. The book is called "Krueger's Men". Currently, you have the Zimbabwe dictator printing money (the same guy that turned a food exporter into a starving country by confiscating the white-owned farms). Hopefully you get the picture: printing money is rarely a good thing.

The main evils in my book: destruction of the middle class, added layer of risk and uncertainty, stealth or not-so-stealth taxation, distortion of economic information, favoring speculation over production, collapse in capital spending and other productive activities, corruption, crime, black markets, loss of civility and political instability.

What can one do?
I think that one should be concerned with real principal preservation in times of rapid inflation. There are several ways to do that: desirable hard assets (gold, gold coins, gold bullion, silver, oil, gasoline, firewood, firearms, ammo), consumable soft assets (wheat, rice, tobacco, canned food, alcohol, medical supplies), productive land. There is also a very high likelihood that your earnings power will diminish greatly and will take years to recover. There is also a high likelihood that simply obtaining basic necessities (food, transportation, medical care) will not be as easy as it is now.

Think what happens in price control situations.
If fuel prices get capped, fuel will disappear, so you can forget about any food deliveries or transportation in general. Imagine that: no fuel for ambulances and doctors not going to work because their pay buys nothing, or they can't even make the 15-mi commute.
If wheat prices get capped, wheat/flour/bread will disappear. Prices provide valuable information to the participants in the market, which includes producers (duh!). You can expect that there will be 0 acres of wheat planted, and everything will go to the non-capped commodities, if any are left. Now if farmers can't run the tractors because of fuel shortages, guess what is next.
Now mind you, price controls are very popular with the electorate. They always, always fail but it does not stop politicians from imposing them. Read up on Chavez in Venezuela, and how a country can be a major oil exporter at $100 per bbl, and yet have no milk or sugar in the stores. Fascinating stories come from there and Argentina, and, unfortunately, we seem to be following their playbook.

What asset classes am I leaving out?
(1) Stocks. Here and there you read that stocks are a natural hedge. Forget it. You do not know if the companies you invest in will be hit with price controls, or disproportionate inputs inflation, or labor strife, or who knows what other unforeseeable event. On top, the economy will likely crash in hyperinflation, taking many companies down with it. I would even stay out of food and energy stocks: nothing can prevent Congress from declaring a certain industry "strategic", Russia-style, and expropriating it, directly or indirectly.
(2) TIPs. The same entity that prints the money determines the CPI index. Enough said. Moreover, in high inflation, you'd need daily indexing. So forget TIPs.
(3) Cash and fixed income investments. For obvious reasons. Why anyone would hold bonds at this stage is beyond me.
(4) Real estate (ex-productive land). Not an obvious one. Real estate prices move in part with real incomes. Real incomes will crash down. Ditto for rent and investment properties. Rents might even be caped by the localities.
(5) "Objects": art, antiques, books, furniture, clothing, etc. They will have no value in a world where getting food is a challenge.
(6) Other currencies: this is very, very tricky. In "normal" hyperinflations, the transactions are often linked to a "hard" currency, the usually the dollar (Argentina/Lat Am, Russia) or the Deutsche Mark (across former Yugoslavia). Usually the hard currency is widely held and circulated. What can replace the US dollar in the US? Very few people here are accustomed to dealing in foreign currencies. All other major currencies (EUR, JPY, GBP) are likely to be devalued as well due to protectionism and deficit spending in each locale. The Canadian dollar? I do not know if there are enough to provide any utility on a large scale. Moreover, the loonie is too linked to the US. Which leaves barter, which is extraordinarily inefficient.

The video discusses "who wins" since society as a whole loses. The obvious answer is the money creator which can magically print the money to repay its debts. Debtors that are able to rise prices and still sell whatever they have should have a great time. People with insight as to what the printer will do next will win. People with foresight should make out ok. Diligent, responsible people with savings will lose a lot. Low-income people will lose whatever they have.


Further reading:
Overview
Weimar Republic
Argentina


The video from the American University in Bulgaria.