Why the US Government Would Be Bankrupted By Deflation

1. INFLATION IS GOOD FOR BORROWERS

Inflation benefits issuers of debt. This can be seen with the intuition that inflation makes each unit of currency less valuable every year. So in an inflationary environment, each dollar you borrow becomes worth less as time passes.

For an individual the link between your interest owed (mortgage, credit cards) and your cash flow (job, investments) may not benefit as quickly from inflation. Wages lag behind traditional metrics tracking inflation (CPI, PPI). For a business, however, the link is clear.

Suppose that you are CEO of Metal-Free Paper Clip LLC. Each year for 10 years the price of a paper clip has risen 10%. You have a great incentive to borrow to finance anything, because you can make 10% more revenue next year even if you sell the same amount of paper clips -- purely from inflation! So if you took a loan in 2004, each year inflation made it easier for you to pay your debt service.

2. LONG TERM INFLATION EXPANDS THE LIQUIDITY OF FINANCIAL MARKETS

When investors pour money into an asset, two things can happen. If the supply of the asset stays the same, then the price will rise. But if the price stays the same, you can bet good money that the supply has increased to absorb the new cash.

The latter is what happens every month in the market for US treasury bonds. We have already seen how exporting nations have huge incentives to reinvest dollar reserves in US government bonds. Since the price of these bonds (especially the shortest maturities) is not doubling and quadrupling every decade, we can be sure that the supply has been increasing. This can also be seen in the ballooning US national debt figure. That number is financed by government bonds.

The latest multidecade boom in world trade had set off a wave of inflation that made the US government bond market one of the most liquid in the world as exporting nations scrambled to reinvest currency reserves. This made it easy for our government to deficit spend and issue debt to make up the difference. All this debt issuance and spending further increased systemic inflation, which was fine with the government, since inflation benefits borrowers. Past debt could be repaid by an ever expanding market for future US treasury debt.

3. DEFLATION IS KNOCKING AT THE DOOR

The financial crisis has brought the prospect of a sustained deflationary environment closer to reality than it has been at any point in the post war period. This is frightening to those in government who are privy to our leveraged position. If world trade were to decline; if inflation were to decline; if the government bond market were to lose its increasing liquidity momentum, the government would be up sh@#$ creek without a paddle.

Deflation is good for debt holders. When prices are falling, they are promised a stable rate of return and preservation of capital. This is, of course, holding everything equal. If the debt you hold is US government paper and we continue our current deflationary cycle, then its bad for you too.

The government runs a gigantic ponzi scheme to finance its perpetual deficit spending. If the market for government bonds was to contract in a meaningful way, the government could go bankrupt overnight. This is compounded by the fact that the government went "all in" by using increased short term financing to retire long term debt. This exposes the US treasury to the same financing risk that took Bear Strearns out back by the woodshed.

2009 will be an interesting year. As with all declines, there will be wild switches made by consumers as their lives are affected. People will shift from ipods to food, with a million more switches to come as the recession deepens. This will provide opportunities for upside profit. But everything will be short-lived. We are still firmly in a deflationary spiral. Until government intervention takes hold, the case for a coming US currency/debt crisis is extremely compelling.

The Problems for Recovery: The Declining US Trade Gap

The US trade gap fell by 28% in November 2008. While this is a backward looking number, it is still horrifying. It means that the export economies of the world are under terrible stress. The US trade gap is the milk that sustains the infant economies that rely almost entirely on exports. Not that the US economy is supreme: it is an adult who is addicted to heroin. Our economy must get its fix of foreign credit or else the whole system will collapse.

This leaves the financial markets perilously close to the edge. The Chinese-American symbiotic liquidity cycle had analogues in Japan, South Korea, India, and all over Asia. This drove trade and cash flows between the US and many countries. Once US trading partners reached a certain level of economic sophistication, complex import-export linkages developed within the Asian ecnomies themselves.

This macroeconomic process drove the markets on the way up because it perpetuated rising asset prices. Higher prices meant more producers could profitably enter business. This led to increases in jobs, bank lending, and general economic activity. That in turn led to higher asset prices and so on.

The problem is that prices are falling, largely due to an acute global financial panic. This has thrown the feedback cycle in reverse. Falling prices put companies out of business. As firms consume less materials and labor (layoffs) money fails to reach places it used to. Retail firms fail and economies throw large amounts of workers into idleness. Ripples of failure perpetuate through the economy.

The only thing that can stop this cycle (maybe) are the governments of the world. Their actions are powerful, but take a long time to manifest. In the short term, a cycle of economic pain and destruction is unavoidable. 2009 may turn out to be a bad year.

But the rationale for an eventual recovery is compelling. The Federal reserve has engaged in stimulus policies that are unprecedented in the post WWII era. Ben Bernanke's rhetoric leaves no room for interpretation: he will do anything, including printing money, to avoid long term deflation.

This means that at some point the fed will go too far. Perhaps they already have. Prices will stabilize sometime in the next year or two. When that happens zero borrowing costs will inflate bubbles just by necessity. Someone will borrow for zero percent and lend for two percent, and the whole system will reflate.

The Treasury Bond Bubble: Yet Another Ponzi Scheme by the Fed

Image by Scorpions and Centaurs via FlickrThe chart below represents the iShares Barclay's 20-year Treasury ETF (symbol: TLT) which invests in long term US treasury bonds (20 years to 30 years). The price of this normally stable ETF rose nearly 30% from November 2008 to the beginning of 2009.

This explosion in value was due to the Federal Reserve's decesion to lower interest rates to a "range" of 0 to 0.25%. This action was taken in concert with large-scale buying of long term Treasury Bonds.

The Fed is essentially doing the largest refinance in history. The government is borrowing at 0% for three to six months and using the money to buy its own longer dated debt. This has the effect of raising long bond prices and lowering their yield (since in bonds, price and yield are inversely related). This lowers the government's long term borrowing costs. It all looks very good on paper.

The problem is that this strategy makes the Federal Reserve, US Treasury, and entire US gov't vulnerable to the same risks that brought down investment banks Bear Stearns and Lehman Bro's. These companies met their ends in large part because they relied on funding which had to be "rolled over" every three to six months. Sound familiar?

The government is doing the exact same thing. By relying on huge auctions of short term t-bills, the gov't is able to retire long term debt. But this short term debt comes due quickly, and thus must be paid back by selling new debt. This means that there has to be a long line of people willing to lend the government money at 0% for the forseeable future.

By relying on short term capital to fund the government, the Fed has begun the most desperate and risky stage of its intervention. This will either work a treat or lead to the comeplete unravelling of the financial system. There is no middle ground here, we stand on the pin-point of history. Either outcome will be spectacular.

The New January Effect: How the First Trading Day of the Year Effects Stock Market Volatility

The chart above shows why I will day trade the stock market on every first day of the year: the intraday volatility increases. Intuitively, the graph represents the amount (in percentage) that the first day volatility increases over "normal," which is defined as the average daily intraday volatility over the previous year. The first trading day affords an average increase in volatility of 0.52%.

Usually one has to try very hard to estimate when and where volatility will strike. But when you have a good idea of the timing of large price spikes your life becomes a whole lot easier.

Where the Next Bubbles Will Come From and How They Will End

One of the biggest problems with our current financial system is the fact that lower interest rates -- or the reasonable expectation of falling future interest rates -- encourages overinvestment. This inevitably leads to speculation and a subsequent asset price bubble. As Kindleberger states in his timeless "Manias, Panics, and Crashes" over trading through speculation will be followed by a "CONVULSION." Oftentimes this is some outside news factor that suddenly makes the boom model untenable.

In the case of the current crisis, the exogenous news factor was the pricking of another asset price bubble: the housing market. When ripples from the housing bust hit the banks of the world, it created a chain reaction. While our banks lost lots of money on their crappy mortgage exposure, their losses were dwarfed in magnitude by those experienced in the subsequent world stock market carnage. Some 30 TRILLION DOLLARS of wealth evaporated in 2008. But how much was made on the way up? Considering the current boom can be traced to the 1970's 30 trillion is just a drop in the bucket.

One lesson must be leaned from the thousands of years humans have used money and trade to lubricate their lives. Markets will have booms. Booms will lead to busts. But when the rate of interest is near zero percent: the urge to lever up will become too great.

Somewhere, sometime in the future, some trader at some bank will figure out that he can borrow from the fed for zero percent and lend for two percent. He will make a huge bonus and all his trader friends will do the same type of trade. The next year many traders will leave this bank and go to other banks and hedge funds. There they will tell tales of their trade, and they will borrow money at zero percent and lend money at two percent. Except when EVERYBODY does this, we will have another credit bubble.

The money lent out at 2% won't just sit in a drawer some where. It will be invested in some asset. If the speed at which money is being lent creates more money that needs to be invested than the supply of existing assets, prices will rise. But we can't use classical economics here. This is because while the supply of assets will certainly increase from bankers hocking IPO's and new bond issues, financial assets are not normal goods.

When a normal good or service rises in price, people consume less of it. When the price of a stock goes up, more people want to buy it. They see others making a killing and want a piece of their own. Likewise, when prices go down people sell more: they don't want to lose even more money. This means that credit bubbles become unstoppable reinforcing "virtuous cycles." These, of course, are followed by horrifying unrelenting market declines (vicious cycles).

Prices will stabilize. Money will be relent at too low interest rates. Money will be borrowed by firms and investors which will push up asset prices. More money will be lent. Some will go to increased demand for borrowed funds by speculators. They want to take advantage of rising prices. More money will be lent...

Oil Making a Bottom

I am in no way long. I'm not going long. This is in no way an endorsement to buy anything in this market. But I am going to call this a bottom in oil and most other commodities for at least 6 months. If i'm right: expect a huge rip off the bottom that is in no way sustainable.

How the Stock Market Works 2: Some Simple Statistical Arbitrage

So I'm gonna attempt to explain some statistical arbitrage (or stat arb, in the truncated parlance of the street). Depending on your experience level, your reaction to this post should range from "duh" all the way through "well uhh" straight through to the "what the fu..." Its OK, you're gonna make it, I promise. Just stick with it and you will come out a smarter person on the other side.

In finance, there are many assets which seem to be driven by the same process. The fate of a collection of oil companies will rise and fall with the price of oil. A parent company may make record profits only if its partially owned subsidiary company gets a new contract. Or it could be something as simple as company A owns a 20% stake in company B. For whatever reason, there are plenty of examples of how the price of two seemingly different assets are linked together. When an educated investor sees two stocks moving together, he should know that there is an opportunity for profit.

Asset prices that move in concert are known as "cointegrated." Although this term has a technical definition, the intuition is straightforward. If the price of an asset rises, we would expect the price of its cointegrated partners to be rising as well. If prices are not moving together, it is because of some temporary anomaly. Thus an investor can profit by buying one cointegrated asset and selling another.

In particular, suppose we have two related assets- A and B- and we observe A rising and B falling. The arbitrageur can then sell A and buy B. Now he has a "market-neutral" position. Theoretically he does not care what direction the market as a whole takes because he is both long and short.

The investor above is betting only that the spread between the two cointegrated assets will narrow (long and short at the same time is known as a spread) . This will occur if A decreases more than B decreases or if A increases less than B increases.

For example, suppose we're long 100 shares of B and short 100 shares of A. If the market increases, its likely that our two stocks will also increase. We will make profit if the money we make in one side of the spread is more than we're losing on the other. If A rises 2 points and B rises 2.5 points, we will have lost 200 on the short position and made 250 on the long position, netting out to a profit of 50 dollars. Else, if A rose 3 points, we would lose 50 dollars.

It is important to note that a trader can make a spread out of any two assets. You could go long gold and short gasoline for example. But it is the idea of cointegration that makes the above spread so powerful. If two assets are truly related, then the spread will eventually narrow, netting the stat arb a profit.

The risks are twofold. The first is that the spread will increase so much in the short term as to bankrupt the arbitrageur before the relationship returns to normal. This is a very real risk, especially if leverage is involved. The second risk is that the relationship will cease to exist. Perhaps company A dumped its holdings of company B. Maybe company A had a corrupt CEO who embezzled billions and takes the equity to zero overnight. Either way, the fortunes of the two companies could diverge quite strikingly.

On the whole, the cointegration trading described above is useful only for calm and stable markets. But risk profiles can be adjusted for any market. In a benign market, this strategy would seek small but frequent intraday returns. The stat arb would thus make alot of trades to capitalize off of low volatility in the size of the spread itself. In a crazy market like we have now, the number of trades would be cut down dramatically. Spreads have gotten very volatile, and opposing small moves could send one to the poorhouse. Waiting for spreads to widen significantly is the only way to implement this strategy in a high volatility marketplace.

What the Data Can't Tell You: Plucking the string of the market

Image via Wikipedia
So much time and effort has been placed in the pursuit of analyzing past stock market data sets to mine for statistically significant anomalies. This is a great process for determining what would have made you money in the past, but is lousy for predicting how the strategy will perform when large amounts of money are employed to capture the discovered anomaly. Oftentimes, especially in statistical arbitrage, the presence of one or two more large players can tip a once profitable strategy into a money pit.

The key to arbitrage is being the first or second to find it... and staying small. Scaling up a strategy is hard, but making small amounts of sure money is easy for those patient enough. Perfecting a stable of small but consistently profitable arbitrage strategies is the key to long term income.

A successful arbitrageur should be able to be both statistician and wildcatter. We must pluck the string of whatever market instrument we have assembled and listen to what sound results. We must model the interaction of our strategies with the market as judiciously as we derive the theoretical arbitrage itself. Otherwise, taking a strategy from theory to practice is impractical and useless.

This financial crisis has taught that even the most statistically inclined of us must have a sense of just going with the flow. Make a decision. See what happens. Go from there. Use the tools that have worked before but with new assumptions.

Sorry for the Absence

First of all I would like to allay fears that my buy the dips mentality has put me asunder. I mean, it would have, had I continued to follow a V-shaped recovery hypothesis that failed to materialize. As the crisis unfolded, it became clear that we were at the beginning of a prolonged period of economic change. As such, some serious revamping of my strategies was in order.

My personal trading has gone from directional to completely market neutral. I am no longer trying to make money on the market going in a particular direction. The market is sh#! and may remain so for much longer than expected. Thus arbitrage strategies (and the sure but small profit) take precedence over killing it on one side of the market.

I would not abandon the buy on the dips philosophy entirely. As this website points out, the traditional public sentiment indicator seems to be alive and well. This states that when the public is rushing to one particular side of the market, a smart trader had best be taking the opposite side of their trade. This chart shows that one could have used the google search traffic for the term "stock market" to time each major bottom we have experienced since Feb 2007. Pretty amazing to see it in action.

Sorry again for the disappearing act. My goal is to continue to provide quality content at a more reasonable pace. Keep it posted. Happy Holidays. Here's to a better 2009 for everyone!